Is China a Threat to the Dominance of the U.S Dollar as a Global Reserve Currency?

  

A threat to the mighty U.S dollar as a global reserve

 

You are looking at the mighty U.S. dollar, the global reserve currency, which is helping the U.S. maintain the largest military in the world and gives it immense power to impose sanctions on all of its enemies.

 

But now the world's most prominent analysts in economics believe that this might all be about to change. The reason for these bold predictions is that during his recent visit to Saudi Arabia, Chinese President Xi Jinping presented a bold new plan that threatens the US dollar as the world's reserve currency.

 

To understand China's plan, let's start with its motive. In other words, why does China want to end dollar dominance? The simple answer is that China is unhappy with how dominant the dollar is because it gives it's rival the United States, too great advantages in their global rivalry.

 

The first advantage is that by issuing the world's reserve currency, the United States can sustainably spend much more than it earns internationally than it otherwise could. Economists typically refer to this advantage as the United States' exorbitant privilege, a term that was coined by the French in the 1960s when the dollar was already the world's reserve currency.

 

The United States' exorbitant privilege primarily refers to the fact that the United States is pretty much the last country in the world that needs to worry about a currency crisis, such as the one experienced by Lebanon and Sri Lanka.

 

You see in each of these cases, the country ran out of the dollars that were needed for crucial imports. But since the U.S. issues these dollars itself, it can literally never run out of them because the demand for dollars is so great internationally, the U.S. can spend much more than it otherwise could on, for example, military aid and military bases, which is obviously quite a big advantage compared to China. But that's not all.

 

The second major advantage that the dollar gives the United States is that it allows it to hurt its enemies greatly by excluding them from the dollar-based international financial system. This prevents them from buying crucial imports or getting new loans.

 

Now, the US can easily do this by forbidding any US bank to do business with its enemies. And since most foreign banks heavily rely on US banks to facilitate dollar transactions, it also means that the US was even able to force big Chinese banks to stop working with Russian banks.

 

Of course, we know that China now trades more with Russia than ever, but it had to do so via its smaller banks, for which it didn't matter so much if they were excluded from the dollar system. Add to this that the US and its allies froze a large chunk of Russian foreign currency reserves last year. And you can imagine that China is quite motivated to come up with a plan to end dollar dominance.

 

Is it simple as you think?

 

But at this point you might ask, this should be simple, right? China could just ask other countries to pay it in renminbi or any other currency. But yeah, actually, it's not that simple. Well, China's government is really powerful, forcing foreign companies and countries to accept and maybe payments are not that easy. So it will have to convince them instead, by using the power of economic incentives for its bold new plan to end dollar dominance.

 

After hearing more about the plan to end dollar dominance, a plan that is partially about encouraging the usage of multiple currencies, but mainly about making China's currency, the renminbi, a viable alternative to the mighty US dollar. So how could you do this?

 

Well, to convince people outside of China to accept the renminbi, China will need to make it more attractive for traders and countries outside of China to use the renminbi. And I believe that it can do so in three main ways.

 

·        First, it will need to make it easier to spend renminbi internationally.

 

·        And second, it needs to make it more attractive to save in renminbi-denominated assets.

 

·        And finally, third, it will need to make it easier for foreigners to obtain renminbi by increasing the currency's liquidity.

For each of these categories, let's use a scale of 1 to 10 to rate how the dollar, the current renminbi, and the planned future renminbi score on these three categories spending ability, investment ability, and liquidity.

 

The first category is the spent ability of the US dollar and renminbi.

 

Imagine that you are an exporter outside of the US and China. Would you be willing to accept dollars or renminbi rather than your own currency? if we look at the data, it's not very surprising that exporters outside the United States currently invoice between 70% to 80% of the transactions in US dollars, with a European notable exception. And given that a whopping 88% of transactions in foreign exchange markets involve the US dollar or at least one side of the trade. It also makes sense that it is the cheapest currency to exchange in and out of.

 

On the other hand, the renminbi is only the eighth most traded currency and most people are moving through the dollar system to convert their local currency interim and vice versa. So when it comes to spending ability, I'd give the US dollar an eight out of ten and the renminbi at the moment only a score of three out of ten.

 

But this is where China's bold plan comes in. In a speech to the Gulf States. And if the Gulf countries accept, they will join other major energy exporters such as Russia, Venezuela, and Iran, which already accept payments in renminbi. This would make the renminbi much more spendable, given that you can now spend them on oil. What's more, Xi promised Gulf countries to deepen digital currency cooperation

and advance the multiple central bank digital currency bridge project. This will also greatly help in making the renminbi easier to spend internationally.

 

A group of four central banks or the big players of this game.

 

You see, when Mr. Xi is talking about the multiple central bank digital currency project, he is talking about rerouting core global payments from big sanctionable private banks to a group of four central banks that would rapidly expand if it is up to China. And if China can actually pull that off, it could be a pretty damn effective way to dodge US sanctions in the future, while at the same time making the renminbi much more spendable on the global stage.

 

Of course, we don't know how many countries will actually start using the system, but the thing with dependability is that once some people accept a currency, it is immediately much more spendable for others, which might then also start accepting and so on.

 

Economists call this a network effect. And while this is highly speculative of me, China's plan could raise the renminbi spending ability very fast indeed, maybe even to a seven or eight score. If you follow the line of thinking of prominent financial analysts like Credit Suisse's Zoltan Poszar.

 

Invest ability.

 

It didn't sufficiently take into account the second category of what makes a currency internationally attractive. Invest ability.

