Three weeks ago, the International Monetary Fund (IMF) announced that the Chinese renminbi (aka yuan) would join a group of other currencies to comprise what’s called the SDR (Special Drawing Rights) basket. This led some pundits to speculate that this step was a sign that the renminbi would inevitably replace the US dollar as the world’s “reserve currency.”
Having reserve currency status is a big deal. Because the terms of the 70-year-old Bretton Woods Agreement basically made the US dollar the world’s reserve currency, the US essentially sets global monetary policy. Foreign banks, businesses, and governments have no real choice but to hold trillions of dollars to facilitate trading and settle debts.
In other words, reserve currency status creates a huge demand for dollars worldwide. And that’s a huge advantage for the US because it allows its government to build up enormous budget deficits, year after year, without eroding the value of the dollar or raising interest rates.
Without reserve currency status, the US would follow the path of every other country whose spending far outweighs revenues. Think of Argentina in the 1990s or Venezuela today. That’s what the US would look like if the dollar lost reserve currency status.
But there’s no sign that will happen anytime soon. The US dollar is trading at multi-year highs against all major currencies, including the renminbi. Its upward momentum accelerated last week when the Federal Reserve announced its first interest rate increase in almost a decade.
It’s true that China has put in place a number of initiatives that are a possible path to reserve currency status. For instance, in 2014, Russia and China agreed to settle debts in their own domestic currencies, cutting dependence on the US dollar. China has signed agreements with Singapore and the European Union providing for direct settlement of debts in renminbi, not dollars. And the addition of the renminbi to the SDR club means that central banks will start holding this currency as part of their reserves.