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China is increasingly looking to diversify its foreign exchange assets to reduce exposure to the US dollar. Illustration: Lau Ka-kuen

China’s push to loosen US dollar dominance takes on new urgency after Western sanctions on Russia

  • Some Chinese advisers are urging the government to overhaul the exchange rate regime and turn the yuan into an anchor currency, especially for the Asia region
  • Worries are mounting that China could be kicked out of the Swift financial messaging system or cut off from its foreign assets if relations with the US worsen

Western sanctions on Russia over its invasion of Ukraine and spillover from US interest rate hikes have fuelled discussion in China about how to reduce reliance on the dollar system and establish the yuan as a strong, internationally-traded reserve currency.

Calls for China to create a more independent financial regime come amid patchy relations with the West, following the onset of the US-China trade war in 2018, the coronavirus outbreak and tensions over geopolitical issues ranging from Hong Kong to Taiwan.

With concerns growing in China about exposure to the US dollar system, some government advisers are urging authorities to overhaul the exchange rate regime and turn the yuan into an anchor currency, especially for the Asia region.

“Yuan issuance is currently anchored to the US dollar to a certain extent … It is by no means a long-term solution from the perspective of China’s future international status and development needs,” Huang Qifan, former mayor of Chongqing municipality in southwest China, told the Tsinghua PBCSF Chief Economist Forum a week ago.

This issue has become more urgent in the increasingly complex international power game
Huang Qifan

The yuan should be tied to China’s gross domestic product and sovereign credit, Huang said.

“An independent currency anchor would give China’s government bond yield curve and monetary policy, as well as the pricing of domestic financial assets, a benchmark,” he said.

“This issue has become more urgent in the increasingly complex international power game – and it needs to be studied.”

More than two years since the pandemic began, US and Chinese monetary policy is diverging. Beijing is loosening to shore up the economy, while the US Federal Reserve is tightening to rein in inflation. As a result, China’s yield advantage over US Treasuries has disappeared, driving massive capital outflows and weakness in the yuan.

Huang’s comments reflect the prevailing view in China that the international environment is becoming more hostile. After Russia was hit with a barrage of sanctions for invading Ukraine, worries have mounted that China too could be kicked out of the Swift financial messaging system and refused access to the dollar if relations with the US worsen.

How the US uses global dollar payments system to impose sanctions

Liu Shengjun, head of the Shanghai-based China Financial Reform Research Institute, a private research organisation, said sanctions on Russia have sounded alarm bells, but the country’s heavy exposure to the US dollar, market and technology mean there is little room to manoeuvre.

“We need to make preparations,” he said. “But it should stay low profile and its pace should be well managed.”

The threat of US financial decoupling has already forced regulators to build a Cross-Border Interbank Payment System, a Chinese equivalent to Swift, and step up collaboration on international use of the digital yuan.

But more work needs to be done. Ultimately, the creditworthiness of a currency depends on the country’s economic size, monetary policy and international acceptance, Liu said, adding China must continue developing the economy, building more sophisticated financial markets and promoting overseas use of the yuan.

“US sanctions won’t work out if more countries want to accept yuan,” he said.

Beijing’s embrace of the US-led international economic and financial system – including the World Bank, the International Monetary Fund (IMF) and the World Trade Organization – helped transform it from a poor farming nation in the 1970s to the world’s top exporter and second largest economy.

However, the dollars China earned through its massive export machine often flowed back to the US or were invested in dollar-denominated assets by the central bank.

As the yuan is not fully convertible under China’s capital account, the People’s Bank of China (PBOC) prints yuan to buy overseas assets through its funds outstanding for foreign exchange, a major tool used to manage liquidity before 2015. At the end of April, the outstanding amount of funds was 21.1 trillion yuan (US$3.1 trillion).

Despite strict capital controls, the Chinese economy is vulnerable to international financial turbulence. The 2008 global financial crisis caused the loss of 20 million factory jobs and there was huge volatility in the yuan’s exchange rate between 2015-17, due to tightening by the US Federal Reserve and a one-off devaluation of the yuan.

