The dollar remains the world’s dominant international currency. The dollar, the euro and the RMB account for 60%, 20% and 3% of global foreign-exchange reserves, respectively. In the Americas, Asia-Pacific, Europe and “the rest of the world,” the US currency also accounts for roughly 100%, 70%, 25% and 80% of export invoicing, respectively, while around 90% of all global foreign-exchange transactions are in dollars. It is also the currency of choice for international finance, dominating international and foreign currency banking claims and liabilities as well as foreign currency debt issuance.
Economist Barry Eichengreen and colleagues have spoken of the “stealth erosion” of the dollar’s international position. Since the creation of the euro in 1999, the dollar share of global foreign-exchange reserves has fallen from 71% to 59%. But this alleged erosion has benefitted currencies other than the RMB and the euro. And part of the decline can be explained by changes in currency valuations as well as financial return optimization rather than changes to liquidity preferences.
Dollar Dominance and Geo-Economic Power
Dollar dominance puts the US in the position of “mature debtor” (able to borrow in its own currency, limiting financial risks), while it forces China into the role of “immature creditor” (with its foreign claims largely denominated in dollars, increasing financial risks). Ironically, this means the debtor (United States) is more powerful and less vulnerable, while the creditor (China) is more vulnerable and less powerful. Given the role the dollar plays in the international financial system, US financial and economic shocks are quickly transmitted to the rest of the world, including China. (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.
Geo-economically, Washington derives political power from issuing the world’s dominant currency because others are reliant on the dollar as a means of international payment. 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, the US would also encounter significant resistance from partners and allies. 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 neutrals, partners, or allies.
Sanctions targeting China’s critical imports and exploiting its strategic vulnerabilities, such as energy or foodstuffs, would be very cost-effective from an American perspective. Beijing is keenly aware of this vulnerability, and this is precisely why China has an interest in insulating its foreign trade, especially critical imports, from targeted dollar sanctions by promoting greater use of the RMB in its foreign trade.
Obstacles to RMB Internationalization
China meets some conditions necessary for the RMB to become a prominent international currency, including economic size and a rapidly growing stock of financial assets. It also has extensive foreign trade relations. But 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 foreign investors and governments.
In the face of challenges related to the much-needed reform of China’s economic growth model, continued financial fragility risks, and intensifying geo-economic and geopolitical competition, it is difficult to see how China will overcome these impediments. Moving toward full currency convertibility requires 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 necessary reforms, which would no doubt enhance the attractiveness of the RMB, China would still need to build greater geopolitical trust.
Despite these challenges, Beijing remains keen to promote the RMB. The global financial crisis of 2008 provided the initial impetus to internationalize the RMB to make China less vulnerable to US economic and financial policies (and crises). The extensive financial sanctions that the US and its allies imposed on Russia in 2022 have provided Beijing with even greater incentives to reduce its vulnerability to potential currency sanctions. 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 use of the RMB in China’s foreign trade is a more viable proposition and would help make Beijing less vulnerable to US (and allied) geo-economic coercion.
Promoting the RMB to Reduce USD Dependence
Beijing will therefore continue to promote the use of the RMB for international trade purposes 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 RMB in global payments remains minimal (2%). Only 15% of China’s foreign trade was settled in RMB in 2021. This share is likely to rise, but this will only make a small difference in terms of global RMB use. While it will make Chinese trade less vulnerable to currency sanctions, it will only go so far in lessening China’s financial dependence on the dollar or its trade-related vulnerability.
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. This will provide some degree of insulation from potential dollar sanctions. But greater use of the RMB in trade transactions will not lead to is significantly greater use in non-trade-related international (financial) transactions.
But not all trade must be transacted in RMB to afford China’s foreign trade greater insulation from dollar sanctions, provided the sanctions are targeted and selective. The recent agreement between Beijing and Riyadh to explore making greater use of the RMB in their bilateral trade illustrates this. Both countries have an interest in conducting a greater share of their bilateral trade in RMB so they can sidestep potential dollar sanctions. After all, Chinese energy imports would be 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 large amounts of RMB assets.
Conducting trade in RMB reduces the risk of currency sanctions. But it does not eliminate it. Washington could decide (or 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. In other words, switching to RMB trade does not eliminate the risk of dollar sanctions to Chinese trade, although it significantly raises the political and administrative costs of enforcing dollar sanctions for the US government.
Beijing’s RMB internationalization policy therefore needs to be seen as part of a broader geo-economic competition with the United States, where both sides try 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.
After all, China’s top five import partners (Korea, Japan, US, Australia, and Germany) account for a full 1/3 of Chinese imports. Coincidentally, they also absorb 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 can force or nudge its major trading partners to transact in RMB, the currency’s use in international trade transactions will necessarily be limited.
Efforts to promote the RMB for international transactions will gain greater traction with countries that are at more immediate risk of dollar sanctions and with countries that supply critical goods to China, because their trade is much more likely to become the target of US currency sanctions. The use of the RMB for international private financial transactions 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 will not represent a threat to dollar dominance as long as Beijing fails to implement the necessary financial reforms and gain greater geopolitical trust.
