Is the yuan overtaking the dollar?

The latest news on China to hit the headlines is “China has overtaken Japan to become the world’s number second largest economy”. In 2005, China's gross domestic product was around $2.3 trillion, about half Japan's economy. However China’s economy has more than doubled in just 5 years. The next hot questions are will China overtake the US economy and will the yuan become the most accepted currency worldwide? 

The answer to both those questions is –not yet! China’s economy will need to triple to catch up with USA economy. More importantly the Chinese currency will need to become a free floating currency. Only and only if the currency is allowed to trade and pride itself freely can it become a medium of exchange worldwide. 

As we can see in the last 5 years the GDO growth rates have averaged at a whopping 11.2% 

Will China let go?
The very basis of the China’s spectacular growth has been the control over the pricing over the yuan. This strategy has helped China keep their exports competitively prices against competitors and also imports more expensive, encouraging a “buy local” policy. 

The US along with other trading nations has been pressurizing China for a free float yuan to give it the right exchange value. In a recent US Treasury report, the Obama administration stopped short of accusing China of currency manipulation but it did say that the yuan was “substantially undervalued.” 

The yuan has touched near record highs in 17 years, after China’s central bank, the People's Bank of China (PBOC), raised interest rates for the third time in four months to curb inflation. China has been taking some baby steps toward an open currency. For instance, it has allowed some American companies to finance their China projects by selling yuan denominated bonds in Hong Kong. PBOC has also allowed Chinese corporates to use the yuan for overseas business ventures and acquisitions, subject to approval from Chinese regulators. Yi Gang, deputy governor of PBOC and head of the State Administration of Foreign Exchange, has said that China's capital account will be more open during the 12th Five-Year Plan, the national development strategy for 2011- 2015. 

As you can see the China’s foreign exchange reserves have been growing substantially. In 2007, the growth was 43.3%. The growth rates have thereafter slowed down, perhaps because of a larger base to expand on. 

China’s huge foreign exchange reserves are held mainly in American treasury bonds. A falling dollar is eroding the value of China’s huge dollar-denominated holdings. It is in China’s interest to move towards a fully convertible currency on capital account. 

By all indications, if China aims at being a dominant global player it will have to let go of its controls and give yuan a free float. 

A stronger yuan will work in India’s favor as it will make Indian goods and service more competitively priced in relative terms. Hope the world is able to crack this problem very soon or else we need to learn the game - 'play cheap'.

(The author is CEO, India Forex Advisors)