Today's Deep Dive is 1,385 words and a 8-minute read.
The Russian invasion of Ukraine in 2022 sent immediate shocks around the world, triggering multiple crises, including migration into Europe by displaced Ukrainians, global food insecurity and European energy insecurity. Longer term impacts have also unfolded, such as NATO enlargement to deter Russian aggression. Perhaps even more significantly, the global trade landscape shifted as Russia responded to the largest sanction regime ever imposed; Russia sought to avoid economic isolation by reorienting its trade eastward towards countries not enforcing western sanctions. With Russia shut out of the global financial system, the Kremlin has been forced to rely on currencies other than the dollar and the euro. Economists have long considered de-dollarization as a marginal risk, seeing the dollar's standing as the global reserve currency as secure with no real competitor. However, in a period of just over two years, China and Russia have succeeded in de-dollarizing their trading relationship and other countries are seeking to “de-risk” their economies from the dollar.
The rapidity of de-dollarization, in what had previously been considered a slowly developing and marginal risk, is causing a re-thinking about the long-term impacts of the Ukraine War on the global financial system.
For multinational businesses, the risks of rapid, global de-dollarization are not imminent, but developments merit monitoring and contingency planning for shifting trends. Partial de-dollarization among China's trading partners is likely to grow and over time could lead to regionalism with hardening financial spheres of influence and accompanying trade and non-trade barriers. Currency risks may increase, creating incentives for diversifying exposure.
Why the Greenback is King
Since World War II, the US dollar has been the world's leading reserve currency for international trade. Part of this is linked to the US's global position and the size of its economy. But there are technical reasons as well. Central banks hold foreign exchange reserves to mitigate risks such as economic shocks, pay for imports, service debts and manage the value of their own currency. A reserve currency needs to be in steady supply and be held and traded in a large, liquid and low-risk asset market. There should also be a minimum of capital controls, as users want to be able to access their money on demand.
The US dollar meets these requirements, in addition to benefiting from self-reinforcing partnerships and institutions, which make trading in dollars less costly, more efficient and high confidence. Today, the US dollar dominates across the global financial system, in foreign reserve holdings, trade invoicing, deferred payment and currency transactions.
China's Global Yuanization Plans
China has a grand strategy of self-sufficiency, including financial self-sufficiency. For the latter, Beijing has a long-term strategy to replace the US dollar with the yuan (or renminbi as it is called internationally) as the dominant international reserve currency. China has supported the internationalization of the renminbi by developing a network of dedicated renminbi clearing banks, the renminbi cross-border international payment system (CIPS), renminbi swap lines with foreign central banks and bilateral agreements with countries to increase renminbi usage.
However, there are many obstacles in its path, the primary ones being that Beijing would have to permit greater currency freedom, inward and outward investment outside the control of the Chinese Communist Party and fully establish the rule of law. Currently, the yuan falls far short of the requirements of stability, convertibility (liquidity) and availability for global economy. As of Q1 2024, according to the IMF, the yuan is in distant fifth place in the tally of the largest international reserve currencies: US dollars, 58.85%; euro, 19.69%; Japanese yen, 5.69%; British pound, 4.85%; and Chinese yuan, 2.15%. Per the US Federal Reserve, CIPS processes about $60 billion in payments, compared to the $1,800 billion payments processed each day by the Clearing House Interbank Payments Systems (CHIPS), the main vehicle used for settling large US dollar transactions.
That said, de-dollarization of trade is seen as a step along the way to Beijing's ultimate goal for the yuan becoming the predominant international reserve currency.
Geopolitics Fuel De-dollarization
Western sanctions on Russia have enabled Beijing to test plans long in development to replace the dollar with the yuan for cross-border trade at scale. Beijing found a willing partner in Russia to conduct trade in yuan and to establish the financial infrastructure to support yuan transactions with third parties. As of April 2024, the Kremlin announced that more than 90% of mutual payments with China have been transferred to national currency. In 2023, the yuan replaced the dollar as the most traded foreign currency on the Moscow Exchange and exceeded the dollar in terms of foreign currency held in Russian banks. Russia converted debts previously held in dollars and euros to yuan, tripling the value of yuan-denominated loans in Russia to $46.1 billion.
Russian banks have started to join China's CIPS international payment system (as a partial alternative to SWIFT, the Swiss-based secure global messaging system for financial transactions). Russia is using the CIPS in addition to its own System for Transfer of Financial Messages (SPFS) for cross-border clearing and settlement with third countries. These institutions enable Russia to settle transactions in national currencies, circumventing sanctions restricting the use of the dollar. It also enables Beijing to improve the operation of the CIPS, increasing its capacity to handle more transactions and for larger amounts, making it easier to use, faster and more flexible to local business requirements. According to the People's Bank of China, in 2023, the CIPS processed 6.6113 million transactions, totaling RMB 123.06 trillion ($17.09 trillion), a 50.26% and 27.27% percent increase, year-on-year. CIPS participants are located in 117 countries and regions around the world.
The US has tried to curtail the growing financial relationship between China and Russia by authorizing secondary sanctions on banks enabling transactions that support the Russian military-industrial complex. This has led to some reduction in monthly trade figures as the larger Chinese banks imposed restrictions. However, this is likely a short-term impact as the Chinese and Russian banking systems adjust and channel financial services requirements to smaller, regional banks that are not exposed to the US market and dollar-denominated transactions. While transaction costs are likely to go up, with few good alternatives, businesses will be forced to take this in stride and will pass along the costs to the consumer.
BRICS Advocate De-Dollarization Despite Risks
De-dollarization is not limited to trade between China and Russia but can be seen in emerging economies and is advocated by the BRICS (an intergovernmental organization founded by Brazil, Russia, India, China and South Africa, with Egypt, Ethiopia, Iran and the United Arab Emirates joining in 2024). Complaints about the dollar's hegemony include that US monetary policy leads to dollar shortages, and reduces the ability of economies to manage currency depreciation and inflation. Countries with dollar shortages cannot manage the supply/demand imbalance by issuing debt in dollars because there is little investor appeal. Furthermore, rising interest rates in the US attract capital away from emerging market assets, weakening emerging market currencies. Using local currency to settle transactions within emerging markets is seen as a way to reduce the negative impacts over overdependence on the dollar. However, instability of local currencies and a lack of financial infrastructure present major obstacles for many BRICS members, which creates an advantage for the Chinese yuan to fill the void. In this scenario, participant countries would merely exchange one set of risks for another, i.e., the integration of their economies in a trading bloc controlled by the Chinese Communist Party.
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