The US dollar has been reigning as the world currency since at least World War II. There are signs that this may change and that new currencies are likely to challenge the hegemony of the US dollar.

Which currencies are the candidates for challenging the dollar?

Before answering this question it is useful to quickly discuss the conditions for a currency to become a world currency. There are essentially three conditions. The first one is size. Only countries with a large economy produce a currency that will be used everywhere in the world as a unit of account and a medium of exchange. Large is to be understood both economically and financially. The country must have a large economy (measured by GDP) and large financial markets that provide a lot of choice for investors.

Second, it must be a country with a strong government that has influence in the world and that also provides for domestic stability. This stability is to be understood both politically and financially. Politically unstable countries will not produce a world currency, nor will countries that fail to produce financial stability do so. Investors will not want to hold currencies that are associated with great uncertainty about its future value.

Third, a currency can only become a world currency if it is fully convertible, meaning foreigners can freely buy and sell the currency. If there are restrictions on the exchange of the currency, that currency will never graduate to a world currency.

When we look around the world we must admit that not many currencies satisfy these three conditions. The currency that comes closest is the renminbi, next is the euro. So what are the chances for the RMB and the euro to challenge the dollar and to become the world currency? Let's start with the RMB and look at the three conditions.

It is clear that China is rapidly overtaking the US as the biggest economy in the world. It is likely that China will achieve this status within the next 10 years, even taking into account the recent economic slowdown. In addition, the potential for the Chinese economy to become much bigger than the US economy is a very real one.

Associated with economic size is financial size. Here China has more work to do. Until recently the Chinese economy was very much dependent on bank finance. Capital markets (bond and equity markets) were poorly developed. This is changing though, creating the prospects that China will have financial markets that can rival the US financial markets. However, it will take a longer time for China to surpass the financial size of the US than it will to reach a higher economic size.

China has a strong and stable political system, the second condition for producing a world currency. The key will be for China to achieve a sustainable growth path that reduces its growth dependence on exports and investment as well as reorients its economy toward more consumption. When this is achieved the conditions for long-term economic stability will be guaranteed, a prerequisite for creating a world currency.

Finally, full convertibility will have to be instituted. China has started to liberalize capital movements and has reduced exchange controls. There is still much to do in order to reach the goal of full convertibility, a situation where domestic residents and foreigners can freely buy and sell RMB against other currencies.

It is important to be aware that full convertibility will have important implications on the way savings are channeled toward investment projects in China. Today, a large part of this process is still under political and administrative control. In a world of full convertibility the Chinese authorities will have a much lower influence on how domestic investment projects are selected. When Chinese firms are free to borrow anywhere, financial markets rather than the Chinese authorities will decide about this. This, of course, is not without risks, but it is inherent in financial liberalization.

The RMB is a serious candidate to challenge the supremacy of the dollar. I would even go further and argue that in the long run it is almost inevitable that this will happen. The condition for this to occur is that China continues on the road of domestic and external financial liberalization.

The other currency that has some prospects for challenging the dollar is the euro. The prospects for the euro to become a world currency, however, are much slimmer than for the RMB.

The eurozone today has about the same economic size as the US. In contrast with China, however, there is little prospect that the eurozone's economy will become bigger than the US economy. The reverse is more likely to happen.

The size of financial markets in the eurozone is still substantially smaller than in the US. Again, in contrast with China, there is little prospect that it will overtake the US. The European Commission has launched a plan to create a capital markets union. Even if this is successful it is unlikely to create financial markets of the size of the US' financial markets and of the size of the future Chinese financial markets. This has much to do with a political dimension.

The main obstacle for the euro to become a world currency is political. The euro is a currency without a country. There is an absence of a unified nation with a central government that backs up the currency. This lack of political union was at the core of the eurozone crisis that erupted in 2010. It also leads to uncertainty as to the future of the euro. When such existential uncertainty exists about a currency, that currency cannot become a world currency. Whereas the RMB is very likely to become a world currency, challenging the supremacy of the US dollar, the euro is not.

The author is a professor at the London School of Economics.

(China Daily European Weekly 05/01/2015 page8)