Global reset – Monetary decoupling (Part 7: Currency wargame scenarios)

Global reset – Monetary decoupling (Part 7: Currency wargame scenarios)

Phuah Eng Chye (11 September 2021)

The greenback’s dominance has likely peaked. Too many factors are working against the USD and downside risks are growing. But it is unlikely there will be a clear victor in the forthcoming currency war either with the consensus view favouring a gradual transition from a unipolar to a multi-polar reserve currency system.

Joshua Aizenman and Hiro Ito notes “the most probable global currency scenario will be a multipolar one centered around the dollar, euro, and renminbi. This scenario is supported by the likelihood that the United States, the euro area, and China will constitute the three major growth poles by that time, providing stimulus to other countries through trade, finance, and technology channels and thereby creating international demand for their currencies”. “We may be living at times where the U.S., Euro Zone and China compete with each other for greater dominance of their corresponding currency and financial system within their geographic and geopolitical periphery…it may come with greater global uncertainty associated with a resultant limited supply of public goods services induced by growing competition among the three global blocks”.

Lyn Alden points out “what the next system will look like is an open question…Whatever form it takes, it’ll be decentralized in the sense that it won’t be completely tied to any one country’s currency, since no country is big enough for that anymore. It’ll be based around neutral reserve assets, and/or a more regional-reserve model based on a handful of key country currencies, with an expanded variety of payment channels…In this sense, the world moves from a global reserve currency to a handful of regional reserve currencies. It doesn’t require new technology or new neutral currency units to do this, but it does require the continued development and usage of non-dollar payment systems”.

Another aspect to consider is the changing monetary landscape where the central banks and asset managers have expanded their role at the expense of global banks. In the process, there has been relative stagnation in cross-border USD-denominated banking intermediation as reflected by the increasing role of the Federal Reserve in providing access to USD liquidity to foreign institutions. This indicates the USD operates in a liquidity congestion paradigm where massive QE create excess liquidity supply but the liquidity circulates within the domestic market and economy because, for whatever reason, isn’t flowing into export-surplus countries while raising the risks of investing or lending to weak economies. Intuitively, excess US liquidity should result in a weaker dollar. The liquidity congestion paradigm leads to the perverse outcome of a stable or slightly stronger USD. Since the excess US liquidity cannot find a home abroad, it flows into USD-denominated assets and creates bubbly conditions. In fact, the US QE liquidity has flowed into money market funds and the Federal Reserve had to mop up the excess liquidity they created through reverse repo[1] operations. Hence, liquidity congestion is linked to the issue of balance sheet tapering (affecting) liquidity for fund managers or, more extreme, normalisation which could cause interest rates to spike with direct and knock-on negative effects on the value of USD portfolios and the Federal Reserve balance sheet. Tapering and normalisation can only be undertaken without adverse effects if there is sufficient private sector intermediation capacity to replenish the liquidity lost due to central bank normalisation. Due to the pandemic, many countries are undertaking large-scale QE and experiencing liquidity congestion, it is not evident if this situation can be sustained for long. A fall-out would certainly influence the direction of the currency war.

US policy scenarios

The policy landscape has changed significantly with decoupling. In response to the 2008 global financial crisis, China supported US and Europe in coordinating expansionary policies to engineer a global economic recovery. In contrast, today China maintains a relatively tight monetary policy to guard against contagion spillover effects from the loose US and European fiscal and monetary stimulus. In effect, the US and Chinese monetary policies are on a collision course and it is unclear how the tensions from policy divergence will be resolved.

In terms of the impact on currencies, the policy paths of yuan and euro are more predictable as China and EU are pursuing expansion of international usage as a means of enhancing their independence. On the other hand, US policy reactions to threats to the greenback’s supremacy are unpredictable and could have a decisive impact on outcomes. Below are scenarios covering potential policy paths[2].

