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Tuesday, Sep 22, 2020

China’s wish to end US dollar dominance is unlikely to come true with no genuine challenger in the wings

China’s wish to end US dollar dominance is unlikely to come true with no genuine challenger in the wings

Washington’s moves to sanction both Chinese and Hong Kong officials over the national security law and Xinjiang have highlighted the power of the US dollar. The US dollar has remained the dominant currency since the 1940s, with the euro and the yuan lagging behind in terms of global foreign exchange reserves

One thing that Beijing hates about the world is the dominance of the US dollar, and China has been working for over a decade to undermine its role in global trade and investment. But China’s wish to dethrone the US dollar as the main anchor currency may not come true any time soon even though it has weakened recently, analysts said.

China’s discomfort with the US dollar has become more acute recently with Washington’s moves to sanction both Chinese and Hong Kong officials while also threatening to punish financial institutions dealing with these individuals, including Hong Kong chief executive Carrie Lam Cheng Yuet-ngor.

This power stems from the US dollar’s dominance, leaving China few options to hit back. In an extreme scenario, the US could cut off Chinese businesses and banks from access to the US dollar payment system,seriously disrupting China’s cross-border trade and investment flows.

China is also unhappy with the “exorbitant privilege” enjoyed by Washington because of the US dollar’s role as the main international reserve currency, particularly when the US Federal Reserve engages in monetary easing to address domestic economic woes, as it has done this year, effectively weakening the currency.

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Beijing views the US Federal Reserve’s recent monetary moves as a way of shifting the cost of its domestic problems onto other countries, including China, by collecting seigniorage – a form of profit made by a currency issuer from the people who use it.

Guo Shuqing, the chairman of the China Banking and Insurance Regulatory Commission, also warned that the unprecedented stimulus might plunge the world into another global financial crisis.

“In an international monetary system dominated by the US dollar, the unprecedented, unlimited quantitative easing policy of the US actually consumes the creditworthiness of the dollar and erodes the foundation of global financial stability,” Guo wrote in an article published in the Chinese official journal “Qiushi” last the weekend.

Guo’s concerns come after the US provided trillions of US dollars of stimulus to boost the economy in face of the coronavirus crisis, with more likely on the way. The US Federal Reserve programmes to buy securities and pump money into the financial system – so called quantitative easing – has caused its balance sheet to swell from US$4 trillion in mid-March to roughly US$7 trillion in August.

The US dollar’s weakness in recent months – the US dollar index has lost about 11 per cent since its peak in late March “particularly against the euro” – has further amplified concerns in Beijing that its overseas assets and its more than US$1 trillion in reserves denominated in US dollars will be devalued.

The US Federal Reserve’s easing, along with a deep contraction in US growth, has prompted some strategists, including from investment banking giant Goldman Sachs, to warn that US fiscal and monetary policies may be triggering fears of a “debasement” of the currency, that is, a loss in its ability to preserve the value of investments.

That, in turn, could erode the US dollar’s reign as the dominant force in global foreign exchange markets because the huge amounts of US dollar liquidity in the financial system could eventually lead to a rise in inflation once the pandemic is over, Goldman Sachs said.

However, many other analysts said the US dollar’s status is unlikely to change in the near term because of a number of advantages that other currencies cannot yet match.

Warnings about the US dollar’s demise are not new, with the debate over whether economic stimulus eventually leads to inflation having continued since the global financial crisis more than a decade ago.

Yuan - US dollar exchange rate
Price trends over time for how the Chinese currency trades against the US dollar

Also, even well before the coronavirus pandemic started to ravage the world, there was concern about the US dollar because of the sizeable trade and fiscal deficits being amassed by the US. And between 2003 and 2014, the US dollar index was lower than its current level, at times much lower.

China started to take action to reduce its reliance on the US dollar after the global financial crisis, with Beijing promoting the use of yuan in cross-border deals, however, as the yuan is not freely convertible, it is far from an alternative to the US dollar.

Former central bank governor Zhou Xiaochuan had also floated the idea of using the special drawing rights, an accounting unit at the International Monetary Fund (IMF), to replace certain functions of the US dollar, although China has made few moves to promote it and few businesses in real world use the asset.

In the latest push, current People’s Bank of China governor Yi Gang wrote in an opinion piece in the Financial Times last month that the IMF should allocate special drawing rights to member countries to help combat the impact of the coronavirus, although there has been little follow-up on the proposal.

No matter how Beijing has tried to bypass the US dollar, its predominant global role is well entrenched for the foreseeable future due to its competitors’ weaknesses. And for China, the harsh reality will continue: it still has few cards to play if the US restricts Chinese banks’ access in response to the national security law that Beijing imposed on Hong Kong, analysts said.

Former senior US Treasury official Mark Sobel, who is now the US chair of the Official Monetary and Financial Institutions Forum, a London-based think tank, said speculation about a collapse of the US dollar causing it to lose its reserve status is “incredibly far fetched and implausible”.

According to Sobel, the US still has the deepest and most liquid capital markets in the world, its financial system is resilient and there is global inertia which supports continued US dollar use.

“The dollar was not ordained as the world’s reserve and financial currency or declared so. It happened in response to organic factors – a large vibrant economy, deep liquid capital markets, and strong property rights. These characteristics will not be replicated elsewhere in the coming decade,” Sobel added.

