Beijing’s continued efforts to promote the RMB will only partially mitigate China’s geo-economic vulnerability
> The dollar is and will remain the world’s dominant international currency for the foreseeable future. Issuing the world’s most widely used international currency provides Washington with significant geo-economic power.
> China’s efforts to promote the international role of the RMB have made only limited progress. Limited currency convertibility, underdeveloped domestic financial markets and adversarial geopolitics will continue to limit the attractiveness of the RMB. The creation of a digital RMB will do nothing to this equation.
> Obstacles notwithstanding, Beijing will continue promote the wider use of the RMB in its foreign trade, particularly with countries who might conceivably become the target of US sanctions as well as countries that provide China with critical goods. The greater international use of the RMB will reflect ‘risk diversification,’ but will fail to undermine the central role of the dollar in international trade, let alone international finance.
See also: Promoting the RMB Will Limit, but not Quash China's Vulnerability to US Currency Sanctions
The Dollar Continues to Rule Supreme
The dollar remains the world’s dominant international currency.[1]The numbers speak for themselves. The dollar, the euro and RMB account for 60%, 20% and 3% of global foreign-exchange reserves, respectively. The dollar accounts for roughly 100%, 70%, 25% and 80% of export invoicing in the Americas, Asia-Pacific, Europe and ‘the rest of the world,’ respectively.[2] Remarkably, currencies other than the dollar and the euro account for only about 20% of Asia-Pacific trade, and this share includes the Japanese yen. The RMB does not even dominate regional trade. The dollar is on one side or the other of 90% of all global foreign-exchange transactions, the RMB is on less than 5%. (The two-way nature of international foreign-exchange transactions means that the total adds up to 200%.) Last but not least, the dollar dominates international and foreign currency banking claims and liabilities as well as foreign currency debt issuance, reflecting its dominant role in international finance. Respective RMB shares are 3% or less.
Some analysts have spoken of a ‘stealth erosion’ of the dollar’s international position. Since the creation of the euro in 1999, the dollar share has fallen from 71% to 59%. But the alleged erosion has benefitted currencies other than the RMB and the euro.[3] Part of the decline can be explained by changes in currency valuations. And financial return optimization rather than changes to liquidity preferences may explain much of the rest of the decline. Finally, foreign-exchange reserve holdings capture only one, if admittedly, important aspect of the role of an international currency. Other indicators (see charts) suggest that the dollar is alive and well. For now, the dollar rules supreme. It may do so for lack of alternatives; but it rules supreme all the same.
Foreign Exchange Reserves
(By Currency)
The RMB Faces Major Obstacles
For a country to become the dominant international currency issuers, it needs to meet a number of conditions.[4] First, it needs to have large economy. A large economy engaged in international trade and finance initially provides the impetus for the international use of its currency. Economic size also determines the ability to issue sufficient amounts of safe assets that are held by other countries for liquidity purposes. At present, the United States accounts for 25% of global GDP, China for 18%.
Second, in addition to economic size, a reserve-currency-issuing country must have well-developed financial markets. Markets for government debt need to be deep and liquid so as to allow debt to function as a liquid safe asset. This also requires a stable financial system and a sophisticated financial infrastructure, including derivatives markets. The US treasury market remains the largest and most liquid pool of safe assets, and US capital markets are the most sophisticated in the world. The size of China’s government debt market is expanding rapidly, but liquidity remains very limited. Its capital markets are underdeveloped.
Third, an open capital account is essential for foreigners to raise funds and recycle surpluses in an unconstrainted way. The US capital account is open and the dollar is convertible. By contrast, access, and especially private-sector access, to China’s onshore financial market is restricted and the risk of tighter capital account restrictions is ever-present, given the fragility of China’s financial and, especially, banking system. Although foreign central banks have gained access to Chinese onshore financial markets, access for foreign private investors remains overall very restricted. This sharply curtails the international role of the RMB. Foreign holdings of government can serve as a proxy measure of capital account openness: around 40% of US treasuries are held by non-residents (USD 7 trillion); but foreigners hold less than 10% of government bonds (less than USD 300 billion).