  1. Status quo. Maintaining policy status quo implies continued erosion of USD share. Joshua Aizenman and Hiro Ito note “past decades generated growing discontent that may hasten the deanchoring of the U.S. dollar”. “Cavalier attitude to U.S. public debt management, the prospect of the U.S. divided governance between two parties at times of disappearing middle ground, and the possible future return of America First policies may debase the U.S. status as a stable safe haven providing global public services”. These blunders are inducing “China to move faster towards greater convertibility”, BRICS and emerging markets to reduce their balance exposure to the USD and for the EU to accelerate deepening of its bond market. “In this context, the U.S. exit strategies from COVID-19 with a growing debt overhang, as well as the EZ and Chinese policy choices will determine the durability of the U.S. dollar dominance”. Generally, status quo implies central banks, firms and investors will diversify portfolios (away from USD) to manage the risks of higher exchange rate volatility on refinancing costs and investment returns.
  • King’s gambit. The King’s gambit is a throughput-based strategy to deliberately flood the global system with USD to keep other countries in line. This gambit would be a replay of 1971 when US treasury secretary John Connally proclaimed at a Rome G-10 meeting that “the dollar is our currency, but it’s your problem”. This led “in short order to a roughly 20% depreciation of the dollar”[3]. The large US deficits and excess liquidity therefore puts pressure on other countries to align with US policies and challenges their ability to conduct independent policies.

Countries can react to the King’s gambit by choosing among several variations. First, countries could allow their currencies to appreciate sharply. But if they do, they risk hollowing out of their export manufacturing capacity as in Japanification or the Dutch disease. Second, countries could rely on capital controls to minimise the inflows. In the past, the US lobbied (via the International Monetary Fund) to prohibit capital controls but international support for the removal of controls evaporated after the 1998 Asian financial crisis. It should be noted capital controls provide only temporary relief but the long-term side-effect is to stunt domestic financial sector development[4]. Third, countries could sterilise the inflows and channel these assets into sovereign wealth funds to invest in an international portfolio or to recycle the USD to finance international projects such as the BRI. This is what several export-led economies, including China, has done. International lending however, has two well-known disadvantages; the credit and funding risks in financing infrastructure projects in developing countries are rather substantial.

Overall, a successful King’s gambit must meet at least one of three goals. One is for the excess USD liquidity to find a cross-border home. Part of that liquidity have flowed into China. Reuters reports “foreign cash deposits in China’s banks leapt above $1 trillion…Last year was the first in over a decade or more, that there were more foreign currency deposits than foreign currency loans and that imbalance has grown in 2021″. But there is a lot more USD liquidity stuck at home. Another is for excess USD supply to pre-empt other currencies from getting a foothold in usage. Lastly, USD liquidity works towards reviving private sector direct investments. Unfortunately, it doesn’t look like any of these three goals are being achieved. Foreign central bank holdings of US government debt appear to have generally stagnated. China is mounting a defence against USD inflows by cracking down on what it views as domestic speculative excesses (stocks, crypto, properties and commodities) and this is triggering outflows. There are no signs that abundant USD liquidity is increasing USD share of global currency usage nor reviving private sector direct investments. In fact, the rising trend in the Fed’s share of US debt (as reflected by its bloated balance sheet[5]) signifies foreign buyer capacity is approaching its limits and that the excess USD is congested within the US financial system.

Longer-term, the King’s gambit can succeed if countries decide they want to continue sustaining the familiar regime of financing US imports and consumption. The King’s gambit fails if the USD weakens excessively and generates global inflationary pressures. The risk in this scenario is that it triggers a major credit fall-out, financial contagion and a global depression. It is too early to make a call on the outcome of the King’s gambit.

