As trade within Asia becomes increasingly centred on China, it will start to make sense to denominate that trade in yuan. And since the yuan is already a good store of value, it will soon also become a medium of exchange. Once these conditions are in place, it will make sense to use the yuan as a reserve currency.
Whether the dollar will fall from its status of the major foreign reserve currency is one thing. Whether the Yuan will eventually become a major foreign reserve currency is another thing.
In recent years China has never been truly politically stable. Yes, the shift of power is quite stable (at least from what we see). Yes, there are not yet any major political or social upheaval that can be compared with the Tiananmen square protest occurred in 1989 or the current Arab Spring. However, the political and social problems in China is just being repressed which created the seemingly harmonic situation.
Chinese government's spending on maintaining social stability is even much higher than its military expenditure
And such spending is increasing continuously, despite the government's willingness to exand its influence in Asia-Pacific area (and ultimately the world) which requires great military power. This imlies that Chinese rulers consider its social instability to be an even greater problem (or challenge) than national defense. The arrest of Liu Xiaobo, Zhao Lianhai, Ai Weiwei and Wang Lihong further showed the China's instability, as the government arrests them for fearing that those discontent would gather together and create an upheaval. The serious corruption and the way the government handle the incidents such as the discover of problematic milk powder that contained melamine and the Wenzhou train collision showed showed the injustice of the government, which will increase people's discontent towards the government and will in turn makes the government to spend more on stability as well as repressing much on the sound of discontent, and again lead to people's discontent. If such spiral continues, it can lead to a great social and political instability.
Nowaday, China is similar to the Qianlung era of Qing Dynasty - economic prosperity, with serious corruption and great government spending. The corruption then has asorbed much of the prosperity and caused much social problem and social injustice, which lead to the decline in the emperor's power, and subsequently the fall of the emperor. Can the Chinese dictatorial/authoritarial government stop its corruption? According to Chinese history, corruption free cannot last long since the Qin Dynasty.
For the yuan to displace the dollar, China has to manage things perfectly and America has to screw up badly.
there is always a risk of a major upheaval in China. Yet China's policy touch has been quite assured—in contrast to America, which is on a seemingly inexorable path to fiscal ruin.
China's economic muscle is on its own enough to determine the yuan's victory over the dollar; and that the prestige that goes with issuing the world's reserve currency is a big enough prize to mean China will make the changes needed to ensure it happens. China is a big economy largely by dint of its population. It is not yet rich in terms of per-person income. It also faces a demographic turning point in 10-15 years' time. When Japan started to get old (at a point when it was a lot richer than China), the yen's challenge to the dollar started to fade too,
The reason why the Western currencies and especially the US Dollar have been reserve currencies in the global markets for years is not only because of their economic dominance. They have kept an open and transparent system for dealing in their currencies and have allowed market forces to control their pricing and need. The Chinese have grown to be an economic power house but their internal financial systems, state control over its economy and their secrecy make the Chinese Yuan an unlikely candidate to achieve reserve currency status. It is worth remembering that during the Cold War India & Russia shared bilateral trading which was linked to the Russian Rouble. That experiment did not stand up to the vagaries of the market when India started its path to liberalization. Similarly, the Chinese Yuan needs to be truly free floating with an open and transparent Chinese economy before it can become the lingua franca of global trade and economics.
10 years is a long time, over which much can change, but a reserve currency requires more than just trade and brings with it more baggage than just bragging rights. Being a reserve currency adds value, which means your currency is always overvalued from what it would be without that status.
The Chinese have always deliberately undervalued their currency to maintain a trade advantage. Perhaps some day they will want to pursue a consumer economy at the expense of being a manufacturing economy, but it is difficult to have the vision to imagine that change taking place.
No doubt China will become more and more important in terms of its economic clout and there will be a concomitant demand for transactions to take place in its currency. But, without a democratic process, an independent reserve system and a free and floating exchange rate the RMB will not have a chance of being the reserve currency.
Taking two exceptions the results are the same. 1) Popular revolution, democracy and independent reserve system put in place. Need approximately five years after the set-up to have the trust of the WW system.
2) Chinese government decides that it is in its interest. They claim an independent reserve system, the world buys the story, then first sign of issues China clamps down and all the suckers make huge losses never to trust the Chinese again.
In addition, this is not a one way affair. All WW countries rely on the USD. What other currency are they to use as a reference? The Euro? The Bolivar?!?
The ideal currency is one which has greatly diversified economy underlying it -- one with a deep and growing root system, and one stabilized by an extensive network of trading relationships. High and growing productivity helps too, as does sovereign wealth.
Sounds more like present and future China, and less like present and future America. Unless of course America cleans up its act very quickly.
China will only consider granting full capital-account convertibility to the yuan when it has reached its equilibrium level. Doing so prematurely would lead to a spike, and possibly an overshoot, in the value of the yuan. But if the yuan is made convertible only when it has reached its equilibrium level, it may no longer appreciate with certainty. Investors may be mesmerised by the yuan partly because it seems only to appreciate and never to depreciate. But, ironically, if foreign investors are allowed to buy and hold yuan, that will be precisely the moment when the future direction of the yuan becomes unclear.
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