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The yuan’s share of foreign reserves has risen to a record high, but it continues to trail behind other currencies. Photo: Reuters
Opinion
Macroscope
by Nicholas Spiro
Macroscope
by Nicholas Spiro

Why the yuan isn’t a big winner in shift away from US dollar

  • Sanctions on Russia have led to predictions of the break-up of the global monetary system, with China as the main challenger to US dollar hegemony
  • Yet, for all the signs of the yuan’s rise, there are reasons to be sceptical: China’s need for stability, its murky regulatory landscape, and desire to control its currency

For a sign of the impact of geopolitical realignments on foreign exchange markets, look no further than the surge in trading volumes between the currencies of China and Russia, the two main challengers to US supremacy.

According to data from Bloomberg, monthly volumes in the rouble-yuan pair have soared 1067 per cent since Russia invaded Ukraine in late February. By contrast, trading between the rouble and the US dollar has plunged to its lowest level in a decade, based on its 20-day moving average.

With over half its foreign currency reserves frozen as part of the most far-reaching and punitive Western sanctions ever levelled at a major adversary, Russia has no choice but to rapidly diversify away from the dollar. The “weaponisation” of the greenback is crushing its economy.

Yet, for some currency strategists, concerns that the dollar’s dominant role in the global financial system is being ruthlessly exploited add impetus to forces that have caused its share of international foreign exchange reserves to fall from just over 70 per cent at the turn of the century to 59 per cent today.

A woman walks past commercial premises put up for rent in Moscow on June 8. Photo: AFP

In a provocative report published on March 7, Credit Suisse strategist Zoltan Pozsar argued that the sanctions-induced commodity shock marked a regime shift in the global monetary system. The new order, he claimed, would be “centred around commodity-based currencies in the East that is likely to weaken the Eurodollar system and contribute to inflationary forces in the West”.

The International Monetary Fund’s first deputy managing director Gita Gopinath has also warned about a further erosion of the dollar’s dominance. In March, she said a backlash against the sanctions could lead to a more fragmented and politicised monetary system as small groups of countries trade between themselves.

Many see China as the principal challenger to the dollar, mainly because of the size, increasing sophistication and global integration of its economy and markets. China has also made headway in reducing its dependence on the international cross-border payments system that underpins the primacy of the dollar and other Western currencies.

However, there is ample reason to be sceptical about the yuan’s ability to chip away at the dollar’s supremacy.

First, it is hard to see Beijing underwriting and benefiting from the development of an alternative commodity-backed monetary system. The last thing Chinese policymakers want to do, especially when the economy faces huge challenges, is allow volatile commodity markets to determine the value of the yuan, depriving them of their ability to use monetary policy to support growth or suppress inflation.
Second, China has shown little inclination to become a leading reserve currency issuer. For starters, the yuan is not fully convertible and the country’s capital controls, while not as stringent as they used to be, remain extensive, limiting how much of the currency and other domestic assets foreigners can access.

Although China has made significant strides in liberalising its financial markets, it is still trying to have its cake and eat it by opening up its capital account while maintaining control over its currency and preserving monetary autonomy. These three objectives, known as the “impossible trinity”, are incompatible, hindering the yuan’s internationalisation.

The headquarters of the People’s Bank of China in Beijing, pictured in September 2018. Photo: Reuters
Third, institutions, the rule of law and predictable policy regimes matter. While many countries, particularly developing economies, have long been critical of the dollar’s “exorbitant privilege” in the financial system, this unease pales in comparison to deep concerns about political and regulatory risks in China.
Indeed, these risks have become more acute since Chinese President Xi Jinping launched his “common prosperity” campaign, and Beijing’s close ties to Moscow helped trigger a sharp deterioration in sentiment towards China. The government’s geopolitical and ideological aims have made it harder for the country to capitalise on the shift away from the dollar.

A foretaste of how the international monetary system is most likely to evolve in the coming years is in the findings of an IMF working paper published in March. The study found that none of the dollar’s main rivals – the euro, the pound sterling and the Japanese yen – have gained from its declining share of international reserves since 1999.

Internationalisation of the yuan complicated further by geopolitics

The winners were instead “non-traditional” reserve currencies. While the yuan accounted for a quarter of the shift away from the greenback, the rest of former dollar reserves flowed into smaller economies, such as Canada, Australia, South Korea and Sweden.

Not only have these markets become more liquid, they have all liberalised their financial sectors and have democratic systems of government. Barry Eichengreen, one of the paper’s authors, said every major reserve currency issuer to date has been a democracy, with “checks on executive power”.

To be sure, the yuan will keep increasing its share of global reserves, which currently stands at just under 3 per cent, compared with the yen’s 5.5 per cent. Yet, for political, economic and financial reasons, China is unwilling and unable to become a leading reserve currency issuer. The internationalisation of the yuan has its limits.

Nicholas Spiro is a partner at Lauressa Advisory

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