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The weaponization of the US dollar against Russia after its
invasion of Ukraine has raised expectations that Beijing will
accelerate its de-dollarization efforts, to protect against similar
financial sanctions that Washington could deploy against China
(mainland). While the Chinese renminbi (RMB) is unlikely to
dethrone the US dollar in the global financial system soon,
concerns remain that the dollar's weaponization against Russia has
initiated an irreversible fracturing of the global financial system
that will result in two international monetary systems, one led by
the United States and one by China.
RMB internationalization and development 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 is intended to increase its usage
in international trade and financial transactions, while its
possible ascension to a major global reserve currency entails
RMB-denominated financial assets being widely and heavily held in
central banks' foreign-exchange reserves.
RMB's advancements in the two areas have been marginal, even
with Beijing's greater push on both fronts since the early
2010s.
In foreign-exchange markets trading, the RMB accounted for 4.3%
of one side of total trade in 2019, according to the Bank for
International Settlements' triennial survey - up from 0.9% in 2010.
The US dollar remained the most actively traded currency in the
global forex market, accounting for 88.3% of all trades on one side
in 2019.
The reach of China's CIPS (Cross-Border Interbank Payment
System), the international payment system China launched in 2015,
still pales in comparison with 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 with more than 11,000 of SWIFT's
participating institutions. Moreover, more than 80% of CIPS's
transactions rely on SWIFT's messaging service.
As a reserve currency, the RMB accounted for only 2.8% of
foreign-exchange reserves held by central banks across the globe 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 final quarter of
2021.
Prospects and impact of China's
de-dollarization
Given the RMB remains far behind the US dollar in terms of
international use and the role of the dominant global reserve
currency, what countermeasures could Beijing deploy to protect
China against US financial sanctions like those enacted against
Russia?
Option 1: Diversifying away from US dollar
reserves
To protect against the US freezing China's foreign-exchange
reserves, Beijing could aggressively diversify its reserve holdings
away from US dollar-denominated assets. China reduced its holdings
of US dollar reserves from 79% of its total foreign-exchange
reserves in 1995 to 59% in 2016 (the latest data reported by
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 holdings of dollar reserves to
only 7% of its overall foreign-exchange reserves. However, because
most of Russia's reserve diversifications went 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 the sanctions. Given the size and
depth of advanced economies' financial markets, if Beijing were to
diversify its reserve holdings away from dollar assets, it would
have little choice but to reallocate its portfolio to the financial
instruments of the other advanced economies. Indeed, advanced
economies account for 96% of the global bond market excluding the
US and China. (China cannot hold foreign-exchange reserves in RMB
assets.)
Option 2: Full push for the RMB to achieve major global
reserve currency status
Beijing could launch a forceful push to promote the RMB as a
major global reserve currency. The key obstacle to this option is
not the US dollar's entrenched dominance in international trade and
finance that the RMB has struggled to chip away. Rather, the
essential barrier to the RMB becoming a major global reserve
currency is the Chinese government's inability to fully liberalize
China's capital account, owing to its underdeveloped and
insufficiently robust financial system. China's financial system is
dominated by banks, which are mostly under state command. Given
this, bank lending is not always based on commercial criteria and
generally favors state-owned enterprises or politically connected
private firms. China's bond market lacks transparency because
China's subpar domestic credit rating industry has consistently
provided inflated ratings for Chinese bonds. China's stock markets
are highly volatile owing to poor corporate governance, inadequate
accounting practices, low 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 fully healthy financial
markets could induce debilitating capital flight during periods of
economic stress.
Option 3: Expedite the development of China's central
bank digital currency
Another potential option for China's de-dollarization is to
fast-track the development of its central bank digital currency
(CBDC). CBDC is fiat money issued by the central bank in digital
format, which is widely available to the public. There are two
types of CBDC: wholesale CBDC used by financial institutions, and
retail CBDC used by households and businesses. Wholesale CBDC is
already in use, as they are financial institutions' deposits at the
central bank (that is, reserves). As a result, launching CBDC
effectively means rolling out retail CBDC. The PBoC began
developing China's CBDC - known as e-CNY - in 2017. Regardless of
China's progress in e-CNY's development, requirements for the RMB
to become a major global reserve currency remain the same.
Specifically, China still needs to clear the hurdle of capital
account liberalization. Furthermore, privacy will be a major
concern for the internationalization of e-CNY despite the PBoC's
assurance of e-CNY's "controllable anonymity," given that the
institutional limits on governmental executive power in China are
much more blurred than in advanced economies.
Prospects and impact of "shock and awe" financial
sanctions against China
There are two major components of the US-led financial sanctions
against Russia: removing Russian banks from SWIFT, and freezing the
Russian central bank's foreign-exchange reserves.
It would be nearly impossible to completely cut off China's
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 oil and natural gas imports from
Russia. The international payment system and international supply
chains are two sides of the same coin: goods sold and bought
through the international supply chain are paid and paid for
through the international payment system. Given that 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 dwarfs
that of Russia. China is the world's largest goods trader and is
deeply entrenched across a wide stretch of the global supply chain,
while Russia is mainly a commodities exporter. Thus, completely
cutting off China from the international payment system would send
catastrophic shockwaves through the global economy, as it would
effectively entail a hard decoupling with China. As a result, only
the most extreme geopolitical conflict between China and the US
could put this option on the table.
Freezing China's foreign-exchange reserves would be less
catastrophic than completely removing China from the international
payment system, although the resulting shocks to the global economy
would still be extreme given the country's immense size. Freezing
China's foreign-exchange holdings would severely impair the PBoC's
ability to stabilize the RMB's exchange rate and fend off a
currency crisis. An RMB crash would inevitably ensue, leading to an
import collapse. The Chinese authorities would be likely to impose
strict capital controls to stabilize the RMB. Foreign portfolio
investment in China would be trapped, and multinational enterprises
operating in China would be unable to repatriate their
earnings.
Final word
Beijing's efforts toward RMB internationalization and reserve
currency promotion have been unable to shake the US dollar's
dominance in international finance and its role as the pre-eminent
global reserve currency. China's under-developed and insufficiently
robust financial system is the key technical obstacle to the RMB
becoming a major reserve currency. China's blurry institutional
limitations on governmental executive authority also pose a major
impediment to the RMB's ascension 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
the advanced economies, which would greatly reduce the risk of the
US-led shock-and-awe financial sanctions against China that Beijing
is seeking to avoid.
Posted 04 May 2022 by Todd C. Lee, Chief China Economist, S&P Global Market Intelligence
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.