Global reset – Monetary decoupling (Part 6: The forthcoming currency war)

Global reset – Monetary decoupling (Part 6: The forthcoming currency war)

Phuah Eng Chye (28 August 2021)

In the US-China confrontation, one of the developing battlefields is in currency. No other currency, perhaps gold is the closest, has been able to match the universal acceptance achieved by the USD. But is the era of USD supremacy drawing to a close? Many see this as being determined by the forthcoming currency war between the USD and yuan. If the US is unable to defend its currency supremacy, this would be taken as a sign that its ability to project power globally is diminishing. The forthcoming currency war can thus be interpreted within the context of a potential great power transition. There are several features of the currency war, likely to span over decades, to note.

First, the forthcoming currency war is confrontational. This is different from the transition from sterling to USD which is considered non-confrontational as it was between two allies sharing a common heritage. In contrast, the contest between US and China is confrontational as they are distinctly different in terms of ideologies, race and language and, at several points in history, were enemies.

Second, the forthcoming currency war takes place in an informationalised and financialised global setting. The objective of a modern currency war is to gain advantage to dominate monetary space. The forthcoming currency war is thus a contest of currency strengths[1] rather than weaknesses; and of usage rather than trade competitiveness. A weak currency exposes the superpower to risks from higher inflation, interest rates and capital outflows. A strong currency enables the superpower to be competitive in acquiring foreign resources (including talent) and to project global power through consumption.

Has the currency war started? Maybe. Early indications are USD dominance is slipping while the share of the yuan is rising; albeit from very low levels. Based on International Monetary Fund (IMF) data, Gertrude Chavez-Dreyfuss notes the USD’s share of currency reserves plunged to 59% in 2020 from a high of nearly 73% in 2001; the lowest since the 58% in 1995.  Nonetheless, “the dollar has the largest share of currency reserves held by global central banks”. Reserves held in US dollars rose to an all-time peak of $7 trillion as compared with reserves held in euros which ended at $2.52 trillion. The euro share rose to 21.2%; its highest since 2014 but below the 28% achieved in 2009. The Chinese yuan’s share increased to 2.25% or $267 billion.

Maximilian Kärnfelt notes 42.5% of global payments were cleared in USD and 36.2% in euros in 2019. The Yuan was the fifth most used currency in global payments, after the British pound, the Japanese yen and the Canadian dollar. The Yuan’s annual average monthly share of global payments grew from roughly 0.8% to 1.2% between 2013 and 2018. The two major contenders to USD supremacy are the yuan and the euro.

Yuan – Reserve currency with Chinese characteristics

It is often speculated that China’s aim is for the yuan to unseat the USD. Maximilian Kärnfelt notes “the Chinese government’s ability to realize its declared dream of achieving great power status is hindered by this mismatch between the power of the economy and limited international use of its currency. Numerous Chinese policy documents mention the need for the internationalization of the renminbi”. He explains “China’s leadership faces a broad strategic dilemma. Lacking a widely accepted international currency, China must pay its way in the world using the global currencies of other countries. An aspiring global power that cannot finance itself in its own currency runs the risk that foreign firms and institutions become reluctant to accept its currency as its foreign debt increases. Foreign banks may insist on lending in their own currencies. The risks and limitations include forced curtailment of overseas investments and infrastructure projects from rising debt servicing costs, and exchange rate risk. Under extreme circumstances, access to funds could be restricted, e.g., through sanctions”. He argues “if China’s government were to remove restrictions on capital flows, it would help promote the CNY. However, the country’s leaders would have to sacrifice control of either monetary policy or the exchange rate. They wish to do neither…Given these conflicting goals, China has not formulated an official CNY strategy”.

Many think it is unrealistic to expect the yuan to replace the USD or even to make significant inroads within this decade. The changing economic weights may not support USD dominance but it doesn’t support yuan dominance either. On its part, China appears unwilling to accept the trade-offs of capital market liberalisation. Grégory Claeys and Guntram B. Wolff argues the central bank needs to make available an ample supply of safe assets and be willing to take on the role of international lender of last resort. This explain why countries, such as Germany, are reluctant to promote internationalisation of their currencies as “they feared it could weaken control over monetary policy, generate undesirable exchange rate volatility and result in excessive appreciation of the currency, thus undermining their export-dependent growth model”.