  • Abandonment.  Lyn Alden suggests “one of the potential endgame scenarios for how the United States could choose to abruptly end this system as currently structured. It could decide to cease being the axiom of the global monetary system and simply move to being the biggest individual player in the system by acquiring foreign-exchange reserves, devaluing its currency in the process, adopt various fiscal changes to promote on-shoring, and begin promoting rather than fighting the trend of energy and other commodities being sold in a handful of major currencies around the world rather than just the dollar. In doing so, it would sacrifice some of its international hegemony in favour of more industrial competitiveness and higher domestic economic vibrancy. The dollar would still be a reserve currency, and still the largest individual one, but wouldn’t be the reserve currency like it is now”.
  • Nuclear option. The US could suddenly freeze Chinese or Russian participation in the US-centric financial system. While a low-likelihood event, nonetheless it cannot be eliminated. In this US, Xiang Lan notes some politicians have attempted “to initiate the Compensation for Americans Act aimed at imposing sanctions on CPC officials and freezing Chinese assets in the US. Although the bill was blocked…the specific measures proposed… include freezing the necessary Chinese assets in the US in order to reach a bilateral compensation agreement with China, removing China’s eligibility for World Bank development loans, removing China’s developing country status in international bodies, and prohibiting the use of federal retirement savings for investing in China”. A worst-case scenario would be “prohibiting Chinese state-owned banks from using the USD”. A worst-case scenario could be triggered by a military conflict. In past wars, waring nations use blockades and freeze financial transactions and asset ownership. This scenario is unimaginable in a globalised, financialised and informationalised economy. A nightmare implosion of tightly coupled networks and contagion effects from a breakdown in global trade and global governance. Cross-border commerce and finance will freeze overnight; ownership, intellectual property rights and legal agreement will no longer be recognised; and lawsuits will mushroom. Affected countries would abandon the US network and this will accelerate fragmentation of the global economy into separate trade, currency, legal and information spheres.


Currency wars are a war of attrition and large shifts in currency usage take place over decades. Shifts in currency shares can be modelled based on changes in national debt, central bank and private assets, portfolio allocation and exchange rates. Alternatively, milestones can be used to gauge the direction of structural trends.

The base scenario is for a tripolar reserve currency system. Joshua Aizenman and Hiro Ito suggest it “would take probably decades for the global share of the U.S. dollar to decline below half”. In this regard, “prospects of rapid increase in the global share of the euro and the yuan are challenged by their limited supply…absence of deep euro sovereign bonds backed-stopped by the EU or the ECB limits the threat posed by the euro to the dollar’s dominance. The slow convergence towards a yuan convertibility, and the limited though rising foreign participation in China’s Stock and Bond Markets restrain the viability of the yuan as a global currency”.

The driver of change will be the yuan share of currency reserves and usage. The intriguing question is whether and how fast the yawning gap between China’s substantial share of global GDP and trade and the low use of yuan in global reserves, payments, funding and investment can be bridged. This is normally projected based on two end-dates – 2030 and 2050.

2030 is significant because it is China is expected to match or overtake the US by then. Backed by China’s growing share of the global economy, the yuan is thus expected to make the largest gains in share of usage from currency appreciation, portfolio re-balancing and support from countries affected by US sanctions and BRI partners.

Several forecasts[6] predict the yuan’s share of global foreign exchange reserves could rise from 2.3% in 2020 “to between 5% and 10% by 2030, surpassing the levels of the Japanese yen and British pound”. Morgan Stanley analysts[7] suggest investment portfolio inflows will probably overtake foreign direct investment to reach a cumulative $3 trillion of inflows. They believe China will eventually become an importer of capital and estimates “the country’s current account, which includes trade and payments to foreign investors, could turn negative from 2025 and reach negative 1.2% of GDP by 2030. “This means at least US$180 billion of net foreign capital inflows per year in 2025-30 are needed to finance the current account deficit”.  Xiong Lan notes “this is consistent with the 10.92% currency weight envisaged when the RMB was formally included in the IMF’s Special Drawing Rights basket of currencies in 2016”.

In tandem with the rise of the yuan, a reasonable guess is for the USD share of forex reserves to fall from 59% in 2020 to below 50% by the end of the decade. Countries such as Ireland, Luxembourg, Belgium, Taiwan and India[8] have been major buyers of US treasuries in 2020 and there could be other additional new buyers. But the lack of significant purchases by Japan and China (the two largest central bank holders of US debt), the reversion of central bank balance sheets towards normalcy, and USD depreciation would have the effect of reducing the USD share of forex reserves.