More recently, Chinese authorities have complained about the side-effects of unprecedented US money printing to fight the coronavirus.

‘We don’t want to become anyone’s enemy’: China wary of US forex threats

Yu Yongding, a former central bank adviser, said the yield of China’s foreign exchange assets has long been negative and the freezing of Russian central bank assets showed they were no longer safe.

Yu said China should reduce its US dollar assets, including the US$1.04 trillion worth of US Treasury bills it holds.

“The conflict between the US and Russia tells us that the assets of both the Russian central bank and oligarchs could be confiscated. Security of China’s overseas assets is facing a severe challenge,” he said in a speech to the Tsinghua forum earlier this month.

“We should strike a balance in overseas assets and liabilities and refrain from owning excessive amounts of US dollar assets. China should try not to be a creditor under the current geopolitical conditions.”

Beijing rarely publishes the composition of its foreign exchange assets, but diversification is believed to be under way.


How international sanctions imposed since Ukraine invasion are hitting Russia

How international sanctions imposed since Ukraine invasion are hitting Russia

US dollar assets accounted for 59 per cent of the country’s foreign exchange reserves in 2016, down from 79 per cent in 1995, government data indicated.

Authorities have continued to scale back holdings over the past several months. The foreign exchange reserve has fallen for four straight months, declining by US$130.4 billion to US$3.12 trillion. China’s holdings of US Treasury bills have also dropped for four months in a row, with a combined reduction of US$41.2 billion.

Beijing has made numerous attempts to increase its say in the international financial system since the global financial crisis in 2008.

Zhou Xiaochuan, a former central bank governor, called for the yuan to be used in trade settlement from 2009. He also advocated for use of the IMF’s special drawing rights (SDR) – an international reserve asset to supplement members’ reserves – in pricing and denomination of financial products, saying it would help global monetary stability.

China started to publish both SDR- and US dollar denominated foreign exchange reserves from April 2016.

To further its international ambitions, China wants to turn Shanghai into a yuan asset hub, accelerate trials of its sovereign digital currency and make the yuan an anchor currency for Southeast Asia and belt and road countries.

Two years ago, Ding Zhijie, who heads the research centre of the State Administration of Foreign Exchange, said the yuan had potential to be a regional anchor currency because of the country’s massive trade and investment connections, its large foreign exchange reserves and the yuan’s stability.

“We should focus on the construction of the yuan zone,” he said at a Renmin University meeting.

Beijing’s attempts to internationalise the yuan have made slow progress, though the currency is nowhere near strong enough to challenge the dollar in the foreseeable future.


Ordinary Russians feel economic pain of Western sanctions on Moscow over Ukraine invasion

Ordinary Russians feel economic pain of Western sanctions on Moscow over Ukraine invasion

The yuan accounted for 2.2 per cent of global payments in March, far below 41.07 per cent for the US dollar and 35.36 per cent for the euro.

It accounted for 2.79 per cent of global foreign exchange reserves at the end of 2021 – making it the world’s fifth largest holding – but that was a fraction of the US’ share at 58.5 per cent and 20.6 per cent for the euro.

The yuan’s weight in the IMF’s SDR currency basket rose by 1.36 percentage points to 12.28 per cent at the weekend, though it was overshadowed by the 1.65 percentage point increase for the US dollar, which now accounts for 41.73 per cent of the basket.

China underlines capital pledge as zero-Covid prompts overseas firms exodus

“China’s track record of maintaining steady, relatively high growth and keeping inflation under control means that the yuan might be an attractive option for diversifying offshore financial assets,” said Ronald Anderson, an emeritus professor of finance at the London School of Economics.

But he warned the yuan’s prospect of becoming a major global reserve currency will face challenges if the US steps up containment.

“This escalation to an open economic trade war would be very costly for China, for the US and for most of their trading partners,” he said.

“However, it would probably accelerate the emergence of a world trade system based on two currencies, the [US] dollar and yuan.”