What Growing Enthusiasm for the Yuan Signals for the U.S. Economy

Why Nigeria’s shift away from dollars to Chinese currency is likely a sign of things to come.

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Earlier this year, Nigerian Central Bank Governor Lamido Sanusi made the surprise announcement that Nigeria's central bank would convert 10 percent of its reserve holdings, or about $3.3. billion, from U.S. dollars to the Chinese currency, the yuan. Formerly, Nigeria held nearly all of its reserves in dollars. Sanusi said the change to yuan would be made "as soon as possible."

The announcement received little attention, despite Nigeria's role as the United States' fifth-largest supplier of oil. But the importance of this decision, as well as similar decisions across Africa, is an indication of increasing pessimism about the strength of the U.S. economy. It also shows that emerging countries like Nigeria are becoming increasingly comfortable dealing with China as partners, while distancing themselves from traditional European and American allies.

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"It will be almost living in a dream world to ignore China," Sanusi said. "It's the second-largest economy in the world and it's well-managed."

Nigeria's decision in especially important because of its leadership role in Africa. Because of the country's booming oil industry, many countries throughout the continent look to Nigeria for financial guidance. Its decision to begin the transition toward more robust yuan reserves is likely a sign of things to come.

Importance of reserve currencies. The kind of currency a country holds in reserve plays an important role in national fiscal affairs. The foreign currency serves as an anchor currency, which helps to determine the value of the national currency. For instance, if a country holds U.S. dollars in reserve and the value of the dollar is strong, the value of the national currency also improves. This gives countries purchasing power on international markets.

Reserve currency decisions also indicate global economic strength. As the U.S. economy expanded over the last half of the 20th century, dollars became the default reserve currency. This is still the case, as two-thirds of all international reserve funds are held in dollars. The euro is the second-widest held reserve currency.

However, the stagnant U.S. economy and the ongoing euro crisis have raised questions about the long-term health of each economy. The continued growth of the American economy no longer seems like a sure thing. With serious questions being raised about the euro zone, the European economy is also in serious danger.

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A West African shift. Meanwhile, China's economy has outpaced both the United States and Europe. This growth has allowed Chinese companies to enter markets like Nigeria and begin to lay the foundations of long-term trade relationships.

For instance, trade between China and Nigeria reached a record $7.5 billion last year. Chinese companies are involved in large infrastructure projects, including the construction of a nationwide Nigerian railway system. It's widely believed that once the Nigerian oil market opens to new bidders, Chinese oil companies will begin to compete with European and American oil firms like Exxon and Royal Dutch Shell.

China is expected to make similar inroads in other African markets, including Angola, South Africa, and Algeria. Already Kenya has announced that it plans to hold a large portion of its reserve currency in yuan.

"There a general trend in Africa of an increasing presence in China and an enthusiasm of African countries dealing with China," says Richard Downie, the deputy director of the Africa program at the Center for Strategic and International Studies in Washington. "China has been engaged in Africa … while Western interests have been patchy and wavered over the years."

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Still a long way from a dominant yuan. Despite growing enthusiasm about the yuan, it is not likely to replace the dollar as the most important reserve currency for years. China does not sell bonds, making it difficult for outside investors to accurately price the value of the currency. It also undervalues its currency. This makes it cheaper for consumers to buy Chinese products, but obscures the actual strength of the Chinese economy.