China probably views capital account liberalisation as a poisoned chalice. It is mindful Japan’s financial system weaknesses hampered it from managing the adverse consequences of the sharp yen appreciation after the 1985 Plaza Accord[2]. The lesson on financial system soundness was hammered home again in the 1998 Asian financial crisis. Thus, the ascendancy of the yuan will be held back by China’s gradual approach to financial sector development.

Near term, China’s modest ambitions appear to be to position the yuan as a reserve currency with Chinese characteristics. Ex-deputy central bank governor Hu Xiaolian[3] acknowledges “for the time being, yuan internationalisation is still at its early stage and oriented toward meeting the import payment needs of China’s domestic market. The transition into a new stage of yuan globalisation will be dependent upon a deeper and broader opening up of China’s financial markets, the realisation of a convertible capital market, as well as closer ties between China and the rest of the world”. “Under its 14th five-year plan, China is aiming to build a multilayered capital market, and develop the links between domestic and overseas capital markets, which supports the inbound flows of overseas yuan and provides foreign entities a smoother channel for investment and financing”. “By the middle of this century, China might have the world’s biggest, and most open financial market to function with the world’s most inclusive rules and norms promoting international cooperation…By that time, the yuan is likely to be the currency of choice and could be freely used, serving global trade and investment as it becomes a reliable and trustworthy currency.” This suggest the Chinese view that the yuan could only aspire to be a premier global currency in 2050.

China is laying the groundwork for further internationalisation. At the government level, swap arrangements are important to ensure countries can meet foreign currency shortages “without having to turn to the US and the IMF for assistance[4]”. Nonetheless, there are geopolitical obstacles to navigate. C.P. Chandrasekhar relates after the 1998 Asian financial crisis, Japan proposed to establish an Asian Monetary Fund (AMF) but this was rejected due to concerns “this would lead to excessive Japanese economic and political influence…Faced with its own economic woes and handicapped by its relationship with the US, Japan has fallen behind in the race for regional leadership”.

The first regional arrangement “was the Chiang Mai Initiative (CMI), involving the ASEAN+3 (China, Japan, and South Korea)”, a network of bilateral foreign exchange swap arrangements intended to be independent of US influence and IMF-style conditionality and to sidestep regional tensions”. In practice, the CMI “failed to meet these requirements” due to a decision to “outsource the task of monitoring and surveillance of countries availing of the swaps under the CMI to the IMF. Nonetheless, China has continued to make further progress. Between 2009 and 2020, the People’s Bank of China (PBoC) entered into bilateral, local currency swap arrangements with 41 central banks, mostly in Asia. China is also exploring bilateral and multilateral payment and clearing arrangements, particularly for the digital yuan.

The yuan’s natural advantage is the size of China’s market. China is in a position to insist on the use of yuan as an infrastructure developer and trading partner with developing economies. Yaya J. Fanusie and Emily Jin notes “China is already promoting increased renminbi use for cross-border transactions under Belt and Road. For example, China expanded bilateral local-currency swap programs to over 20 countries and established renminbi settlement banks in eight Belt and Road nations…established 56 economic cooperation zones and 12 free-trade agreements with more than 10 Belt and Road countries in Europe and Asia”. Berardi Alessia and Huang Claire notes “in Q1 2021, cross-border RMB receipts and payments accounted for nearly 50% of BoP flows, up from less than 20% in 2016. The PBoC revealed that transactions with Asian economies and the Belt & Road economies grew quickly. The trend was facilitated by the string of RMB offshore clearing banks in the related countries, and set-ups of bilateral currency swap agreements between the PBoC and peer central banks. Multilateral cooperation among the Asian central banks have gained pace, the amendment to Chiang Mai agreement now allows the use of members local currencies in addition to USD for financing within the total capacity of $240 billion”.

