Every few weeks another claim that China's currency, the renminbi, is destined to become a reserve currency surfaces. Why this is fanciful is easily explained. First, we have to understand what turns a currency from merely a means of exchange to settle payments to a reserve currency.

A reserve currency is one that is held by a variety of nations as reserves in their central bank and banking system as a source of stability and to support domestic credit extended by the central bank and banking system. Gold performs the same two functions, which is why central banks also tend to hold gold as reserves.

A reserve currency must have four attributes to fulfill its functions as a source of stability and to support domestic credit extended by the institution holding the reserves:

1. It must be liquid, i.e. marketable in size and in any global market.

2. It must be stable enough to hold its value and liquidity during crises.

3. It must be available in size, i.e. hundreds of billions of dollar equivalents must be available to grease the tremendous global needs for reserves and liquid means of universal exchange.

4. The nation issuing the reserve currency must export the currency in sufficient quantities to act as a reserve currency. Nations can only export currency by running trade deficits, i.e. exporting currency in exchange for goods and services supplied by other nations.

In other words, any nation running trade surpluses cannot issue a reserve currency. China currently runs a trade surplus of $285 billion annually, which simply means it imports currencies in exchange for goods and services sold to other nations.

Let's say a nation wanted to use renminbi (RMB) for their reserves. Where would they get their hands on, say $100 billion of RMB? The only source of RMB is nations running trade surpluses with China, that is, nations who sold more goods and services to China than they bought from China. In these circumstance, China exports in currency in exchange for the goods and services it purchased. The nation running the surplus with China ends up with RMB.

These RMB can be traded for other currencies on the global currency market, or invested in China or used to buy goods and services that trade in RMB. So a nation seeking to build a reserve of RMB would have to buy the RMB from the only nations with RMB, i.e. nations with trade surpluses with China.

China runs trade deficits with a number of nations exporting raw materials and energy to China such as Australia and Saudi Arabia. It also runs large trade deficits with South Korea, which sells China machinery and electrical equipment.

The question of the RMB becoming a reserve currency boils down to this: does Chine export enough RMB via trade deficits to supply the global economy with sufficient RMB to provide reserves in size and be liquid and stable?

Those answering "yes, China does export enough RMB to act as a reserve currency" have to answer how a nation that imports a net $285 billion a year of other nations' currencies can possibly export enough of its currency to act as a reserve currency.

Many people confuse using currency to settle trade payments with a reserve currency. People read about an agreement between China and, say, Brazil, to settle their trade balances with RMB rather than dollars, and they quickly leap to the erroneous conclusion that the dollar is losing its reserve status.

This is an apples-to-oranges error. If China and Brazil settle trade in RMB, the net currency exchange is limited to the trade surplus or deficit between the two nations. After the trade balances have been settled, either Brazil exports reals to China (i.e. Brazil ran a trade deficit with China) or China exports RMB to Brazil (i.e. China ran a trade deficit with Brazil).

The net sum of currency exported is modest, and could not possibly supply the world economy with enough surplus RMB to become a reserve currency.

Another mistake people make is they assume China can simply print RMB and magically make these RMB available on the open market. It doesn't work that way; trade and currency accounts are closed circles. If China runs a $300 billion annual surplus with the U.S., it ends up with $300 billion in its reserves. If China runs a 120 billion euro surplus with the EU, it ends up with 120 billion euros in its reserves.

China can issue credit in RMB within China based on these reserves, but it has no means to export RMB into the global marketplace except by running sustained, substantial net trade deficits.

Any reserve currency must be exported in size, roughly $1 trillion at a bare minimum. Recall that that the reserve currency isn't just a means of exchange--it sits in central banks as the foundation for credit issued domestically in the holder's own currency. The reserve currency is also needed to pay debt denominated in the reserve currency.

Each of these functions demands hundreds of billions of dollar equivalents annually.

Any nation running a $285 billion net annual trade surplus cannot possibly export enough of its currency to act as a reserve currency. The only nation exporting its currency in sufficient size to act as a reserve currency is the U.S. Japan cannot, the EU cannot, and China cannot, because they all run net trade surpluses.

EU Trade with China

U.S. Trade Deficit by Country

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