Fourth, ‘rule of law’ is important for foreigners to hold claims in and on another country. Rule of law generally is often defined as to comprise political stability, economic stability, the protection of property rights, and the predictability of public policies. Heavy-handed government intervention, including measures that prevent foreigners from accessing, or transacting in, onshore financial markets or otherwise interfere in markets in an unpredictable way, limit the appeal of holding a country’s currency. The United States has established a decent enough track record in this respect, recent measures targeting Russia notwithstanding. China, in part due to its economic and financial vulnerabilities and in part due to its state-interventionist economic model, is seen as more likely to intervene, and intervene more unpredictably.
Fifth, geopolitical relations are crucial. [5] A country that has an antagonistic relationship with another country will be reluctant to rely extensively (let alone predominantly) on this country’s currency to engage in international transactions or hold this country’s liabilities. Geopolitical alignment and allegiances matter. (The USSR held much of its international assets in London rather than Washington.) The dollar benefits from America’s wide-ranging and long-standing network of military allies and economic partners, which includes virtually all of the world’s major economies. By contrast, China has a far lesser network, which, other than Russia, does not include any major economy.
In short, China meets some of the conditions necessary for the RMB to become a prominent international currency, including economic size and a rapidly growing stock of financial assets, including government deb (see table). It also has extensive foreign trade relations. In fact, for 120 countries in the world, China is the largest trade partner. Yet the RMB makes up only a tiny fraction of international payments and foreign-exchange reserves. This is owed to the fact that the RMB is not freely convertible and domestic capital markets are relatively underdeveloped. Concerns about the rule of law and China’s geopolitical relations also diminish the attractiveness of the RMB in the eyes of many investors and governments.
Beijing’s Internationalization Policies Amount to a Fully-Fledged Strategy
China is facing difficult-to-overcome obstacles in terms of promoting the RMB. In face of the challenges related to the much-needed reform of its economic growth model, continued financial fragility risks, and intensifying geo-economic and geopolitical competition, it is difficult to see how China will be able to overcome these obstacles. Moving toward full currency convertibility would need to be preceded by a successful reform of China’s economic model, the strengthening of the banking sector, and the development of deep and liquid domestic financial markets. Even if Beijing were able to implement all the necessary reform, which would no doubt enhance the attractiveness of the RMB, China would still need to build greater geopolitical trust. [6]
Despite these challenges, Beijing remains very keen to promote the RMB. The global financial crisis of 2008 provided it with the initial impetus to internationalize the RMB in order to make China less vulnerable to US economic and financial policies (and crises). The extensive financial sanctions US and its allies imposed on Russia in 2022 has provided Beijing with even greater incentives to reduce its vulnerability to potential currency sanctions, if this was at all needed. Beijing understands that challenging the dollar as the dominant international currency is not a realistic goal in the short- to medium-term. However, promoting greater RMB in China’s foreign trade is a more viable proposition and would help make Beijing (slightly) less vulnerable to US (and allied) geo-economic coercion.
Indeed, looking at Chinese policies over the past decade and a half, it is clear that Beijing has been keen to reduce its dollar dependence. The sum of individual policies amounts to a fairly cohesive, if thus far not very successful strategy to limit dollar dependence. Here is a list of the these policies.
