Can China’s Yuan Replace the Dollar as the World Reserve Currency?

July 24, 2024 / Vignesh / Human Behavior

Background

I found this article so insightful, so I sought the author’s permission to republish it. Author, Shrivarshini M is a journalism student. Understanding economics intertwined with global politics is a complex subject. She did an amazing job in structuring complex topic in a very understandable structure. Kudos!!

Original Article

Introduction:

Countries maintain foreign exchange reserves to address balance of payments requirements, intervene in currency markets, offer liquidity in foreign currencies to local economic participants, and for other purposes such as bolstering confidence in the national currency and facilitating overseas borrowing. Consequently, these reserves are typically held in currencies extensively utilised for international transactions and heavily traded in global forex markets. (IMF, 2018)

There are certain criteria required for any currency to become the world reserve currency. To attain the world reserve currency, the respective country’s financial market should have a deep and flexible structure. Also, it should be easily convertible to other currencies and should be widely accepted in international trade for the primary payment. In addition to these criteria, the country’s economic size (GDP) and its share in world trade should be in the higher percentage (Chouhan, 2022).

The growth of the Chinese economy has increased the use of Yuan on a global level and the foreign trade volume acts as the primary factor for its widespread use (Fabrichnaya et al., 2024). The increase in the global payments of Yuan to 4.52% (SWIFT, 2024), shows international support towards Yuan becoming the world reserve currency. Additionally, the International Monetary Fund (IMF) raised the weightage of Yuan 1.36% points to 12.28%, becoming the 3rd largest in the IMF’s Special Drawing Rights (SDR) basket of currencies. The questions arise here are, do international institutions predict the Yuan’s emergence as the world reserve currency? Does Yuan really have the ability to replace the Dollar as the world reserve currency?

This research article is a qualitative study of the effectiveness of China’s initiatives in promoting the Yuan as the world reserve currency. It also analyses whether Yuan meets the parameters of the world reserve currency. Sources include government press releases and documents, research papers on this topic, and other multimedia sources including videos and livestreams. The scope of the article, however, is limited to a surface-level analysis. Further research is to be done to mitigate the issues faced by the Chinese government in promoting the Yuan. The article seeks to add to the existing knowledge pool and provide an overview of the current scenario for further research.

How effective is China in terms of promoting the Yuan?

Today, China focuses exclusively on promoting the Yuan through trade. China’s trade in goods using the Yuan grew by 0.2% year on year to 41.76 trillion Yuan in 2023 (China Trade, 2024). The China FX Market Self-Regulatory Framework 2024 advised major state-owned banks to cut their dollar deposit rates, as a way of encouraging exporters and households to switch dollar receipts into Yuan (FOREX.com, 2024). However, this initiative caused Chinese export to decline by 7.5% in March 2024 (Dsouza, 2024).

The Chinese Yuan is finding it hard to fight the U.S. Dollar in the global trade market. In the aim of internationalising Yuan, the Chinese government has established 13 RMB clearing centres worldwide including UK, U.S., China Taiwan, Hong Kong, South Africa and so on (BOCUSA, 2024). In the RMB clearing centres, the Bank of China maintains crossborder RMB clearing, an extensive clearing network, 24-hour clearing operations and so on (SWIFT, 2024). The establishment of cross-border cash pooling in a pilot programme in 2021, has allowed multinational companies to simplify cash management operations by integrating and transferring RMB funds between the domestic and foreign subsidiaries.

Cross-border treasury operations activate the foreign exchange, which in turn boosts the liquidity of the RMB. (Societe Generale, 2023) These functions help China to increase the RMB offshore businesses. The UK secures 2nd position with 4.87% after Hong Kong in the offshore RMB economy (SWIFT Business Intelligence, 2024). In 2023, Chinese companies’ investments (taking place in Yuan) in the UK accounted for 53% of the total deals (China Chamber of Commerce UK, 2023). As Chinese corporations expand their business worldwide, usage of offshore RMB also increases. This leads to an increase in the volume of (Yuan) money supply. The value of the RMB offshore market has risen from 1.79% in 2009 to 7.25% in April 2024 (Marketwatch, 2024).

The People’s Republic of China (PRC) has also developed an alternative to the SWIFT transaction system that is primarily denominated in USD with the CIPS (Cross-Border Interbank Payment System) system that is primarily denominated in Yuan, which includes around 160 countries (Wang, 2023). CIPS has processed a 50% increase in the Yuan transaction volume (Lawfare, 2023). PRC is also collaborating with Cross-border Financial Information Services (CCFIS) to further promote cross-border development (Societe Generale, 2023). It strengthens the position of the Yuan in the global financial order.

China is ahead in the development of a Central Bank Digital Currency (CBDC), and the internationalisation of the digital yuan, or e-CNY, could be the revolution in global trade. The Bridge project, supported by China, the Hong Kong Special Administrative Region, Thailand and others, is the largest cross-border CBDC initiative. (Societe Generale, 2024) In November 2023, China’s People’s Bank and UAE’s Central Bank had a currency swap agreement worth US$4.58 billion with the MoU in digital currency development. (Business Standard, 2024). It boosts bilateral trade and strengthens monetary cooperation with other economies to maintain financial stability.

