Whither the Dollar-The Chinese Challenge

Since World War Two and the Bretton Woods agreements that established the post-war dollar-centric global financial system, the dollar has been the pre-eminent vehicle (reserve/international) currency. The dollar accounts for over 60% of global foreign exchange reserves and 80% of world trade is dollar-denominated, as are 100% of the global transactions in oil and other commodities. Moreover, the chronic U.S. external deficits have provided global markets with abundant dollar liquidity.

Potential rivals to the dollar, in particular the euro, did not live up to their initial promise.  The other major currencies, in particular the Japanese yen and the pound sterling, remained small players in both global reserves and global trade.

Is the dollar’s position as the preeminent global vehicle currency under attack? Does the rise of China as a global power threaten the dollar’s position? Would a normalization of the dollar’s global position be beneficial to the global economy, including the United State?  These are some of the questions that have become more relevant, especially since a number of analysts and academic economists have argued that the indiscriminate application of sanctions, tariffs and other punitive actions by the Trump administration have roiled the global financial system and opened the door for a search for alternatives for the dollar. Particularly troubling is the effort by the U.S. Treasury to block Iranian financial institutions from SWIFT (The Society for Worldwide Interbank Telecommunication), the key global interbank payments network of 11,000 banks.   

The threats to the position of the dollar come from two directions: the rise of non-dollar payment systems, and a challenge to the dollar’s international position as a reserve currency.

The internationalization of the Chinese currency (the yuan, CNY, aka the renminbi, RMB) is a natural consequence of China’s global economic and financial clout. China is the second largest economy in the word, but the first in terms of global manufacturing and trade. The country has massive foreign exchange reserves estimated at over $3 trillion at the end of 2018.  If it happens, RMB internationalization will be arguably the most important global financial event since the birth of the euro. Moreover, China is intent on challenging dollar supremacy by establishing RMB-based rival payment and trading systems.

However, there are three criteria to assess a currency’s ability to fulfill the role of an international (aka reserve or vehicle currency):

• The use of the currency in international trade transactions
• The use of the currency as an investment currency
• The use of the currency as reserve currency on central banks’ balance sheets

China has achieved significant strides as measured by these criteria.  At the same time, we must recognize China’s limitations--the country is in many ways at the beginning of a prolonged and non-linear process.

The RMB as a Trading Currency: In mid-2018, about 15% of China’s foreign trade was settled inn RMB, up from 1% in 2010—the proportion is proportionally higher if you look at  China’s trade with other Asian countries. China is also leveraging the Belt & Road Initiative (BRI) to increase the use of RMB in both outward direct investment (ODI) and trade transactions. Furthermore, the Chinese authorities have liberalized capital market rules, allowing increased access to Chinese financial assets by foreign investors. According to the Bank for International Settlements (BIS), the RMB almost doubled its share of daily global currency trading between 2013 and 2016 (BIS, 2016), from $120 billion to $204 billion, and is the eight most-traded currency in the world (4% of total trades), although it still trails the major currencies.  SWIFT reports that the RMB is now in fifth position in terms of global payment flows and now accounts for about 2% of these flows.  Finally, the Chinese government established an RMB payments clearing system in October 2016, the China International Payments System (CIPS). The system is still under construction, and currently has 680 direct and indirect participants

The RMB as a Reserve Currency: The People’s Bank of China has provided RMB liquidity by establishing swap lines with the major central banks.  Moreover, the Chinese currency is now part of international currencies held by major central banks, accounting for about 1.8% of global allocated foreign exchange reserves. T. he Chinese currency RMB also became one of the component currencies of the Special Drawing Rights (SDR) since October 1, 2016.  .

Oil Trading: The Chinese government has also set up a petro-yuan futures market in early 2018, allowing for the trading of oil futures s in yuan. The petro-yuan market now accounts for about 15% of the global oil trading volume.

As mentioned before, the wave of U.S sanctions—against Russia and Iran in particular—has spawned new interest in developing non-dollar payment systems.  In addition to the Chinese efforts, we can cite the proposed Iran-EU barter mechanism proposed by the EU. 

However, the use of the Chinese RMB as a reserve currency is likely to remain limited in the medium term. China lacks two important necessary conditions in this regard: deep capital markets and efficient derivative markets. Moreover, there are many regulatory obstacles to such a role, including limitations on foreign ownership and government intervention. Finally,  China has improved its relative position, it is starting from a very small base. Ultimately, the internationalization of the RMB will require a degree of financial liberalization that goes against the grain of the government’s emphasis on economic control.   Nevertheless, the RMB is likely to expand its role as a trade currency as more Chinese bilateral trade moves from dollar to RMB denomination. 

Challenging the dollar directly in the short term will remain difficult, as the dollar still accounts for 63% of global foreign exchange reserves, 88% of daily turnover in the foreign currency market and 40% of the SWIFT payment volume.  More threatening would be a sharp shift away by the Chinese central bank from dollar-denominated assets.  In the meantime, the abuse of its global financial power by the United States government will allow niche players like China to expand their global financial position.