> Allowing RMB overseas deposits and establishment of offshore RMB bond market (2003- )
> Creation of cross-border trade RMB settlement (2008)
> Selective, limited liberalization of capital account restrictions for inbound and outbound investment (e.g. Stock Connect Hong Kong), including providing greater access to its onshore bond markets to foreign central bank (2011- )
> (Modest) move towards more market-determined RMB exchange rate (2015)
> Establishment of bilateral and multilateral RMB swap lines (including the upgrading of the Chang Mai initiative)[7] and creation of a local currency settlement framework to facilitate current account and foreign direct investment transactions with selected countries (2009- )
> Creation of a Cross-Border Interbank Payments System (CIPS), which allows for clearing and settlement, as a possible future substitute for SWIFT (2015)[8]
> Provision of RMB-denominated financing in the context of official and quasi-official bilateral lending, including the Belt and Road Initiative (2013) and the newly established Asian Infrastructure Investment Bank (2016)
> Successful diplomatic effort to include RMB in the IMF’s special drawing rights currency basket currency basket (2016)
> Ongoing efforts to move toward a more market-based, more sophisticated and robust financial and banking system (1999 - )
> Promotion of onshore commodity and commodities futures markets with the goal of turning them into global benchmarks (e.g. oil futures contracts) (2018)
> Creation of a central bank digital currency (or e-yuan), with a view to extending it cross-border (2022)
E-Yuan Won’t Be a Game-Changer
If the RMB cannot dethrone the dollar, might the so-called ‘e-yuan’ do so? No. First of all, private digital money is not going to replace national money. Private digital money does a poor job in terms of fulfilling the store of value (excessive volatility), unit of account (limited market pricing) and medium of exchange functions (high transactions costs). At least, it does so for the time being. Moreover, national governments will be reluctant to see their monetary sovereignty undermined and related benefits appropriated by private markets. Risks related to terrorism financing, money laundering, tax evasion, cyberattacks and financial instability provide further incentives for national regulation, sharply circumscribing the use of private crypto-currencies, including for international transaction purposes.
Central bank digital currencies (CBDC), or public crypto-currencies are a slightly different matter. Relying on ‘crypto’ technology, they can help lower transaction costs.[9] CBDCs raise many challenges in terms of their impact on traditional payments systems, credit creation and bank disintermediation as well as the effectiveness of monetary policy. Putting these aside, extending a CBDC like the e-yuan beyond a country’s border raises many of the same issues that plague the international role and standing of the regular RMB. Granted, the e-yuan may allow for lower transaction costs and may facilitate transactions between any two currencies, while sidestepping the need to “trade through” a liquid and widely used international currency and related infrastructure (such as SWIFT). But it needs to meet the same condition as a fiat international currency: rule of law, political and economic stability, deep and liquid financial markets, currency convertibility and geopolitical trust. And if the economic and geo-economic gains outweighed these concerns, it is difficult to see how the United States would stand idly and not create an e-dollar to dampen the relative attractiveness of the e-yuan.
In brief, the emergence of digital currencies, including central bank digital currencies, does not do away with the importance of economic size, deep and liquid financial markets, currency convertibility and geopolitical trust.[10] If anything, an extension of the e-yuan for international use might allow Beijing to exert even greater control over the modalities of its use, given the even greater centralized control a centralized digital technology affords the issuer. This turns it into an even more efficient geo-economic tool than traditional international fiat currencies. All of this may or may make the e-yuan more attractive to some smaller economies, but it is unlikely to make the -e-yuan more attractive in the eyes of actual and potential antagonists.
Beijing Remain Keener Than Ever to Boost the Role of the RMB in its Foreign Trade
The self-reinforcing dynamics of geopolitical and economic alliances as well as the prevalence of network effects and the dollar’s incumbency advantage will sharply curtail the international role of the RMB So will China’s instability to open its capital account. But the large-scale US and allied financial sanctions imposed on Russia following the invasion of Ukraine have further increased Beijing’s incentives to promote wider RMB use in its foreign trade. Beijing will therefore continue to promote the use of the RMB for international trade purposes in order to reduce its vulnerability to dollar sanctions. This will help boost the international use of the RMB – without however jeopardizing the dominant role of the dollar. The share of the RMB in global payments remains minimal (2%). Only 15% of China’s foreign trade is settled in RMB in 2021. [11] This share is likely to rise, but this will only make a small difference in terms of global RMB use (see chart). While this will make Chinese trade less vulnerable to currency sanctions, it will only go so far in terms of lessening China’s financial dependence on the dollar or its trade-related vulnerability.