However, for the big exporters, it recently became possible to open renminbi accounts with big banks in places like London and New York.

 

And even more importantly, since 2009, in Chinese, the markets have opened up to big investors, which in response have been pouring money into China. China still heavily restricts access to its financial markets for foreigners, and while that is somewhat annoying for big global companies, it's an absolute nightmare for a gigantic exporter like Saudi Arabia.

 

You see, Saudi Arabia earns so much foreign currency by exporting oil that it cannot possibly hope to spend it all. But since it is so big, if it moves money into and especially out of the small portion of China's markets that are available to them, it actually will move the markets when doing so.

 

This means that when the country invests in Chinese markets, they will go up and they will profit from this. But the reverse is also true. If it moves money out of China quickly for any reason, it will incur big losses because the price will go down when it does so.

And this is what made the dollar so attractive to big exporters such as Saudi Arabia and China. U.S. markets are so deep that they can easily store these large money flows without significantly impacting the price of U.S. markets.

 

However, what made the US market quite a bit less attractive to countries like Saudi Arabia is that the US decided to freeze the assets of several Russian investors as well as its central bank.

 

Last year. At that point, many semi-friendly countries immediately started wondering if our money is really that safe in the United States? But while foreign investors seem reasonably well protected in China at the moment, they also worry that China can abruptly change the rules of the game if it sees fit, or that it will impose economic sanctions of its own. So let's get back to the scoring part. Given that its markets are super easily accessible, can take in tons of money, and are fairly safe for most of us.

 

I'd give the US dollar still a seven out of ten for investor ability. On the other hand, while China's markets have grown tremendously, they're still not as deep as those in the US and would score a six out of ten if it wasn't for all those financial restrictions.

 

liquidity or obtainability

 

But those still in place currently only give the renminbi a three out of ten for investor ability. During the visit, Xi said that he wanted to facilitate entry into China's capital markets for Gulf Cooperation Council countries. In other words, he is proposing to open up China's financial markets further for oil exporters, potentially increasing visibility in these countries from, let's say, a three to a five. So while China's plan is a step in the right direction, it's not quite so threatening yet. And even though on the surface it seems that China could just simply open up its financial markets, it might actually not be so easy, since China has recently again had to resort to heavy financial restrictions to prevent large flows of money from leaving the country. So let's see if it can make up for that in our final category of currency attractiveness. Liquidity. Now, liquidity or obtain ability is a bit of a tricky category. And what I mean by it is that a country should be able to easily obtain a foreign currency without moving the price too much. How can they do this? Well, there are basically two strategies that countries are currently pursuing. On the one hand, there's the development strategy that Asian economies like South Korea, Japan, and China followed. It involves promoting exports while heavily restricting imports. That way, these countries are able to accumulate large quantities of dollars, which they then saved in US markets.

 

On the other hand, there are countries like Pakistan, Sri Lanka, and Turkey, which borrow dollars to fund their imports while forgetting to make their country's export sector particularly competitive. And then when the dollar alone stopped, these countries got into a lot of trouble when they could no longer afford to buy crucial imports such as fuel and food. But you might now wonder, couldn't they just print their own currency to then buy dollars on the markets and use these to buy food and fuel?

 

Well, yes. But as you can imagine, that would reduce the value of their own currencies quite quickly, making food and fuel more and more expensive, producing inflation, which the population typically doesn't like. After all, this is why Sri Lankans rose up last year to throw out their leaders. And while this is admittedly a bit of a simplification, it's pretty clear to see why that export-oriented Asian strategy to get dollar liquidity was so popular. However, it is at this point that a lot of economists, in my humble opinion, fail to make a crucial next step. After all, for all these Asian economies to accumulate dollars by exporting more than they import, someone else has to import more than it exports.

 

For the last decades that someone has been in the United States. So you could argue that by allowing these and other economies to export more than they import to the United States, the dollar became quite a bit more attractive as the international currency of choice for these countries. Of course, on top of that, the US has deep. Financial markets are also a really good place to get dollar-denominated loans. So I'd say the dollar scores an impressive nine out of ten on liquidity or update ability. On the other hand, China is a net exporter, which means that on average it is drawing in renminbi, leaving less for the world to trade with. So the main way to obtain renminbi abroad is through borrowing, which admittedly you can increasingly do via China's Belt and Road initiative and growing offshore financial system. However, since this is such a risky strategy for now only gives China's renminbi a two out of ten rating on liquidity. But did China think about this issue in its bold new plan? Well, a little bit. Well, in Saudi Arabia, she did indeed mention an increase in currency swap corporations, which are essentially a way of lending that is very popular between central banks. And this is part of a pattern. China has rapidly increased its network of renminbi swap lines. But this would only push the renminbi up by one point or so in my rating. To truly challenge the dollar. When it comes to liquidity, I think China's best shot is increasing the renminbi in circulation worldwide by opening up its vast consumer market while encouraging its poorer neighbors to export to it.

 

Conclusion

 

But since that hasn't happened so far, I'd say that current concerns about the renminbi replacing the dollar are way overblown. Yes, China is making its currency much more spendable and yes, sanctions have made countries question how smart it is to invest all of their savings in US dollars. But as you can clearly see, the renminbi still has a long way to go to become an attractive alternative to the dollar. For those of us that are outside of China and the United States, sure, if you live in a country like Russia, Iran, or Venezuela, then yes, China's plan is already working, but this is mainly due to US sanctions. After all, if we would use our rating system in these countries, the dollar would currently score by smaller.