The shift in the RMB’s reserve currency math: A deep dive

In the early 2010s, the RMB was proclaimed to be poised to become a leading rival to the United States dollar.

Despite the efforts of authorities and the positioning of the internationalization of the RMB as a source of ‘national pride,’ the results have been lukewarm.

However, the Ukraine war may have altered reserve currency math for good.

On currency

In an earlier piece for Invezz entitled ‘No holds barred as China launches frontal assault on American dollar hegemony’, I wrote,

Value is a notoriously difficult concept to identify, pin down and distil into its explanatory components…. (Currencies) label and attempt to quantify value, and transform a previously abstract, highly individual idea into a shareable, tradable one. The individual characteristics of goods and services give way to a single encapsulating numerical unit which can describe the entity of interest.

Further,

Their rise and fall are dictated by prevailing economic realities, political imperatives and societal attitudes towards the issuer.

Thus, currencies, which bring an unseen value to life, are by their very nature temporary.

Their effectiveness and level of acceptance can change, sometimes violently, especially in challenging economic circumstances.

However, there are rare currencies that have excelled in certain periods and have withstood the pressure placed on them, and even come to dictate broader economic events. These are referred to as ‘reserve currencies.’

An example of this dynamic would be what Professor Eshwar Prasad of Cornell University, and earlier, the head of the IMF’s China division, calls “the dollar trap.”

Despite the many challenges to the USD in the decades gone by, it has retained its position at the top of the monetary pecking order, as the global reserve currency.

In fact, Professor Prasad points out, that the greenback instils such extraordinary faith in economic agents as a safe haven, that even when the United States has been the source of global financial disruption, investors and portfolio managers have rushed to seek refuge in the dollar.

I would not yet agree with the bitcoins depicted in this graph but it offers a picture of how reserve currency status has evolved through time.

Dollar dominance

The centrality of the dollar to financial flows becomes evident looking at the FX market.

In its Triennial Central Bank Survey, the Bank of International Settlements (BIS) noted that a staggering 88.5% of all Forex trades in April 2022 involved the USD.

This was up from 88.3% in 2019 and dwarfed the euro which stood at 30.5%, and declined from 32.3% three years earlier.

The most common trade was the USD/EUR at 22.7% in 2022, down from 24% in 2019. This is likely in part a reaction to the falling attractiveness of the euro.

It is worth noting that the renminbi is ahead of several leading Western challenger currencies such as the AUD, CAD, and CHF.

In addition, as per Federal Reserve data, the dollar accounts for over four-fifths of trade invoicing in every single region except for Europe (where the euro holds sway).

Renminbi’s rise

Some of the key factors that support the RMB are discussed below:

Sanctions

A flurry of hard-hitting sanctions on Russia by the US and its allies has proved devastating to the global trust in the greenback.

Many emerging countries have become wary of their near-complete reliance on the dollar for investments, trade, savings, foreign currency reserves and economic management.

This sense of apprehension was amplified by reports such as by The Economist which found that countries accounting for 63.6% of the global population (ex-Russia) were neutral or in favour of Russia’s position.

Concerns about the ability of the US to disrupt financial flows via the SWIFT network are not new but have suddenly been forced into becoming the most urgent question in global monetary debates.

The Atlantic Council’s GeoEconomics Center has catalogued a total of 1,009 Russian entities that have been sanctioned by the United States, with another 964 such actions from the UK, EU, Canada, Japan, Switzerland, and Australia, as of April 17, 2023.

In their communication challenging dollar hegemony, the Chinese government claimed that overall US sanctions increased by nearly 1000% between 2000 and 2021.

Other than the threat of sanctions, the US dollar’s position has profound impacts on monetary policy, capital outflows, exchange rate and financial instability, and debt levels which have in the past weakened the economic sovereignty of other nations.

As a result, the OMFIF Global Public Investor report launched in July 2022 noted that 31% of reserve managers surveyed were planning to increase RMB holdings in a 12–24-month window.

Bilateral swap lines

Bilateral swap lines are facilities that central banks use to increase market liquidity at home by exchanging each other’s currencies at a fixed exchange rate with interest at a future date.

Many of these lines are being used to sidestep the influence of the dollar.

As part of its RMB internationalization strategy, the Chinese government has been actively establishing non-dollar swap lines for over a decade and is now up to at least 41.

Earlier this month, Bloomberg reported that the use of RMB-denominated swap lines by global central banks accelerated to approximately $16 billion in Q1 2023, a jump of nearly 20% since the previous interval.

The sudden surge in RMB demand is a strong indicator of the urgency of governments the world over to shift away from the dollar.

Lena Petrova, CPA, a financial expert and popular Youtuber noted,

(The yuan is) getting more and more widely used and it’s getting stronger… (it is) now perceived as an alternative (to the dollar). Of course, using it is a risk but for the countries of the global South it’s just as much of a risk as to continue using the dollar…typically the turnaround time for these currency swaps is relatively short, so the risk is very little which is why the yuan is an appealing option…

Since the outbreak of the Ukraine war, Russia’s transactions in yuan have exploded by a multiple of 32, across export payments, savings, and investments.

In addition, Bloomberg anticipates that Russia will purchase $200 million worth of yuan per month for its foreign currency reserves.  This marks a dramatic shift in Russia’s ‘self-insurance’ approach.