The challenge of yuan internationalisation goes beyond supporting trade and FDI. China’s preparations for further yuan internationalisation should include:

  1. A strong yuan policy[5]. At its stage of development, more production and exports will not be helpful to China but will worsen problems further down the road. Its dual circulation policy acknowledges this point by switching reliance on the export sector to the domestic economy as the driver of growth. In tandem with this, a strong yuan policy would help project China’s economic power as a rising consumer country. Nonetheless, China would not wish to repeat Japan’s currency experience[6] and would likely prefer a Singapore-style managed, gradual appreciation of its currency value. Berardi Alessia and Huang Claire points out “instead of limiting its movement against the USD, the PBoC has chosen to tolerate higher volatility in the USD/CNY pair, in exchange for lower volatility of the RMB against other currencies. Essentially, the central bank releases the USD/CNY fixing rate on a daily basis, which in a large part reflects the overnight movement of a basket of currencies against the dollar. By matching the reference basket’s movement against the dollar in daily pricing, RMB is able to anchor itself with the reference basket, without an actual Asian currency bloc”. They note this “resembles the early integration effort of European economies in creating the snake in the tunnel mechanism, under which member states’ currencies could fluctuate within narrow limits against each other and the dollar”.
  • Address system vulnerabilities. As is typical for emerging economies, China’s capital market is under-developed and has vulnerabilities such as excessive retail speculation, weak disclosures and governance, fraud, market abuses, bankruptcy uncertainties, tax evasion and money-laundering. In the mid-1980s, Japan liberalised its markets and the inflows resulted in a massive property and property price bubble. Japan never recovered fully from its subsequent collapse. China thus cannot fully open up its market nor liberalise capital controls until it builds sufficient resilience and regulatory defences against speculative attacks on its currency, domestic asset prices and financial system. But recent new regulations and enforcement is paving the way for further liberalisation. China accelerated housecleaning and cracked down hard on malpractices, market abuses, asset price bubbles (internet stocks, properties) and systemic vulnerabilities (platform domination, crypto currencies). New regulations have been drawn up to strengthen oversight and system discipline. The timing is also more than coincidental; it that it pre-empted an inflow of USD liquidity which would have pumped asset prices higher as well as relieved the pressure on the yuan to appreciate.
  • Capital market development agenda. Capital market development is crucial for currency internationalisation. China has a large traditional banking industry but intermediation capabilities and market venues are under-developed. Based on experiences in other countries, this requires deepening domestic liquidity pools and skill sets to support the expansion of yuan and foreign-denominated financial products. This role will be played by China’s asset management industry, which ranks among the largest in Asia. Industry growth took off recently and should be sustained over the next two decades. In tandem with AUM growth, China needs to strengthen domestic intermediation capacity and enhance regulatory oversight on disclosures, compliance, governance, safekeeping and risk management. Regulation will underpin product development in areas like bonds, derivatives and fintech. China’s recent enforcement actions on companies listed overseas seem to indicate its preference these stocks relist on domestic exchanges which would boost their growth and usage of yuan. This would strengthen China’s confidence in expanding international participation in its markets.
  • Leverage on global leadership in digital finance. China is already a global leader in fintech and digital currencies. China can leapfrog (disrupt) the legacy international financial system and build its own digital-based financial infrastructure (including for payments and settlement). It is likely China will build a zone that is conducive to regulatory oversight; particularly in tracking ownership authenticity. This will constrain offshore speculative attacks which usually rely on round-tripping and multiple rehypothecation of collateral. This will allow China to expand the supply of yuan assets without worrying about speculative attacks; though concerns will shift to the risks posed by potential cyber-attacks.
  • Develop financial ecosystem. China also faces several obstacles in the international financial system. George Jia highlights global investors face difficulties in China’s markets due to “operational challenges brought about by the lack of consistency between China’s settlement arrangements and widely adopted global post trade standards…Time zone differences and China’s tight settlement cycle create a further challenge, as market participants are only given 3.5 hours to settle their trades in the current settlement arrangement”. In addition, “the inclusion of Chinese stocks and bonds in major global indices in recent years makes things even more complex, as it places increased pressure on global investors that rely on a passive investing strategy to review their operational challenges for high volume cross-border transactions into China”.

