It's no secret that China's economy has grown at a breakneck pace over the past couple of decades. It recently surpassed Japan's to become the second largest in the world and, if growth continues at its current pace, is set to surpass the United States' within the next two decades.
Given China's rising shares of global trade and finance, a number of experts are now suggesting that China's currency, the yuan, is on an inevitable path toward becoming an international reserve currency to rival the dollar. But one major reason suggests that it won't be happening anytime soon.
What makes a global reserve currency?
To attempt to answer this critical question, it's important to address what factors make a currency attractive as an international reserve currency. The two generally accepted prerequisites are widespread international usage and convertibility. But a few additional factors are usually important, as well.
Typically, an international reserve currency must be backed by a large economy that plays an important role in global trade and finance. Next, for investors like foreign central banks to want to hold large reserves of a currency, they need to have faith in the policies that determine that currency's value.
Third, reserve currencies tend to be freely traded and have a flexible exchange rate – one that is determined by the markets. Their issuing countries also tend to have open capital accounts, meaning that capital can flow in and out of the country's borders free of restrictions.
Finally, reserve currencies tend to be issued by countries with strong financial markets, as measured by breadth, depth, and liquidity. A reserve currency economy's financial markets should display a wide range and large volume of financial instruments, including instruments for hedging risk, and ample liquidity, as measured by trading volume.
While each of these points can be addressed one-by-one, let's take a look at the strength of China's financial markets, and why it may be an impediment to the yuan becoming a leading global reserve currency to replace the dollar.
China's stock market development
To be fair, China has made a number of strides in developing its financial markets. The country's equity markets have gained international prominence in recent years, surpassing Japan's domestic stock market in terms of total market capitalization in 2009 to attain the world's number two spot.
The Shanghai Stock Exchange is currently the sixth largest stock exchange in the world by market capitalization. In 2010, it registered a trading volume of around 386 trillion yuan (excluding foreign-exchange transactions), which represents a tenfold increase from 2005.
As this rapid progress suggests, China has highly ambitious plans to convert Shanghai into a global financial center. The country's leading economic planning authority, the National Development and Reform Commission (NDRC), has targets in place that aim to nearly triple Shanghai's 2010 trading volume by 2015. They also have plans to allow foreign companies to be listed on the exchange, which has drawn interest from international firms like HSBC and Coca-Cola (NYSE:KO).
The NDRC also aims to greatly expand derivatives usage in the Shanghai market. By 2015, the city hopes to become one of the world's premier five financial derivative markets, planning to offer a wide array of financial derivative instruments related to stocks and bonds, as well as foreign-exchange and interest rates. The NRDC also hinted that it would continue to enlarge the scale of credit derivative products, and introduce structured derivatives when appropriate.
In addition to this rapid expansion of China's domestic equity markets, a number of Chinese companies are now listed on international exchanges, and have drawn the interest of international investors. For instance, Chinese firms like Renren (NYSE:RENN), Baidu (NASDAQ:BIDU), Dangdang (NYSE:DANG), and Yongye (NASDAQ: YONG) -- in addition to having entertaining ticker symbols -- are traded on American exchanges and have three-month average daily trading volumes near or above 1 million shares, with the exception of Yongye.
Bond markets still have a lot of catching up to do
But, despite the rapid growth of China's equity markets, they remain highly volatile and plagued by allegations of dismal corporate governance. As such, they are unlikely to play a substantial role in promoting the internationalization of the yuan.
At any rate, a country's bond markets matter much, much more for promoting its currency's internationalization. After all, an important reason why the dollar has remained the leading reserve currency for several decades is the unparalleled depth and liquidity of U.S. government bond markets.
China's bond markets are still in their infancy, which poses a major challenge. Without large and liquid bond markets, the yuan is unlikely to gain further international prominence. While China's government bond market is decently large in absolute terms, it lacks sufficient liquidity.
On the other hand, China's corporate bond market has relatively greater liquidity, though it remains relatively tiny. At any rate, while China's debt markets have grown rapidly, they remain trifling when judged from an international perspective; a minuscule 0.1% of international debt is issued in yuan.
As you can see, China's financial markets still have a lot of catching up to do if the yuan is to become a serious contender for international reserve status. Further progress will require sweeping reforms of China's financial sector, which remains largely state-controlled, and the dismantling of restrictions on capital flows into and out of the country.
Unfortunately, liberalizing a country's capital account is a tricky process that would almost certainly require China to adopt a more flexible exchange rate. Even if China somehow manages to overcome the numerous and deep-seated vested interests that want to maintain capital account restrictions, the path to attaining global reserve status will likely be longer and more drawn-out than many commentators seem to believe.
Fool contributor Arjun Sreekumar has no positions in the stocks mentioned above. The Motley Fool owns shares of Baidu. Motley Fool newsletter services recommend Baidu and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.