In 2023, China has also inked local currency bilateral agreements with Brazil, Argentina, Kazakhstan, Bangladesh, Pakistan, and Laos, and is seeking to operationalize new lines in the Middle East.

With China being a crucial trading partner to most countries, there is significant potential to expand and consolidate its bilateral coverage in this manner, particularly if a non-SWIFT alternative blunts the threat of sanctions.

Middle East diplomacy

The Middle East’s oil-rich nations are especially important partners for resource-hungry China.

In a significant move, the Chinese government was able to broker an agreement between Saudi Arabia and Iran to resume diplomatic ties, putting a stop to the regional conflict.

This was nearly unthinkable not long ago and has helped China establish a strong image in the region.

In addition, the Chinese government is likely closing in on formulating an FTA with the Gulf Co-operating Council (GCC) countries which include the UAE, Bahrain, Saudi Arabia, Oman, Qatar, and Kuwait.

As leading exporters of petroleum and mineral oils, this would likely help boost the RMB-denominated energy trade as well as investment links.

Iraq has also announced plans to start trade in yuan as well.

Crucially, Saudi Arabia is reportedly in advanced talks to join the BRICS bank, a potential game changer for the petrodollar.

Global attractiveness

The Standard Chartered Renminbi Globalisation Index (RGI) has tracked the impressive internationalization of the RMB in the past two years, documenting a rise of 18.5% in 2021 and a further bump of 26.6% in 2022. This capped off 5 consecutive years of continuous improvements.

The tracker did fall modestly in the month of April, coming in at 3320, down by 1.18% since the previous month, primarily due to a decline in the growth of CNH deposits and external headwinds.

However, the trajectory is clear, and with seemingly no end to the military conflict in Ukraine or the threat of sanctions, more countries will likely gravitate towards the RMB.

The Chinese government launched offshore yuan markets in key financial centres including Singapore, London, Paris, Hong Kong, and Luxembourg to further its global agenda.

Chinese cross-border trade

In a startling turnaround, the yuan outdid the greenback in Chinese cross-border transactions in March 2023, accounting for 48.4% of all transactions, while the dollar slipped to 46.7%.

The above graph charts the share of RMB in cross-border settlements only with China.

The red dashed line implies that as of 2021, 25% of sampled countries utilized over 70% of RMB in their China transactions. This is up from near zero in 2010.

At that time, the USD accounted for 83% of these transactions indicating an often-understated momentum in RMB uptake.

Petrova adds,

…this has never happened before and we probably should not underestimate it simply because the Yuan traditionally is discounted as the result of the amount of control that the Chinese government has over its currency.

CIPS and digital yuan

Perhaps most importantly, China is a leader in the digitization of currencies and launched its Cross-Border Interbank Payment System (CIPS) in 2015, through which RMB trades are accepted via 1,500+ global banks.

With a digital-savvy population, the current e-CNY trials have reached 260 million wallets, amounting to over RMB 13.6 billion.

Crucially, this new infrastructure targets the expansion of economic activities and in doing so provides a distinct offering as compared to existing market players.

Challenging the ‘dollar trap’ in unfriendly conditions

Despite its best efforts, conventional understanding would suggest that China lacks some crucial ingredients to assume the position of global reserve currency anytime in the near future.

Undoubtedly, it has a long way to go.

Two key areas that have restricted its rise are its restrictive capital controls as well as the tight band that the currency is managed within.

The lack of openness hurts liquidity, price discovery in the financial markets, financial innovation, and has even hampered withdrawals.

Other than the factors mentioned above, a reserve currency issuer would be expected to have deep bond markets, sound taxation and relatively transparent and effective governance.

The RMB’s unlikely performance

The above issues are well-known, especially in terms of the image of Chinese state interference.

However, as the OMFIF survey suggested, a growing cohort of global reserve managers are drawn to diversifying into the yuan, while the RMB which accounted for 4% of currency trades in 2019, nearly doubled to 7% in 2022.

But perhaps what is most impressive is as Kelvin Lau, Standard Chartered’s senior economist for greater China, and Edward Pan, the bank’s China macro strategist, put it,

This is no small feat, in our view, considering the impact on market sentiment from strong headwinds such as rising global rates, US dollar strength, global geopolitical uncertainties, local Covid disruptions and slowing China growth.

Some thoughts

The RMB has been able to navigate severe challenges thus far, including widespread covid lockdowns, public unrest, high Fed policy rates and dollar inertia.

The aggressive Fed policy has not been successful in dissuading an accelerated shift to the RMB.

China lacks an open capital account, embodies plenty of state control and the currency itself is closely managed within a tight corridor. These factors should arguably disqualify the yuan from becoming more rapidly accepted.

However, is it possible that conventional reserve currency beliefs are changing?

The seismic shift in geopolitics, particularly in relation to sanctions policies has strengthened the yuan’s global standing in a compressed time frame.

This transition will take time in coming, but the yuan’s ability to be an attractive option in an unfriendly environment such as this, suggests an improvement in social attitudes towards the currency.

The relatively low credibility that has often plagued the Chinese authorities as well as widely-held concerns of angering the US government is dissipating, and should not be underestimated in the process of de-dollarization.  

If commercially-viable alternative payment mechanisms materialize, such as at the BRICS summit later this year, this may intensify the challenge to the dollar. This would be especially true if US inflation rebounds sharply later this year.

The RMB will not displace the dollar overnight, but equally, it may happen at a faster clip than what conventional wisdom would suggest.

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