Cheah Cheng Hye and James Fok notes “the international regulatory framework governing global financial institutions still assigns much greater risk weightings to Chinese securities, making them much more capital intensive to hold. Illiquidity exacerbates this problem, since Chinese securities are not widely accepted as collateral in international markets”. China’s large pool of bank deposits is largely untapped and China could facilitate portfolio outflows which international businesses and other countries would be eager to access. However, “Chinese outbound portfolio flows today would be wholly dependent on a Western-controlled global custody network, leaving it heavily exposed to the type of financial sanctions that have been applied to Russia and Iran”.

In particular, China needs to consider how it can develop its financial information ecosystem; particularly for international participants. China needs to strengthen the transparency, integrity, independence and depth of audits and analysis of companies and financial products. It needs to build the capabilities and reputation of domestic gate-keepers such as journalists, analysts, rating agencies and index providers. In addition, reforms are needed to strengthen local and international confidence in Chinese laws and dispute and debt resolution processes. While it has adopted international regulations and practices, China tends to forge its own development paths as it believes that rules should be suited to its own circumstances and understanding. This create areas which deviates from international norms which are often established to suit Western participants and circumstances. Different rules and norms are another area where greater conflicts are anticipated.

Euro – the perennial runner-up

Grégory Claeys and Guntram B. Wolff notes “when created two decades ago, the euro immediately became the world’s second most important currency. But it has remained a distant second to the US dollar. Its internationalisation peaked in 2005 and went into reverse with the euro crisis, never fully recovering since”. Europeans were aggrieved by the 1944 Bretton Woods agreement which affirmed the leading status of USD which was pegged gold while other currencies were pegged to USD. This afforded US the ability to conduct economic policies without being constrained by balance-of-payments deficits. Valéry Giscard d’Estaing, criticised this as an exorbitant privilege[7] and there were complaints of subsidising American living standards and multinationals which were able to buy European goods and assets cheap due to the over-valued dollar.

Europe’s belief in the international role of its currency resurfaces occasionally. In recent years, Grégory Claeys and Guntram B. Wolff notes “with a United States administration less inclined towards multilateral solutions and willing to use its currency to extend its domestic policies beyond its borders (for instance by forcing European firms to cut ties with Crimea, Cuba or Iran), the European Union is considering promoting a greater international role for the euro. Regular attention is now paid to it in policy speeches, in particular in the context of the European Commission’s stated desire for the EU to play a more strategic geopolitical role. The European Central Bank, meanwhile, has abandoned its traditional neutral stance on this question”.

However, there are hurdles. Europe lags in the economic, finance, technology and military spheres. The EU is fragmented and has difficulty forging consensus. So far, the EU has not displayed the willingness to create a sufficient supply of safe assets to meet international demand. In addition, Grégory Claeys and Guntram B. Wolff notes several sovereign bonds from euro-area countries lost their AAA ratings during the euro crisis. “The stock of AAA-rated debt securities from the euro area declined from around 40% of its GDP in 2008 to 20% in 2018, while the supply of AAA-rated US Federal debt securities increased from 65% of GDP to more than 100%…Overall, the monetary union does not meet all the criteria for the euro to become a dominant currency. The only solution is to improve the institutional setup of the monetary union”.  Demonstrating “a more determined attitude on the part of the ECB (by offering more easily currency swaps to countries in which euro liquidity is important) would help, as would progress on an EU external/defence policy and a more visible geopolitical role”.

After Brexit, the EU needs to consider the strategic positioning of its capital markets. UK’s departure means EU’s (as opposed to Europe) share of the global economy and markets has shrunk and this will eventually affect its global influence. At the same time, Brexit provides the EU opportunities to reshape a more cohesive identity and to deepen its capital markets to support a greater international role for the Euro. The EU enjoys the advantage of its hinterland[8] and are already increasing efforts to relocate financial business from the UK. Eshe Nelson notes “some impacts from Brexit were immediate: On the first working day of 2021, trading in European shares shifted from venues in London to major cities in the bloc. Then London’s share of euro-denominated derivatives trading dropped sharply. There’s anxiety over what could go next”.

