The future of the dollar as a reserve currency has been discussed for a long time, but not as much as recently. There are a number of internal and external reasons for this. Among the former, the most obvious risk is debt sustainability, especially after the huge fiscal and monetary stimulus associated with COVID-19. Given the large share of US debt in the hands of foreign investors, the risk of a sell-off directly affects the state of the dollar’s reserve currency.
Rising China Strengthens Yuan
Past experience shows that a sudden loss of confidence in the reserve currency is unlikely unless there is another currency, with a much stronger economy and very liquid financial markets to take over. This is where China could jeopardize the dollar’s position as a reserve currency.
In fact, among the external factors that could affect the future of the dollar, China’s economic recovery is by far the most significant. History shows that an economic recovery must ultimately be accompanied by a much wider international use of its currency. However, this has not yet happened with the yuan, and only 2 percent of the world’s cross-border payments are made in this currency.
First of all, this is due to the fact that the yuan is non-convertible, which means that it cannot move freely to and from China. Secondly, China’s financial markets, especially the treasury market, are not yet as liquid as the US dollar markets, and there is no hope that this will happen any time soon. The question is whether such reasons could be more important than China’s economic influence and, most importantly, China’s renewed interest in promoting the internationalization of the yuan.
China’s desire to internationalize the yuan
While the internationalization of the renminbi has long been an important task for Chinese politicians, other more pressing issues, such as strong growth, have come under the spotlight. America’s resistance to China’s rise has shifted from the trading arena to technology and the extraterritorial use of the dollar. The US administration has imposed sanctions against a large number of Chinese targets, whether they be military-related companies or the so-called organization on which the US imposes export controls on related technologies. These sanctions would not have been possible if the dollar were not the world’s reserve currency. This is why Chinese politicians are more than ever seeking to reduce China’s dependence on the dollar as a financial or investment vehicle, which can only be achieved through widespread acceptance of the renminbi as an international currency.
Full convertibility is a must
China’s first attempt to internationalize the yuan focused on making Hong Kong a global hub for offshore yuan business and then expanded to other offshore hubs, which did not work after the 2015 Chinese financial turmoil. Now, China is again trying to stimulate cross-border acceptance of its digital currency, capitalizing on the first-mover advantage. This is important not only in the long term, but immediately, as it can help China bypass the use of the dollar if necessary.
But internationalizing a currency requires more than just technical training. It also requires the fulfillment of certain conditions for its global recognition, namely the preservation of its value due to price stability, the supply of a large pool of highly liquid assets,
Will the digital yuan matter?
This means that the Chinese government will need to take additional steps to liberalize its capital account in order to increase the full convertibility of the renminbi. The key question is whether the digital yuan, E-CNY, can help the Chinese authorities ensure greater capital account openness while still being able to track capital flows and act accordingly. This explains why E-CNY’s traceability under the guise of “controlled anonymity” is key, as it allows China to control seemingly free financial flows. In other words, a digital currency could offer a way to promote the renminbi as an international currency while maintaining control over cross-border flows.
The exchange of financial transaction data is also an important stumbling block. Another important factor that needs to be improved is the liquidity of RMB financial assets. Although the size of the bond market has grown rapidly since the global financial crisis, it is dominated by lending to corporate and financial institutions. More liquidity is required for central government securities with a longer yield curve and clearer benchmarks. But whether E-CNY can help on this front remains a question.
Risks to the dollar
In short, the dollar remains the world’s largest reserve currency, but it faces both internal and external risks. Domestic risk actually stems from the need to fund huge debt through monetary and fiscal stimulus, especially in the aftermath of the COVID-19 crisis. It is still not clear if the US will remain productive enough to pay off the debt.
On the external front, China is struggling to lift the yuan to the pedestal of reserve currencies while trying to outflank the dollar. His plan is to boost cross-border use of China’s digital currency, but that’s easier said than done.
Until its currency is fully convertible, it will take time for it to be finally accepted outside the PRC’s borders.