The recent dollar-denominated financial sanctions imposed on Russia by the United States inadvertently highlight the growing significance of the yuan (RMB) as an alternative currency. While today’s immediate concerns revolve around Moscow’s ability to avoid sanctions through transactions in the RMB, the significance of the emerging US-China currency competition has a far-reaching effect. Many countries are reevaluating their trade and strategic interests, including increasing the use of the yuan. As a result, after six years of stagnation, China’s efforts to internationalize the yuan are seeing increasing success. If the United States is to maintain its position in the global financial system, it must support its strong institutions based on the world’s trust in the dollar.
As of early January 2022, shares of the Chinese yuan in world payments have reached record highs, as shown in the graph below.
Countries blacklisted by US transactions in yuan, which supports China’s currency internationalization plan. For example, about half of North Korea uses the yuan for domestic transactions. Iran and Myanmar accept yuan-denominated purchases from China. Following sanctions imposed by the Western financial system, Russia is now repaying its foreign debt in yuan. In all of these cases, dollar-directed sanctions have pushed countries toward the dollar’s rival, the yuan.
Other countries that maintain trade relations with the United States are reconsidering the dollar as their trade and investment with China increases. Saudi Arabia, a major oil supplier to the United States and China, is considering a yuan-major oil deal with Beijing. In 2018, officials from 14 African countries discussed using the yuan as a regional reserve currency. The Belt and Road Initiative (BRI) in Beijing is a global economic program that seeks to rebuild global trade around China. In Zimbabwe, the yuan became the legal tender after China canceled its debt. ASEAN, a Southeast Asian alliance, has exchanged bilateral currencies with China, according to global financial review economist Dr. Kalim Siddiqui argues that the “death of the US dollar” will be 7 Indonesia has signed a bilateral agreement to promote the use of the yuan. Baizhu Chen, a professor of clinical finance and business economics at the University of Southern California, explained that such nations “think their economies may be hostage to US policy” and “want to diversify their risks.”
China plans to reshape its payment system with the rollout of a digital yuan, or e-CNY. In response, members of Congress have raised concerns about the potential for the digital yuan to evade U.S. sanctions and threaten the status of the dollar as a reserve currency. In addition, the digital yuan could facilitate cross-border payments without SWIFT, a global interbank messaging system, undermining US interests and strengthening China’s financial strength.
However, China’s financial structure hinders the internationalization process. Strict capital controls limit capitalization by making capital withdrawals from China equally difficult for its citizens and investors. Foreign businesses registered in China are also bound by strict foreign exchange regulations that delay or limit the transfer of business capital. Capital account liberalization is a prerequisite for widespread currency use, but Nicholas Lardy and Patrick Douglas, researchers at the Peterson Institute for International Economics, note that “China still does not meet any of the requirements for convertibility.”
The graph below shows that China’s progress lags behind in promoting the use of its currency in world trade. RMBs account for only 2 percent of global transactions, where the US dollar still controls 40 percent of all transactions. For now, the dollar remains king.
What countries consider when using a currency
Although sanctions may force some states to adopt the yuan, most countries balance their use of the RMB and USD based on their strategic and economic interests. For example, despite China being its largest trading partner, Japan keeps a large percentage of its foreign reserves in US dollars. African countries, which mainly hold dollars and euros, can add yuan to their portfolios to repay Chinese infrastructure loans. In Southeast Asia, Cambodia receives large Chinese investments and shows interest in the RMB to reduce transaction costs. However, Cambodia still pegs its own currency with the dollar.
The yuan’s political control and the difficulty of using it in trade explain the mixed results. China’s weak foreign exchange infrastructure makes it difficult for cross-border transactions. The introduction of a digital yuan makes it easier to manage international payments, but only if other countries establish interoperability with their financial systems. The USD also maintains its first-mover advantage, network influence and reliability over the Chinese yuan.
Countries also favor the reserve currencies of states with strong diplomatic and military influence, such as the United States. This trend exists because states want to trade in currencies that promote national security and mutual financial stability among alliance members.
An American security-dependent state often buys Washington’s currency-dependent debt, such as U.S. Treasury bonds. One study estimates that “military alliances increase the share of international units in foreign exchange reserves by about 30 percentage points.” Another study found that countries that do not have nuclear weapons have 35 percent more US dollars in reserves.
In the context of US-China hostility, countries are fundamentally realistic in their choice of currency. Nations are in favor of economic utility until security concerns are clear. For some countries affiliated with the United States, such as Australia and Japan, a strong trade relationship with China is increasingly less relevant in the face of geopolitical tensions. Countries often prioritize national security, alliances and values over maintaining economic ties when taking sides in conflicts.
Other states, such as Southeast Asia and Africa, find themselves in the middle of a strategically balanced game. As the Chinese economy grows, most countries can hold different portfolios of foreign exchange to hedge against uncertainty. A prime example of this rebalancing act is Israel’s central bank adding the yuan to its foreign exchange reserves along with three other currencies. The move comes as Jerusalem strengthens its trade ties with Beijing and expands technology exports worldwide. Finally, while adding Chinese currency, the Israelis presented a purposeful observation on changing the global balance of strategic and economic power by lowering their dollar-euro ratio.
A Breton Woods III?
Another factor that could contribute to the yuan’s rise is the global revision on the basis of financial stability. The first Breton Woods system sought to create a uniform global currency system with currencies tied to gold prices. After President Nixon removed the United States from the gold standard, however, Bretton Woods ceased to exist in its original form. As a result, the world was transformed into Breton Woods II, a de facto system that served as a US Treasury-based anchor. Now, analysts like Credit Suisse Managing Director, Joltan Pozser, have predicted the rise of a Breton Woods III backed by product prices.
Pozzar noted that concerns over the combination of loose monetary policy in the United States, rising commodity prices, and the disarmament of the dollar have prompted countries to reconsider their relationship with the American currency. While the United States is sending Russian goods to the ground with sanctions, China’s central bank will benefit by buying Moscow’s exports at a discounted rate. After the end of the Russia-Ukraine war, Pozzar predicted that the US dollar would weaken and the RMB would strengthen and be supported by commodities. As a result, reserve portfolios and currency-traded transactions in Bretton Woods III are likely to be more versatile and dynamic than static. This restructuring gave the yuan another opportunity to specialize in holding and using international currencies.
It is unknown at this time what he will do after leaving the post. Yet, there is no doubt that the world is entering a new financial balance. But if China wants to establish monetary dominance, it must build trustworthy institutions, respectable diplomacy and responsible stakeholders in the international system. It remains to be seen whether Beijing has the capacity to meet these objectives.