At the end of this decade, the expectation is for the euro to retain its second place and possibly hold onto its 20% share if it is recognised as the neutral choice in a tripolar currency regime. The trend towards localisation of liquidity[9] and shrinking economic shares implies there will likely be marginalisation of fringe international currencies such as the yen, sterling, AUD and Canadian dollar.

In the commercial space, the yuan benefits from China’s economic strengths. Berardi Alessia and Huang Claire explains “SWIFT transaction data often leaves a false impression that RMB internationalisation progress has stalled, since RMB’s share in the global payments market has stayed below 3% for six years and its popularity rank appears to be stuck in fifth place after USD, EUR, GBP and JPY. This, however, understates RMB settlement that happens outside of the SWIFT platform, as China launched its own payment system CIPS in October 2015. In five and half years, transactions through CIPS have risen to RMB 45.2tn ($6.5tn) in 2020 from none, driving cross-border RMB settlement in trade and investments to triple in 2020 from 2016-17, a much faster rate than SWIFT transactions would otherwise suggest”. They add that “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”.

Xiong Lan notes “China’s core concern is domestic, aiming to ensure domestic financial stability and the stability of the RMB exchange rate”. In contrast, “the US’s core concern is global, which aims to ensure global capital flow mainly in the USD, resulting in global financial instability and huge debts. As long as this situation persists, the status of the RMB and USD will fundamentally not change”. He thinks “the pace of RMB internationalisation is determined by the pace of the development of the China-US competition towards confrontation. If the competitive momentum exceeds that of confrontation”, RMB internationalisation will be slower and the RMB surpassing the GBP and the JPY in 2039-2040. “Once the US commences a wider range and stronger financial sanctions against China, RMB internationalisation will definitely accelerate” and the RMB could surpass either the GBP or JPY before 2029.

It is debatable whether the euro or USD will be the currency ceding more ground to a yuan advance. Research by Georgios Georgiadis, Helena Le Mezo, Arnaud Mehl and Cédric Tille show “the growing share of China in international trade has primarily benefited the dollar, and to a lower extent the renminbi, at the expense of local currencies and the euro. Hence, our results suggest that the emergence of China and its currency have eroded the status of the euro, but strengthened that of the dollar”. This is consistent with the theory that “due to history dependence, the emergence of another economy as large as the incumbent dominant-currency issuer actually strengthens the incumbent dominant currency’s position at the expense of existing challenger currencies as long as it is not accompanied with shifts in global anchor currency choices and a deterioration of the incumbent’s macroeconomic stability”. They also “provide evidence that the People’s Bank of China’s global network of currency swap lines has been associated with increases in renminbi invoicing, at least in countries for which China accounts for a large share of trade. This increase has occurred at the expense of both the euro and the dollar, with the impact on the dollar being more robust”.

The critical bottleneck for yuan internationalisation lies is its capital market. China needs to accelerate capital market development before it can be confident in liberalising capital controls. The changes appear to have started as growth in the domestic asset management industry and capital market is taking off and global intermediaries are increasing their yuan holdings. Karen Yeung notes “overseas entities held 3.4 trillion yuan (US$531 billion) in yuan-denominated equities and 3.3 trillion yuan in yuan-denominated bonds at the end of last year, up 62 per cent and 47 per cent from the previous year, respectively”.

In this regard, the capital market has been a bastion of strength for USD supremacy – it is dominant in product creation, intermediation, asset management, clearing and settlement. But decoupling, investment restrictions and sanctions implies shrinking participation and demand and signifies a USD retreat from global markets. For example, recent US and Chinese actions on China listings will lead to a reduction in Chinese private sector use of USD for funding and investing.  Europe, preoccupied by the internal tussle between UK and EU, and wary of being caught in the middle of the US-China tensions, will opt to stay neutral. Generally, the share of the yuan in global payments, funding and investment should rise from negligible levels to around 10% largely at the expense of USD by the end of this decade. The main constraint on yuan usage will be the pace of China’s financial liberalisation and the expansion of yuan international intermediation capacity.

