China's yuan could challenge dollar role in a decade

A U.S. $100 banknote placed next to 100 yuan banknotes in a picture illustration taken in Beijing, October 16, 2010.

LONDON (Reuters) - Here's a bold prediction to feed Western worries that power is shifting inexorably to the East: China's yuan could overtake the U.S. dollar as the world's principal reserve currency as soon as next decade.

Beijing has been promoting the use of the yuan beyond its borders since 2009 to settle trade transactions. The resulting build-up of deposits in Hong Kong has spawned a thriving yuan bond market.

Internationalizing the yuan, also known as the renminbi (RMB), brings with it a host of financial and political benefits. Notably, it allows China to build up claims on the rest of the world in yuan rather than increasing exposure to foreign currencies, especially a dollar that it distrusts.

But the consensus has been that China, as is its wont, would tread gingerly. The ruling, risk-averse Communist Party would keep capital controls in place, thus retaining its grip over the exchange rate and interest rates but preventing the yuan from becoming a truly international currency.

Arvind Subramanian, a senior fellow at the Peterson Institute for International Economics, a Washington think tank, sees things differently.

"Chinese economic dominance is more imminent and more broad-based -- encompassing output, trade, and currency -- than is currently recognized," he writes in a new book, 'Eclipse: Living in the Shadow of China's Economic Dominance'.

Using an index of country shares in the world's gross domestic product, trade and net exports of capital stretching back to 1870, Subramanian calculates China is already on the cusp of overtaking the United States as the world's leading economy. On conservative assumptions, it will soon carve out an unassailable lead.

"By 2030, this dominance could resemble that of the United States in the 1970s and the United Kingdom around 1870. And this economic dominance will in turn elevate the renminbi to premier reserve currency status much sooner than currently expected," he writes.

Indeed, that time could come in a decade, based on the conclusion of prominent economic historian Barry Eichengreen that the dollar displaced sterling as the main global currency within about 10 years of the United States surpassing Britain as the world's dominant economic power.

A POLITICAL WAY OUT

In a telephone interview, Subramanian said the rise of the renminbi was not pre-ordained. Critically, China would need to scrap curbs on foreigners' access to the yuan for purely financial purposes; it would also have to win the trust of international investors by making its domestic markets deeper and more transparent.

Subramanian acknowledged that China's reformers were not yet winning the argument; Beijing remained wedded to a pro-export model that had successfully powered strong economic growth and thereby conferred legitimacy on the Communist Party.

But he said the costs of pursuing mercantilism were increasingly apparent: millions of Chinese factory workers lost their jobs when exports collapsed in late 2008, and inflation is rising in part because the yuan is being artificially held down.

Subramanian's key insight is that building on the current yuan liberalization experiment and eventually making the renminbi convertible would offer China's leaders a political exit from mercantilism.

"Exporters will be kicking and screaming when the exchange rate goes up, but at least the leadership can say 'look at the huge gains: we have the RMB eclipsing the dollar and the world's number one currency'. It seems to me that that nationalistic card they can play is a very important one from the point of view of domestic politics," Subramanian said.

Alicia Garcia-Herrero, chief emerging markets economist at Spanish bank BBVA in Hong Kong, agreed that the yuan could attain the status of a reserve currency, widely used by central banks and other official institutions, sooner than expected.

By analogy with Thailand and its currency, the baht, she said the yuan could become freely convertible even if China did not dismantle all its capital controls.

"If China avoids massive inflows it could happen within five years. Five years ago, you couldn't have imagined what has happened with the RMB bond market," Garcia-Herrero said. "The trend is very clear."

PLANNING FOR THE LONG RUN

In promoting the yuan's use overseas, China's leaders are seizing an opportunity to gain a foothold in Asia at the expense of the United States, Europe and Japan, all weakened by the global financial crisis, Garcia-Herrero said.

But she said Beijing was also making preparations for the distant day when an aging China, now the world's biggest holder of foreign-exchange reserves, would become a net debtor.

"If you have a reserve currency, the stronger your currency in terms of international use, especially official use, the better chance you have for others to lend you money. We've seen that with the U.S.," Garcia-Herrero said.

"That is the important lesson in the long, long run, and so you have to start well in advance."

In the meantime, China-watchers expect more and more of the country's trade to be invoiced and settled in renminbi.

Simon Freemantle and Jeremy Stevens, economists at Standard Bank, Africa's largest, believe 40 percent of Sino-African trade will be settled in renminbi by 2015. That would amount to $100 billion -- more than total two-way trade in 2010.

"China will start the program by targeting African partners which are destinations for sizable Chinese exports, regional heavyweights and have mature financial markets: first Nigeria and South Africa, then Kenya, and afterwards Angola and Ghana," they said in a report.

Rosy projections of the unstoppable rise of China, or of emerging markets in general, invite the objection that extrapolating past trends into the indefinite future is fraught with danger.

Subramanian duly laces his book with caveats but nevertheless concludes that the economic world in 2030 will be unrecognizably different from what it is today as poorer, more populous countries grow faster than advanced economies.

"A key message is that the dominant West will have to start readjusting to the new reality of relative but not necessarily absolute decline," he writes. "In particular, the economic dominance and hegemony of the United States will be under challenge from a rising China."

(Editing by Andrew Torchia)