In December 2015, the International Monetary Fund welcomed the Chinese yuan into its elite
club of global currencies.
This means that the yuan, also called the renminbi, will join the US dollar, the Euro,
the British pound and the Japanese yen as the world’s most reliable and freely usable
denominations.
So, What makes a strong currency?
Well, the strength of a currency is generally measured by its purchasing power, which is
the amount of goods or services that one unit of money can buy.
Since modern currencies are not backed by a collateral like gold, their value is entirely
dependent on external factors.
This would include things like how much control a government has on the currency, whether
or not it has a fair exchange rate and its long term stability.
All of these contribute to public faith in the value of a currency.
For example, in 2005, the Turkish government eliminated six zeros from its Lira overnight.
This essentially converted 1 million lira to a single lira, and people accepted this
immediately, because they had faith in the economy that was backing it.
The number on the bills didn’t really matter.
Overall, people tend to have greater faith in currencies that are widely used and internationally
accepted.
In that way, a currency’s value is not only based on what you can buy with it, but on
how much of the world uses it.
Currencies that are internationally trusted are often referred to as Hard Currencies.
The US dollar, the Euro, the British pound and the Japanese yen all fall into this category
because, again, the governments and economies that back them are seen as strong and stable.
In fact, many countries have abandoned their domestic currency in favor of hard currency.
Over one dozen countries and territories have adopted the US dollar as their own, a process
commonly known as “dollarizing”.
Moreover, both average citizens and investors tend to prefer hard currencies during times
of political unrest or global economic instability.
When rapid inflation hit Latin America in the 1980’s, many people there temporarily
switched to the dollar, fearing that their domestic currencies would continue to go down
in value.
Because of their consistency and reliability, currencies like the US dollar and the Euro
are kept in huge reserves by nations with minor currencies.
These nations use their reserve currencies for international trade or borrowing foreign
money.
US dollars are the most popular reserve currency, counting for roughly 60 percent of all global
foreign exchange reserves.
What’s more, the dollar is included in roughly 90 percent of all international transactions.
So, how has the Chinese Yuan made its way into this elite group of currencies?
Well, the Chinese government has recently loosened some control over its currency and
built trading hubs in other countries.
As a result, market forces will play a bigger role in setting the value of the Yuan, and
the currency will be more tradeable, and less susceptible to government manipulation.
The newly powerful Yuan is already gaining ground on the Euro, and China hopes that their
currency will one day rival the dollar as the number one reserve currency.
However that prospect remains in the distant future.
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