After President Xi Jinping’s visit to Saudi Arabia, the leaders were considering accepting the Yuan instead of the Dollar for oil sales, if that happens then there is a possibility for the backlash of Dollar’s dominance in the global petroleum market. (EAF, 2024) Currently, UAE’s Dollar investment is more than $3 Trillion. After the Hamas-Israel conflict, crude oil prices rose to 4.5% (EIA, 2024). If the UAE plans to get rid of this tension, it will be more advantageous for China’s initiative to promote Yuan in this region. Then it will automatically pave the way for the internationalisation of the Chinese Yuan in the global oil market. (Kapadia, 2023).

The SWIFT’s ban on several Russian banks, made Russia opt for an alternative currency. (Casarini & Fatiguso, 2022) In 2023, after the Ukraine-Russia war, trade using Yuan accounted for almost 42% of all foreign currency traded on the Moscow exchange (Pollard, 2024). Yuan progressively increased trade and investment activities in this region. At the same time, western countries like Canada, and New Zealand rejected the negotiations of China in trading with the Yuan. They consider the Yuan as an unstable currency compared to the Dollar (GIS, 2023), while the Dollar’s global payment has been reduced to 59.5% (de Best, 2024).

How will China benefit from Yuan attaining the position of world reserve currency?

The benefits of being a world reserve currency are as follows. At the international level, it enables its traders to make transactions in their currency rather than foreign currency. Trading in their currency will boost the speed of payment as the number of intermediaries involved in the exchange process is reduced, and the final transaction will be settled faster. As more transactions are denominated in the reserve currency, it tends to provide more liquidity for the currency. (IBA, 2023) By this way, it enhances the country’s power on the global stage and ensures comfortable convertibility while travelling abroad. For the issuer of reserve currency, transaction costs will be reduced since both sides of the transaction involve the same currency. Exchange rate risk will also be reduced because there is no need for currency conversion for trade from the issuer side. The reserve currency is perceived as low risk, as it protects the country from periodic economic fluctuations. (Boyle, 2021)

Does Yuan meet the parameters of world reserve currency?

In 2023, the growth rate of China’s financial assets is 9.9% (NFRA, 2024). It shows the flexible structure of the financial market of the country. RMB convertibility has been a concern, as China is facing pressure of capital outflows (USD 75B) despite being the 2nd largest economy with an economic growth rate of 5.2%. (NSU, 2024) It becomes a risk factor for the Yuan’s internationalisation.

China’s final consumption in 2023 contributed 82.5% of the overall GDP growth of the country (NBS, 2024). With this, China secures the third position in the global consumption market. It drives China from an investment model to a consumption model. China has more than 400 million female consumers aged 20 to 60, and their spending accounts for more than 10 trillion yuan. (Alibaba Outlook, 2023) Women’s contribution (Consumption rate 2.0%) drove an economic growth of 5.2% larger than the 2022 (NBS China, 2023). In addition to the local women consumers, Chinese products are being consumed globally, contributing 20.68% of the overall exports of China (Statista, 2024). SHE-economy of China has gained global attention with its output. But, as China didn’t bring any legal regulations regarding bilateral trade using Yuan, it won’t create any positive impact for the currency.

China is consistently considered the world’s largest trading nation in terms of total trade, taking most of the world’s trade. The US is also among the largest trading partners in the world, accounting for a large share of global trade. China’s share in the world merchandise trade has been 14.2% (Dyvik, 2024). The share of the US in world trade has been 5% (Global Trade Outlook, 2024). This percentage reflects their status as major economies and trading nations in the world. China’s trade volume has increased over the past decade, making it the world’s largest trading partner, while the US remains at its peak despite varying trade policies and economic trends.

The USD remains dominant in the world’s foreign exchange reserves, with 58% of the world’s reserves denominated in USD. In contrast, the yuan’s share is 2.29%. (IMF, 2024) Although the yuan’s share of global reserves is relatively small, it is slowly growing as China’s economy grows and its financial markets become more integrated into the global economy. Countries with substantial USD reserves receive stability and liquidity benefits but face risks associated with the depreciation of the USD or changes in US economic policy. For holders of the yuan, there is potential to diversify and participate in China’s economic growth but with consideration given to market volatility and regulatory controls.