Nick Corbishley thinks “the UK’s all-important financial services sector, which accounts for more than one-tenth of the UK’s tax revenues and one-fifth of its service exports, is almost certain to lose its current access to the EU market…Brussels appears to have little intention of granting the sector equivalence status any time soon”. London has been the hub for managing European assets and the loss of passporting rights is a major blow. “Some €1.3 trillion of assets have so far been relocated to the EU since the 2016 Brexit referendum…Frankfurt has emerged as the biggest beneficiary of this process, ahead of Paris, Milan, Dublin and Amsterdam. The Bundesbank estimates that non-German banks could end up moving €675 billion euros – roughly half of the total – to Frankfurt”.

Hannah Brenton reports “the EU’s latest battle with Britain concerns interest-rate swaps…cleared through clearinghouses like LCH in London, by far the major player in the industry…at the moment, 90 percent of those using euros are handled by LCH. Within the EU, there’s only one clearinghouse that can manage interest-rate swaps: Eurex in Frankfurt. Getting some or all of euro clearing to shift from London would be a major coup for the EU in the Brexit turf war over financial services”. However, there are risks in disrupting the clearing market as “LCH manages some €46 trillion of notional outstanding euro-denominated interest-rate swaps – equivalent to more than triple the size of the EU’s economy”. “Most industry insiders say they believe Brussels will find it difficult to prise the international market away from London, and so far EU pension funds and insurers have been reluctant to move their positions into the EU…Eurex in Frankfurt has been building up capacity and trying to entice banks to move over, resulting in an increase of euro interest-rate swap volumes at the clearinghouse — though not yet enough to make much of a dent in LCH’s business. Germany’s DekaBank, for instance, switched its business from LCH to Eurex in 2019. According to data from Clarus Financial Technology, Eurex’s market share in euro clearing by trading volume hasn’t shifted much over the last year, standing at 3.7 percent across interest-rate swaps, overnight indexed swaps and basis swaps”.

The EU is a strategically important player in the currency war. It faces a strategic dilemma in relation to the yuan. One opportunity is to compete with the UK for yuan-denominated transactions. Maximilian Kärnfelt notes “London dominates CNY clearing. It has the world’s largest foreign exchange (FX) market, handling a daily average of 37 percent of all global FX deals in 2016…In 2018, a monthly average of 9.4 percent of global CNY transactions were cleared in Europe. The European share of the global total rises to 40.1 percent if Hong Kong’s CNY clearing is excluded from the data. Most of this, 24.7 percent, is cleared in the UK. For foreign exchange trades involving CNY, the European share is even greater”.

Europe is strategically important to achieving yuan internationalisation. Maximilian Kärnfelt points out “China has chosen to focus its CNY internationalization efforts in Europe” as it is a major trading and investment partner. Increasing the use of Yuan in Europe “makes trade easier for Chinese companies by enabling direct payments for European goods and services” as well as facilitates partnerships between Chinese and European companies in international projects.

However, Maximilian Kärnfelt argues “it may be problematic for European businesses to have large exposure to CNY assets. China’s exchange rate regime is opaque…European companies could find their investments subject to arbitrary exchange rate movements driven more by policy in Beijing than by economic outcomes”. “Despite European receptiveness China itself is not always as forthcoming. China can never quite keep itself from making economic and financial matters political”. He concludes “whether Europe should continue supporting the growth of the CNY market depends largely on how China is viewed. Is it a distant power, full of economic opportunity, whose geostrategic goals do not overlap much with Europe’s? If so, then building the CNY market offers commercial benefit without hurting European interests. By contrast, if China is regarded as a strategic competitor with many interests in potential and increasing conflict with Europe’s, then there is a stronger case for caution”.

Overall, the Euro lacks the qualities to compete to be the largest reserve currency but it is an important pivotal currency. The euro has easily held second spot but it should not take its position for granted as down the road other large developing economies would likely overtake it in economic size. The EU’s quandary is that it is squeezed between two superpowers. While it aims to achieve “strategic autonomy”, it has not clearly laid out what this means. The dilemma is that growth prospects appear brighter if it strengthens linkages and support yuan internationalisation. But the ramifications are that it may end up helping propel the yuan to move ahead of the euro as well as undermine “Western unity”. On the other hand, if it doesn’t support yuan internationalisation, it would curtail its own opportunities and linkages. Nonetheless, the EU will retain substantial support as most other countries and firms would welcome and support a neutral currency outside the purview of the US and China; a currency offering Swiss-like neutrality.


