China, the BRICS and the Challenge to the US Dollar

In a recent official trip to China, Brazilian President Lula da Silva called for an end of the dominance of the US dollar in world trade, a message that has been echoed by the China, Iran, Russia, as well as other countries.  This message reflects the acceleration of the trend towards fragmentation(or deglobalization) of the global economy and the Chinese-led challenge to the Bretton Woods US dollar-dominated global economic architecture, an architecture that looks increasingly frayed and rudderless.

The frustration with the dollar’s dominant position in the world’s financial system is nothing new. Already in the 1960s, the French complained about the “exorbitant privilege” given to the United States by having the dollar as the major global “vehicle” currency.  The dollar’s role as the main international currency essentially allowed the US to live beyond it means by running chronic and growing deficits in both its fiscal accounts and balance of payments. Yet, it offered a number of advantages:  an efficient and deep market in highly rated US Treasury securities, sophisticated risk management and hedging mechanisms and abundant dollar liquidity to fund growing global trade and investment flows.

In the past two decades, the frustration with the US has become even greater with the pervasive regime of sanctions imposed by the US government on countries like China, Russia, Iran, Venezuela and others, effectively cutting off their access to the global financial payments and settlements system at the whim of Washington.

We should see China’s program to internationalize the yuan (CNY, more commonly known as the renmimbi, or RMB ) in this context.  Over the past two decades, China has promoted the use of the yuan in its international trade transactions. As a result, the share of the Chinese yuan in the global currency market has increased significantly, albeit from a very low base, as major Chinese trading partners started conducting business in RMB.  According to the Bank of International Settlements (BIS) latest Triannual Report, daily turnover in the international foreign exchange market increased to $7.5 trillion per day in April 2022, a 14% increase over 2019.  While the dollar, euro, Japanese yen and British pound maintained their relative position (Table 1), the share of the Chinese RMB increased from 4% to 7% over the same period, to around $526 billion per day.  There was a similar increase in RMB settlement volumes on the global SWIFT system to 3.2% of the total in January 2022, putting China in fourth place after the dollar, euro and pound.

Table 1:  BIS Triennal FX Trading Survey 2022

Note that each currency volume is counted twice,

Once for each counterparty

In order to facilitate the use of the RMB, the Chinese authorities took a number of steps in the past few years:

setting up bilateral swap lines with 38 central banks in order to provide RMB liquidity,

setting up 27 off-shore RMB clearing centers in 25 countries

creating up a cross-border payments mechanism (Cross-Border Interbank Payments System, CIPS) as an alternative to the established dominant CHIPS system. China is also established the Shanghai Petroleum and Natural Gas Exchange as a RMB-based trading platform for oil exporting countries.

Setting up a Renminbi Liquidity Arrangement in June 2022 with the BIS with five other countries—Malaysia, Hong Kong, Indonesia, Singapore and Chile—totaling RMB 75 billion (about $13 billion) to provide additional liquidity

The establishment of the BRICS Forum in 2011 has accelerated these trends. The BRICS (Brazil, Russia, India, China and South Africa) account for 42% of global output. However, the group is dominated economically and financially by China.  Starting as an informal group, the BRICS Forum has become more institutionalized, and is a major instrument for China’s challenge to the global financial architecture. Nevertheless, the financial arrangements remain ad hoc, in part driven by US sanctions on countries like Iran and Russia.

 However, while the data is impressive, underlying the progress made  in the internationalization of the RMB , the Chinese currency still accounts for a small share of the global financial markets:  about 2-4% of global cross-border payments and 3% of global central banks assets.  Furthermore, it is mostly limited to trade transactions—as well as investment transactions tied to the massive Chinese Bridge and Roads Initiative (BRI).  The main reasons for this state of affairs are structural, and these structural constraints will limit the scope of RMB internationalization.

Currently, the global financial market remains dominated by the following currencies: the US dollar, the euro, the Japanese yen and the British pound.  The prerequisites for a major international currency are as follows:  a deep and efficient market for internationally traded securities, free capital movement, liquidity, an efficient payments settlements system and hedging/risk management financial instruments.  When we analyze the RMB in this context, we clearly see its shortcomings.

One of the main obstacles to faster RMB internationalization is the small size of the Chinese bond market. China’s internationally traded assets and liabilities account for 4% of the world total.

 Furthermore, Chinese capital controls, which are not likely to be removed anytime soon, limit the trade in these assets. In combination, this explains the fact that the RMB accounts for only 3% of global central bank reserves reflects the limited availability of Chinese securities—central banks usually don’t hold large cash balances

The Chinese financial market is highly regulated and dominated by state-owned banks. Access of foreign banks to China’s capital markets is limited

China’s large and persistent current account surpluses limit the amount of RMB international liquidity. While the Chinese authorities have remedied this situation by offering swap lines with other central banks (currently around RMB 4 trillion, approximately $5 trillion) this limits the availability of the Chinese currency.

Chinese markets offer limited hedging products (forwards and options).  This limits the ability of both Chinese exporters and the country’s trading partners to manage the risk of their RMB positions.  So, for example, while oil exporters such as Iran, Saudi Arabia and Russia denominate their exports to China in RMB, they face currency risks when they convert RMBs to other needed currencies.  So, unless they trade exclusively with China (unlikely), they would need to hedge their RMB inflows and outflows. 

The push to internationalize the RMB is consistent with the extraordinary economic progress made by China over the past few decades, which has led to the country becoming the second largest economy in the world, accounting for 13% of global trade.  At the same time, the push to de-dollarize stems from frustration with the United States’ seeming abuse of its “exorbitant privilege” for political purposes, the push by China and its allies to challenge the U.S global hegemonic economic position and the fragmentation of the world’s global economic and financial architecture.

However, as discussed above, there are chronic technical and structural reasons why the RMB’s internationalization will be limited both in reach and in scope.  Using the RMB makes sense for bilateral trade purposes, or for financing China’s BRI. However, the currency offers few advantages in more sophisticated global financial transactions. The above-mentioned structural problems are unlikely to be resolved in the short and medium term.

Ultimately, the issue of de-dollarization can be seen as a geopolitical one in the short term, part of the efforts of China and its allies (such as Iran, Russia and Brazil) to challenge the U.S both politically and economically.  As argued here, the Chinese currency is a long way from dethroning the dollar (which still accounts for 60% of global reserves and 88% of global foreign currencies trading).  While China has embarked on a major deepening of its economic and energy ties with the Middle East oil producers, the Gulf Cooperation Council (with Saudi Arabia, the UAE, Kuwait, Bahrain, Qatar and Oman) countries still use the US dollar for 80% of their oil trade. 

However, it can also be argued that the RMB has taken its place in the constellation of international currencies alongside the US dollar, the euro, the yen and other major currencies. Yet, the dollar will remain dominant for the foreseeable future, even if the RMB continues to grow in importance. So the question is not so much will the dollar be dethroned by the RMB—a political consideration—but under what conditions can the RMB grow out of being a limited and trade-focused currency to a one with true international characteristics.