Economically, issuing an international currency generates both benefits and economic costs.[12] Among other things (see table), the role of the dollar as the dominant international reserve currency allows America to borrow in its own currency and on more favorable terms, lessening balance-of-payments constraints. Dollar dominance also translates into the US being a ‘mature debtor’ (being able to borrow in its own currency, limiting financial risks), while it forces China into the role of an ‘immature creditor’ (with its foreign claims largely denominated in dollars, increasing financial risks). Ironically, this makes the debtor (United States) more powerful (and less vulnerable) and the creditor (China) more vulnerable (and less powerful). Last but not least, US financial and economic shocks are quickly transmitted to the rest of the world, including China, given the role the dollar plays in the international financial system. (China’s export dependence on the United States exacerbates this vulnerability further.) Continued dollar dominance means that Beijing will have to continue to accept this disadvantage, which exposes it to dollar-related macroeconomic and financial risks. [13]
Geo-economically, issuing the world’s dominant international currency provides Washington with political power due to others’ reliance on the dollar as a means of international payment. [14] The ability to effectively prevent targeted entities from engaging in dollar-based international transactions provides Washington with a powerful geo-economic instrument, if not always to prevent the targeted party from engaging in international trade, but at least to substantially increase the costs of doing so.
Currency and financial sanctions can target individuals, companies, sectors or an entire economy. Granted, it is difficult to see how the United States would impose blanket, economy-wide dollar sanctions on China, barring the outbreak of military hostilities. Not only would this be economically very costly to the United States (and hence relatively inefficient), it would also encounter significant resistance from partners and allies. Hence Washington is far more likely to resort to “smart” or at least targeted sanctions, as they are more cost-effective and provoke less opposition (and greater compliance) from third parties, whether they be neutrals, partners, or allies.[15] Sanctions targeting China’s critical imports and exploiting its strategic vulnerabilities, such as energy or foodstuffs, would be more cost-effective from an American perspective. Beijing is keenly aware of this vulnerability and this is precisely why it has an interest in insulating its foreign trade, and especially critical imports, from targeted dollar sanctions by promoting the greater use of the RMB in its foreign trade.
Conducting Trade in RMB Will Help, But Is No Panacea
While the lack of convertibility will hamper the broader internationalization of the RMB, a combination of further selective capital account liberalization and a further extension of bilateral and multilateral currency swap agreements will allow Beijing to conduct more of its foreign trade in RMB, thus providing an alternative to dollar-based trade ‘just-in-case,’ or a spare tire if you will.[16] This may not be economically efficient (and more costly for transacting parties), but it provides some degree of insulation from potential dollar sanctions. The greater use of the RMB in trade transactions will not, and to a large extent cannot, lead to a significantly greater RMB use in non-trade-related international (financial) transactions. This will put a natural limit on the extent of RMB Use. (Tellingly, whenever countries draw on the PBoC swap lines, they immediately convert the RMB into USD or EUR, underling the continued dominance and centrality of the dollar in terms of international liquidity.)
Moreover, RMB use can only expand so far, for countries that run a deficit with China on a continuous basis will find it difficult to raise RMB, and countries (or rather private sector agents) that run surpluses may be reluctant to end up holding RMB assets, given limited opportunities to recycle their holdings. Furthermore, not all trade needs to be transacted in RMB to afford China’s foreign trade greater insulation from dollar sanctions, provided the latter are targeted and selective. The recent agreement between Beijing and Riyadh to make greater use of the RMB in their bilateral trade illustrates this. Both countries have an interest in conducting (a share of) their bilateral trade in RMB in order to be able to sidestep potential dollar sanctions. After all, Chinese energy imports would make for an easy target for US sanctions. But this is unlikely to lead Saudi Arabia to want to conduct all bilateral trade with China in RMB or hold RMB onshore assets.
In this context, it is worth pointing out that conducting trade in RMB reduces the risk of currency sanctions. But it does not eliminate it. Washington could decide to (threaten to) impose dollar sanctions on any entity that engages in a transaction with a designated counterparty, regardless of whether it is conducted in dollars or not. This would represent a significant geo-economic escalation, and such a measure would be controversial politically as well as more difficult to enforce, given the lower level of visibility of non-dollar transactions from a US perspective. But otherwise there is little that would prevent Washington from doing this.
