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10/11/21
Part Three In a Three Part Series On Digital Currency
In Part Two of our series on digital currency, we wrote about the emergence of Central Bank Digital Currencies (CBDC), virtual legal tender, issued by a central bank. Some have speculated that China’s issuance of a digital yuan could cause shocks within foreign currency markets, challenging the U.S. dollar’s role as the global reserve currency. Deeper analysis suggests these fears are overblown and that the dollar’s role in the global economy should remain intact.
What is a reserve currency?
A reserve currency is a large quantity of a specific currency held in abundance by central banks for the purpose of conducting international transactions and investments, as well as influencing exchange rates. Due in part to our large economy, the U.S. dollar has taken hold as the primary global reserve currency. Foreign central banks hold large quantities of U.S. dollar reserves in the forms of cash and Treasury bonds.
Sources: Blue Chip Partners with data from the International Monetary Fund. Data as of 16 August 2021.
As the global reserve currency, the U.S. dollar has a special advantage, known as exorbitant privilege. Exorbitant privilege refers to a handful of strategic benefits that the U.S. enjoys as a result of the dollar's prevalence. Because most foreign trades are priced in U.S. dollars, America is protected against currency crises that could arise from depleting reserves. Because many countries hold dollar reserves in the form of Treasury bonds, the U.S. can issue debt at a low price. The dollar’s reserve currency status also extends the impact of U.S. sanctions to any transaction involving dollars, empowering the country both politically and economically.
How could CBDC impact global currency reserves?
As more and more countries begin to pursue central bank digital currency, it can be expected that they will transition their currency reserves accordingly. Because of China’s first-mover advantage in CBDC development, some have speculated that the yuan will begin to take over as a global reserve currency; however, because of the economic differences between China and the U.S., it is unlikely that the digital yuan will be able to encroach upon the dollar’s share of global reserves.
The primary advantage the dollar has over the yuan is its stability, backed by the reliable and independent Federal Reserve. China’s central bank, on the other hand, is an executive department of its State Council, and as such, it maintains stricter control over the value of its currency. Through what is called a managed float, China’s central bank keeps its currency relatively fixed to the U.S. dollar’s value, in order to maintain competitive price levels. This makes the yuan a relatively unfavorable store of value for other countries, who would have to put their faith in a foreign government, rather than markets.
Even if China were to allow the market to set the price of the yuan, there are still strict capital flow controls that stymie the potential of a global capital market in its homeland. Primarily, the country takes measures to maintain financial control over enterprises. Among these measures are restricted lending and taxed capital inflows, both of which can impact the stability of the yuan. As long as China maintains a restricted capital account, their currency will be an unfavorable reserve option, even if they are the first to pursue CBDC. For the time being, the U.S. dollar appears to be well positioned as the world’s choice of currency.
Read more about Digital Currency here.
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