The impact of yuan internationalization on the stability of the international monetary system

•We study the impact of yuan internationalization on the stability of key currencies.•We rely on a three-country portfolio balance model.•We consider two alternative currency regimes in China.•Yuan internationalization reduces the instability of exchange rates.•Yuan internationalization reduces the distortions due to China's currency regime. We study the implication of yuan internationalization on the stability of the international monetary system. More specifically, we use a three-country, three-currency portfolio model to analyze the impact of yuan internationalization on exchange rates in the event of trade shocks, with stock-flow adjustment of the net foreign asset positions. We show that the internationalization of the yuan would lessen the response of floating exchange rates to asymmetric trade shocks as well as attenuate the distortionary impact of China keeping its currency pegged to the dollar. Conversely, yuan internationalization would amplify the impact of trade shocks on net foreign asset positions, albeit to a limited extent.