As long as third parties depend on the dollar to a significant extent, they will not want to risk being excluded from dollar transactions or have the American government come after them. The costs of not dealing with a designated party will typically be much smaller than the costs of being excluded from future dollar-based international transactions or related penalties. In other words, switching to RMB trade does not eliminate the risk of dollar sanctions to Chinese trade, but it significantly raises the political and administrative costs of enforcing dollar sanctions for the US government. Beijing’s RMB policy therefore needs be seen as part of the broader geo-economic competition between the United States where both sides to limit their economic and financial vulnerabilities (securitization), while holding the other party ‘at risk’ (weaponization).
The Chinese authorities will continue to push for the RMB to play a greater role in international trade by promoting greater cross-border RMB settlement. This will help enhance RMB use, but only up to a point. China’s top-5 import partners (Korea, Japan, US, Australia, and Germany) account for a full 1/3 of Chinese imports. Coincidentally, they also absorb a full 1/3 of Chinese exports. They are unlikely to conduct much of their bilateral trade with China in a less efficient and politically riskier currency like the RMB. So unless China is able to force or nudge its major trading partners to transact in RMB, its use in international trade transaction is naturally circumscribed. And this is even before accounting for the RMB’s far less user in international financial transactions. Even if Beijing were to settle a full 2/3 of its foreign trade in RMB (and only in RMB), which is highly unlikely, its share in international as well as international trade transactions would remain below 10%.
Efforts to promote the RMB for international transactions will gain greater traction in the case of countries that are at more immediate risk of dollar sanctions as well as with countries that supply critical goods to China, for their trade is much more likely to become the target of US currency sanctions. The use of the RMB for international private financial transaction will remain highly restricted due to limited RMB and capital account convertibility. The RMB will largely remain a ‘risk diversification play,’ imperfectly insulating China’s trade against targeted US dollar sanctions. And it is not going to represent a threat to dollar dominance.
[1] BIS, Dollar debt in swaps and forwards, Quarterly Review, 2022, BIS, The dollar, bank leverage and real economic activity, Working Paper 847, 2020, BIS, US dollar funding, CGFS Paper 65, 2020, BIS, Dollar invoicing, global value chains and the business cycle dynamics of international trade, Working Paper 860, 2020,BIS, Global dollar credit, Working Paper 483, 2015
[2] Federal Reserve, Is the international role of the dollar changing? FEDS Notes, 2021
[3] IMF, The stealth erosion of dollar dominance, Working Paper 58, 2022
[4] Markus Jaeger, Yuan as a reserve currency, Deutsche Bank Research, 2010
[5] Federal Reserve, Geopolitics and the US dollar’s future as a reserve currency, International Finance Discussion Paper 1359, 2022
[6] Federal Reserve, Geopolitics and the U.S. dollar’s future as a reserve currency, International Finance Discussion Papers, 2022
[7] IMF, Evolution of bilateral swap lines, Working Paper 210, 2021
[8] Lawfareblog, Why China’s CIPS matters (and not for the reasons you think), 2022
[9] BIS, The digitalization of money, Working Paper 941, 2021
[10] Eswar Prasad, The future of money (Cambridge 2021)
[11] PBoC, RMB Internationalization Report, 2021
[12] Elias Papaioannou and Richard Portes, Costs and benefits of running an international currency, European Commission European Economy Economic Paper 348, 2008; Pierre-Olivier Gourinchas and Helene Rey, From world banker to world venture capitalist, NBER Working Paper 11563, 2005
[13] BIS, Global dollar credit, Working Paper 483, 2015; BIS, The dollar exchange rate as a global risk factor, Working Paper 695, 2018; BIS, US dollar funding, CGFS Paper 65, 2020
[14] Henry Farrell & Abraham Newman, How global economic networks shape state coercion, International Security 44 (1),;2019
[15] Daniel Drezner, Sanctions sometimes smart, International Studies, 13 (1), 2011
[16] Barry Eichengreen et al., Is capital account convertibility required to for the RMB to acquire reserve currency status? Center for Economic and Policy Research, Discussion Paper 17498, 2022