The weaponization of the US dollar against Russia after its invasion of Ukraine has raised hopes that Beijing will step up its de-dollarization efforts, to protect itself against similar financial sanctions that Washington could roll out against (mainland) China. While the Chinese renminbi (RMB) is unlikely to soon dethrone the US dollar in the global financial system, concerns remain that the weaponization of the dollar against Russia has triggered an irreversible fracture in the global financial system that will result by two international monetary systems, one led by the United States and one by China.
Internationalization and development of the RMB as a reserve currency
The internationalization of the RMB and its potential emergence as a major reserve currency are related but not equivalent. The internationalization of the RMB aims to increase its use in international trade and financial transactions, while its eventual rise to a major global reserve currency means that RMB-denominated financial assets are widely and heavily held in foreign exchange reserves. central banks.
RMB advances in both areas have been marginal, even with Beijing’s biggest push on both fronts since the early 2010s.
- In foreign exchange markets, the RMB accounted for 4.3% on one side of total trade in 2019, according to the Bank for International Settlements triennial survey, compared to 0.9% in 2010. The US dollar remained the currency the most actively traded in 2019. the global forex market, accounting for 88.3% of all transactions on one side in 2019.
- The reach of China’s CIPS (Cross-Border Interbank Payment System), the international payment system launched by China in 2015, still pales in comparison to that of the cross-border financial messaging platform SWIFT (the Society for Worldwide Interbank Financial Telecommunication). . At the end of March 2022, CIPS had 1,304 participants, compared to SWIFT’s more than 11,000 participating institutions. In addition, more than 80% of CIPS transactions rely on SWIFT’s messaging service.
- As a reserve currency, the RMB accounted for just 2.8% of foreign exchange reserves held by central banks around the world in the fourth quarter of 2021. The US dollar, on the other hand, remained the dominant global reserve currency, accounting for 58.8% % of reserves held by central banks in the last quarter of 2021.
Prospects and impact of China’s dedollarization
Given that the RMB lags far behind the US dollar in terms of international usage and the role of the dominant global reserve currency, what countermeasures could Beijing deploy to protect China from US financial sanctions like those enacted against Russia ?
Option 1: Diversify away from US dollar reserves
To protect against the U.S. freezing China’s foreign exchange reserves, Beijing could aggressively diversify its reserve holdings away from U.S. dollar-denominated assets. China has reduced its holdings of US dollar reserves from 79% of its total foreign exchange reserves in 1995 to 59% in 2016 (the latest data from China’s State Administration of Foreign Exchange). This is far less than Russia’s dollar reserve diversification efforts, as the Russian central bank has reduced its dollar reserve holdings to just 7% of its overall foreign exchange reserves. However, since most of Russia’s reserve diversification has gone to financial assets of other advanced economies that are part of the US-led alliance against Moscow, more than half of Russia’s foreign exchange reserves were still frozen by sanctions. Given the size and depth of financial markets in advanced economies, if Beijing were to diversify its reserve holdings away from dollar assets, it would have no choice but to reallocate its portfolio to financial instruments from other economies. advancements. Indeed, advanced economies represent 96% of the global bond market excluding the United States and China. (China cannot hold foreign exchange reserves in RMB assets.)
Option 2: Push for the RMB to achieve the status of the world’s main reserve currency
Beijing could launch a forceful push to promote the RMB as the main global reserve currency. The main obstacle to this option is not the entrenched dominance of the US dollar in international trade and finance which the RMB is struggling to eliminate. On the contrary, the key obstacle preventing the RMB from becoming a major global reserve currency is the inability of the Chinese government to fully liberalize China’s capital account, due to its underdeveloped and insufficiently robust financial system. The Chinese financial system is dominated by banks, which are mostly under state control. In this context, bank loans are not always based on commercial criteria and generally favor public companies or politically connected private companies. The Chinese bond market lacks transparency because China’s below-average domestic credit ratings industry has consistently provided inflated ratings for Chinese bonds. Chinese stock markets are highly volatile due to poor corporate governance, inadequate accounting practices, weak auditing standards and speculative investments by retail investors. If Beijing fully liberalizes China’s capital account, allowing unfettered capital flows across the country’s borders, its less than perfectly healthy financial markets could cause debilitating capital flight during times of economic stress.
Option 3: Accelerate the development of China’s central bank digital currency
Another potential option for China’s dedollarization is to accelerate the development of its central bank digital currency (CBDC). CBDC is fiat currency issued by the central bank in digital format, which is widely available to the public. There are two types of CBDCs: wholesale CBDCs used by financial institutions and retail CBDCs used by households and businesses. Wholesale CBDCs are already in use, as they are financial institutions’ deposits at the central bank (i.e. reserves). Therefore, effectively launching CBDC means rolling out retail CBDC. The PBoC began developing the Chinese CBDC – known as e-CNY – in 2017. Regardless of China’s progress in developing e-CNY, the requirements for the RMB to become a reserve currency major world remain the same. Specifically, China has yet to overcome the hurdle of capital account liberalization. In addition, privacy will be a major concern for the internationalization of e-CNY despite the PBoC’s assurance of the “controllable anonymity” of e-CNY, given that the institutional limits of governmental executive power in China are much more blurred than in advanced economies.
Prospects and impact of the “shock and awe” financial sanctions against China
The US-directed financial sanctions against Russia have two major components: the withdrawal of Russian banks from SWIFT and the freezing of the Russian central bank’s foreign exchange reserves.
It would be almost impossible to completely cut off Chinese banks from SWIFT. Even the sanctions against Russia only imposed a partial exclusion of Russian banks from the system, the reason being Europe’s heavy dependence on imports of oil and natural gas from Russia. The international payment system and international supply chains are two sides of the same coin: goods sold and purchased through the international supply chain are paid for through the international payment system. Since Europe is reluctant to completely cut off oil and natural gas imports from Russia, it cannot completely cut off Russian banks from the payment system.
China’s entrenchment in the international supply chain eclipses that of Russia. China is the world’s largest commodity trader and is deeply embedded in much of the global supply chain, while Russia is primarily a commodity exporter. Thus, completely cutting China off from the international payment system would send catastrophic shockwaves through the global economy, as it would effectively lead to a hard decoupling with China. As a result, only the most extreme geopolitical conflict between China and the United States could put this option on the table.
Freezing China’s foreign exchange reserves would be less catastrophic than removing China completely from the international payments system, although the resulting shocks to the global economy would still be extreme given the country’s vastness. Freezing China’s foreign currency assets would seriously undermine the PBoC’s ability to stabilize the RMB exchange rate and ward off a currency crisis. An RMB crash would inevitably follow, leading to a collapse in imports. Chinese authorities are likely to impose strict capital controls to stabilize the RMB. Foreign portfolio investment in China would be trapped and multinational companies operating in China could not repatriate their profits.
Beijing’s efforts towards internationalizing the RMB and promoting the reserve currency have failed to undermine the US dollar’s dominance in international finance and its role as the preeminent global reserve currency. China’s underdeveloped and insufficiently robust financial system is the main technical obstacle preventing the RMB from becoming a major reserve currency. China’s unclear institutional limitations on the executive authority of government are also a major impediment to the RMB’s rise to a major reserve currency. Ironically, the removal of these major barriers would imply a convergence of China’s economic and political system with that of advanced economies, which would greatly reduce the risk of US-led shock and fear financial sanctions against China that Beijing seeks to impose. avoid.
This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.