The US dollar became the international reserve currency in 1944 after the Bretton Woods Agreement. Today, it still accounts for around 62 per cent of the world’s foreign exchange reserves – although that is down from a peak of more than 85 per cent in the 1970s – followed by the euro at around 20 per cent, according to the IMF.

For many international investors, and especially central banks managing foreign reserves, holding the US dollar means holding US Treasury securities.
In China’s case, the latest figures showed that 58 per cent of China’s foreign exchange reserves as the end of 2015 were held in US dollars.

Barry Eichengreen, professor of economics at the University of California, Berkeley, and a former senior policy adviser to the IMF, said the US dollar’s recent slide is in fact one in a series of readily explicable fluctuations.

The US dollar strengthened on the back of safe-haven flows into US Treasuries when the coronavirus spread around the world in March, and it started to depreciate after the US Federal Reserve poured buckets of liquidity into financial markets starting in May.

The US dollar’s subsequent depreciation reflects the changing prospects for the US and European economies, Eichengreen said. With the spread of the coronavirus, the US outlook is deteriorating, so investors expect the US Federal Reserve to keep interest rates low for longer.

James McCormack, global head of sovereign and supranational ratings at Fitch Ratings, said that there is clearly a desire on the part of policymakers in several countries to curtail the dominance of the US dollar, but real change has yet to take hold.

“It is conceivable that markets eventually adopt a less favourable view of US government creditworthiness, undermining [US] Treasuries’ risk-free status, but even then the Treasury market infrastructure that investors value – its depth and liquidity – could be largely unchanged,” said McCormack.

While economists generally agree that the probability of the US dollar being displaced is negligible in the short term, whether it is likely to happen in the longer term depends in part on the emergence of a viable alternative, with no leading contender currently seen as an option.

Yu Yongding, a prominent Chinese economist who was formerly an adviser to China’s central bank, said whether the US dollar collapses depends on the extent to which the Trump administration further undermines the US’s credibility, and whether the US Federal Reserve can scale back in a stable manner its qualitative easing.

The outlook for the Chinese currency to replace the US dollar as the world’s reserve currency remains out of reach. The share of yuan in the reserves of global central banks is only around 2 per cent, of which a quarter is held by Russia, as Moscow encourages Beijing to be more assertive in challenging Washington’s dominant role in the global economy.

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The euro is a more frequently used currency, and some observers explain the recent increase in demand by pointing to the European Union agreement last month on an unprecedented €750 billion (US$893 billion) stimulus package to shore up the pandemic-ravaged economy that would funded by all 27 member states borrowing jointly from capital markets for the first time.

However, the new bonds that will be issued are equivalent to only 5 per cent of the stock of US Treasuries in the hands of the public.

“It’s a drop in the bucket, in other words. And a drop does not a liquid market in safe assets make,” Eichengreen said.

The European Union recovery fund does show an increase in solidarity that should make the euro a more attractive reserve asset, but Europe runs an external surplus and does not need inflows from reserve managers, said Brad Setser, a former US Treasury official and now a senior fellow at the Council on Foreign Relations. Also, with negative interest rates on its reserve assets, it is effectively taxing central banks around the world who hold their reserves in euros.

German 10-year bonds, the benchmark for continental European bonds, currently have a negative yield of 0.46 per cent, meaning purchasers will not receive all their original investment back when the bond matures, let alone make a profit.

“There is literally no market in Europe large enough to absorb a large outflow from [US] Treasuries. The financial turmoil in March showed that in periods of real distress you still need dollars. And Asian central banks are back in the market, buying dollars to keep their currencies from appreciating. The dollar isn't at any risk of losing its position as the world's leading reserve currency anytime soon,” said Setser.

China’s efforts to get away from the orbit of the US dollar has achieved limited results.

In Hong Kong, Beijing had hoped in 2013 that yuan deposits in Hong Kong would rapidly surpass 3 trillion yuan. However, at the end June, yuan deposits were only 639.9 billion yuan (US$92.5 billion), a 7.9 per cent drop from a year earlier, according to the Hong Kong Monetary Authority.

It has also tried to build up an alliance to “de-dollarise”, partly by signing bilateral currency swaps deals with central banks including the European Union, Japan, Turkey, Argentina and Belarus.China’s “no-dollar” alliance with Russia received a boost after Russia was placed under sanctions by the US after its annexation of Crimea in 2014.

According to the Nikkei Asia Review, the two countries have drastically cut their use of US dollars in bilateral trade in the past few years, dropping to a record low of 46 per cent in the first quarter of 2020.

But the yuan’s share of international payments was still less than 2 per cent in July, which was minuscule in comparison to US dollar’s share of over 40 per cent, followed by the euro at around 32 per cent, according to SWIFT, the financial messaging service that is the primary network used by banks globally to make financial transactions.

“Is there a real alternative for the dollar? The euro is not close, and the yuan is even further,” added Chinese economist Yu. “The best result China can have is not to overthrow the dollar but to seek self-protection [from dollar hegemony].

“For instance, China can reduce its holdings of US dollar assets … so that there’re fewer assets for the US to seize. It is a strategy of running away from it instead of challenging it.”


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