In the longer-term outlook to 2050, the reserve currency mix will probably catch up with global economic secular trends and the yuan could achieve parity with the USD with its market share rising to around 30% each by then. The US shares in payment, funding and investment are likely to fall from their current lofty levels to around 50%. The euro face major challenges as its economic significance shrinks due to the growth of the large emerging economies such as Brazil, India, Indonesia, Russia and South Africa. It is likely that the euro may be overtaken by the yuan and drop into third position.


The currency war is an important aspect of the global reset. In this context, the US is at a disadvantage because of the conflicting objectives of stimulus and decoupling. At a time when it needs global support for its stimulus programs, the US chose to decouple. Decoupling signals an intention to deglobalize. This will lead to de-dollarisation as global use and intermediation of USD will shrink and USD liquidity will stay largely trapped within its borders. The shrinking USD global liquidity has medium-term contractionary implications for US MNCs, intermediaries, corporate profits and asset prices and could have adverse spillovers that could affect global monetary stability.

Overall, the currency war and decoupling suggest the global financial system will transit from a unipolar to a multipolar system; with the danger that it splinters into a regime of trade blocs and regional currency areas running on parallel payment networks and rules. Deglobalisation will thus result in a re-mapping of global capital flows and the global recycling of savings. The outcomes of the currency war will also be affected by information disruption – the emergence of digital currencies and alternative networks – and changes in the intermediation landscape.


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

Evelyn Cheng (4 September 2020) “China’s yuan could become the world’s third largest reserve currency in 10 years, Morgan Stanley predicts”. CNBC.

Georgios Georgiadis, Helena Le Mezo, Arnaud Mehl, Cédric Tille (July 2021) “Fundamentals vs. policies: Can the US dollar’s dominance in global trade be dented?” European Central Bank (ECB).

Joshua Aizenman, Hiro Ito (December 2020) “U.S. macro policies and global economic challenges”. NBER.

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

Kevin Hebner (October 2007) “The dollar is our currency, but it’s your problem”. IPE Magazine.

Lyn Alden (6 December 2020) “The fraying of the US global currency reserve system”.

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?)”

Phuah Eng Chye (28 August 2021) “Global reset – Monetary decoupling (Part 6: The forthcoming currency war)”.

Reuters (1 June 2021) “Analysis – China’s banks are bursting with dollars, and that’s a worry”.

Wolf Richter (30 June 2021) “Fed’s reverse repos spike to $1 trillion. cash drain undoes 8 months of QE”. Wolf Street.

Xiong Lan (28 July 2021) “Escalating China-US confrontation will accelerate RMB internationalisation”. ThinkChina.

[1] Wolf Richter notes “the Fed sold a record $992 billion in Treasury securities in exchange for cash, via overnight reverse repos (RRPs), to 74 counterparties…With these RRPs, the Fed sells Treasury securities and removes cash from the financial system…the Fed has undone over 8 months of QE (at $120 billion per month)…the big issue over the past few months has been the flood of cash in money market funds, and they are trying to find a place to go with it”. My interpretation is that the QE liquidity created by the Fed is congesting within the US system rather than being loaned out or flowing into other countries. As a result, the Fed is being forced to absorb or unwind the liquidity it has created so far this year.

[2] This excludes the scenario where the US tightens its economic belt which would likely trigger a global depression.

[3] Kevin Hebner.

[4] At some point, countries need to lift capital control restrictions on domestic outflows and foreign inflows. Otherwise, local intermediaries never develop the capabilities for international intermediation and eventually local customers bypass these controls and go offshore to meet their international financial needs. There are differing opinions on the degree of financial liberalization and what the outcomes are likely to be. Complete liberalization though is only for countries with ambitions to be international financial centes.

[5] See Wolf Richter.

[6] Quote from Morgan Stanley report reported by Evelyn Cheng. See Xiong Lan also on other similar forecasts.

[7] See Evelyn Cheng.

[8] Wolf Richter.

[9] The localisation of liquidity is explained in “Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)”. Due to QE, the proportion of government debt held by their own central banks will rise further and this implies a decline in forex reserves as a proportion of government debt.