China has several US dollar reserves, especially US treasuries, as part of its foreign exchange reserves. As of March 2024, China held about $1.05 trillion in U.S. Treasuries, making it the second largest foreign holder after Japan (about $1.29 trillion). (Statista, 2024) China’s holdings fluctuate based on economic conditions and policy decisions. China’s holdings in the US Treasury impact global financial markets, influence US bond yields and give China more leverage in US economic policy discussions. (Perez, 2024) On the other hand, foreign exposure to Chinese securities, including government bonds and equities, has been limited by regulatory restrictions and market barriers. As of March 2024, foreign ownership of Chinese government bonds was very low and estimated to be about 9% (CCDC,2024). There is a large asymmetry between China’s USD reserves and foreign reserves of Chinese reserves. China’s USD hedge fund is huge and influenced by global financial markets, while China’s portfolio remains very low due to various problems such as complications in accessing information, limited access to markets, capital controls and so on. (JPY, 2024)

China’s legal system, rooted in civil law and influenced by socialist principles, is not transparent or accessible to foreign companies compared to the common law. (SCIO, 2024) Regulations and decisions may not have the level of openness and understanding expected by international investors. Most Chinese laws and legal documents are primarily available in Mandarin, causing problems for non-Chinese background people, including international investors and businessmen. These disputes involve clashes over land and maritime boundaries, leading to diplomatic standoffs and occasional military standoffs. (Joshi, 2023) For example, China’s construction of artificial islands with military bases in disputed waters has been controversial, contravening international law and maritime law. These actions have raised concerns among ASEAN members and the international community about China’s credibility as a peaceful neighbour and stable partner in economic and diplomatic relations. (Chang, 2024)

ASEAN is one of China’s largest trading partners. In 2023, trade between ASEAN and China reached about $523.7 billion (ASEAN, 2024), making ASEAN as more important than the European Union or the United States in terms of trade volume with China. The trade partnership is based on ASEAN’s role as a major supplier of raw materials and commodities to China, as well as a major market for Chinese exports, especially in electronics, machinery, and manufactured goods. (Chow, 2024) The adoption of the yuan system in international trade depends on trade volumes and economic relations between countries (Chow, 2024). ASEAN countries, which have larger trade with China, tend to adopt the Yuan system because of the depth of economic integration amid the tensions. (Simões, 2022) In contrast, the limited volume of trade and trade imbalance between India and China poses challenges for the adoption of a Yuan system in bilateral trade. In 2023, China’s exports to India were $117.68 billion, while imports from India were about $18.54 billion (UN, 2024). This trade imbalance reflects India’s dependence on Chinese goods in sectors such as electronics, machinery, and pharmaceuticals, while India’s exports to China are primary resources like fuel, pesticides and so on. Lack of trade and severe geopolitical problems have hampered efforts to establish more trade relations and increase the volume of bilateral trade. (IBEF, 2024)

To attain the position of world reserve currency, it should be widely accepted by foreign countries as the basic payment source for trading purposes. In 2023, world trade designated in Dollars is 59.66% while in Yuan is 2.86% (de Best, 2024). Though the Yuan’s percentage has increased compared to the 2022 statistics (1.47%), standing against the Dollar is a hard scenario for it. From the above analysis, it shows that most of the countries are not ready to accept the Yuan. It is slightly a disadvantage for the currency.

Conclusion:

The Yuan is the fourth most active currency for global payments with a share of 4.52% (SWIFT Business Intelligence, 2024), and at the same time, China has the highest reserve of U.S. dollars ($3.2T) (CEIC, 2024). The role of the Yuan is growing; it has expanded from trade settlements to cross-border investments. If the RMB becomes a more attractive asset, then the CIPS and other traditional financial mechanisms could strengthen the position of the Yuan in the global financial order. The analysis states that, as Chinese corporations expand their business worldwide, usage of offshore RMB will also increase. So, the Chinese government should come up with initiatives to further increase offshore businesses.

China’s aggressive actions in land disputes have raised concerns about its credibility among its friendly countries despite strong economic ties. The development of yuan settlements reflects China’s willingness to reduce the US dollar’s reliance on regions with important trade links, such as ASEAN. However, India’s situation differs due to trade imbalances and geopolitical constraints, limiting large-scale yuan-denominated transactions in bilateral trade. These factors highlight the complexities of China’s economic strategy and their relative impact across regions and trading partners.

The Chinese government’s ongoing efforts to globalize the yuan could lead to a gradual increase in its role as a reserve currency, especially in regions such as the Middle East. The emergence of the SHE economy in China represents a paradigm shift, reflecting the increasing power and participation of women in the national economy. It gets attention on a global level. Once the Middle East accepts the Yuan as a trading currency for oil purchases, it could reduce the dominance of the Dollar in this area. Lack of transparency and accessibility to China’s regulatory system could undermine confidence in the Yuan’s global performance. Foreign investors and traders can face serious risks due to restrictions on law enforcement and the protection of their rights, which can prevent them from holding and using assets in the Yuan. The internationalization of the yuan requires compliance with international financial rules and transparency of rules. Difficulties in understanding and managing Chinese law and regulation could impede compliance and integration into global financial markets.

Given the projections of the Chinese economy, the internationalisation of the Yuan will increase but its process will be gradual. Currently, only a few countries are considering using the Chinese currency over the US dollar and it will take some time for the Yuan to match up to the US dollar. In the given geopolitical scenario, the process will be challenging for China, as the Yuan is still relatively smaller than the U.S. Dollar.

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