Ben S. Bernanke (7 January 2016) “The dollar’s international role: An exorbitant privilege?” Brookings.

Berardi Alessia, Huang Claire (2 June 2021) “RMB internationalisation: The new commanding heights”. Amundi Asset Management Research.

C.P. Chandrasekhar (16 April 2021) “How China is offering an alternative to the IMF”. Originally published at Institute for New Economic Thinking (INET).

C.P. Chandrasekhar (April 2021) “The long search for stability: Financial cooperation to address global risks in the East Asian region”. Institute for New Economic Thinking (INET).

Cheah Cheng Hye, James Fok (July 2020) “The renminbi and China’s capital markets: The geopolitical realities”. World Economic Forum (WEF) in collaboration with Oliver Wyman – “China asset management at an inflection point”.

Eshe Nelson (16 April 2021) “How will Britain defend its financial fief after Brexit?” New York Times.

George Jia (July 2020) “Implications of diverging settlement standards”. World Economic Forum (WEF) in collaboration with Oliver Wyman – “China asset management at an inflection point”.

Gertrude Chavez-Dreyfuss (1 April 2021) “US dollar share of global FX reserves in fourth quarter hits lowest in 25 years: IMF”. Reuters.

Grégory Claeys, Guntram B. Wolff (13 October 2020) “For the euro there is no shortcut to becoming a dominant currency”. Bruegel Blog.

Hannah Brenton (26 March 2021) “EU wrestles for control of euro clearing after Brexit”. Politico.

Karen Yeung (11 June 2021) “China’s yuan could become world’s currency of choice by 2050 under dual circulation plan”. SCMP.

Maximilian Kärnfelt (9 January 2020) “China’s currency push”. Mercator Institute for China Studies (Merics).

Nick Corbishley (15 December 2020) “City of London frets about life after 2020”. Naked Capitalism.

Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society.

Phuah Eng Chye (20 July 2019) “Information and development: Development models and landscape change”.

Phuah Eng Chye (23 November 2019) “Information and organisation: China’s surveillance state growth model (Part 2: The clash of models)”.

Phuah Eng Chye (5 June 2021) “Global reset – Two whales in a pond”.

Phuah Eng Chye (19 June 2021) “Global reset – Monetary decoupling (Part 1: Sterilisation and QE)”.

Phuah Eng Chye (3 July 2021) “Global reset – Monetary decoupling (Part 2: Economics of large central bank balance sheets)”.

Phuah Eng Chye (17 July 2021) “Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)”.

Phuah Eng Chye (31 July 2021) “Global reset – Monetary decoupling (Part 4: Lessons from Plaza Accord)”.

Phuah Eng Chye (14 August 2021) “Global reset – Monetary decoupling (Part 5: The end of USD supremacy – Will it be different this time?)”

Yaya J. Fanusie, Emily Jin (January 2021) “China’s digital currency: Adding financial data to digital authoritarianism”. Center for a New American Security (CNAS).

[1] See Global reset – Monetary decoupling (Parts 3 – 5).

[2] “Global reset – Monetary decoupling (Part 4: Lessons from the Plaza Accord)”.

[3] See Karen Yeung.

[4] C.P. Chandrasekhar explains Asians generally viewed the IMF conditionalities on the 1998 bail-outs as severely damaging the Southeast Asian economies and this motivated Asian economies to explore “regional, IMF- and US- independent arrangements that could be accessed in times of financial difficulty”.

[5] “Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)”.

[6] “Global reset – Monetary decoupling (Part 4: Lessons from the Plaza Accord)”.

[7] See Ben S. Bernanke.

[8] See “Information and development: Development models and landscape change” and “Information and organisation: China’s surveillance state growth model (Part 2: The clash of models)”.