The dismal decade (Part 1: De-dollarisation and currency landscape in 2030)

The dismal decade (Part 1: De-dollarisation and currency landscape in 2030)

Phuah Eng Chye (9 December 2023)

I will be concluding my blog series soon and the remaining articles will summarise my views on key economic challenges for this decade. This decade is already proving epochal: The US-China decoupling, the end of the Goldilocks economic era, pandemic and climate deterioration, US withdrawal from Afghanistan, Russian invasion of Ukraine, and the Israeli-Palestine conflict. These series of events are not accidental but reflect the global reset arising from the de-stabilisation of the world order with China closing the gap on US and India steadily progressing towards third place. Other rising Global South economies are similarly threatening to surpass G7 members. The competition for influence and allegiances is intensifying across all fronts – security arrangements, trade, technology, supply chains, finance, content, data and law – and the contests are becoming muscular. As competition turns into conflict, the growth drivers of globalisation, financialisation and informationalisation are shifting into reverse gear and contracting global economic and money multipliers; ensuring that we are on course for a dismal decade.

Mainstream economic narratives on the outlook for this decade tend to have two defects. One it tends to be politicised and weaponised. More often than not, these narratives and advice prove to be misleading and unhelpful. The other is that most mainstream outlooks tend to be restrained by status quo – with change projected at the margin. 2030 scenarios need to be reworked to face up to harsh realities based on deepening economic fragmentation, widespread political-socio-financial instability, the emergence of new conflict hotspots, further pandemic and climate deterioration and the frightening prospect of an accident triggering World War III. I start by reviewing the trend towards de-dollarisation that will reshape the global landscape.

De-dollarisation explained

The fate of dollar hegemony is a hotly debated topic. One camp has pronounced the demise of dollar hegemony as inevitable while the other reiterate there is no alternative (TINA) to USD as the global currency. These narratives obscure the corrosive nature of de-dollarisation as analysed below:

• There is no alternative to de-dollarisation

The blanket sanctions and freezing of Russian central bank and other assets acted as a financial nuclear bomb[1] that destroyed faith that USD (and other Western currencies) would be a safe asset for friends and foe alike. If TINA once underpinned USD supremacy, it is now a wake-up call that there is no alternative to de-dollarisation. De-dollarisation is not about replacing USD but about “unfriendly” nations accelerating efforts to establish an alternative global financial network to insulate themselves from Western sanctions.

• USD share of central bank FX reserves has hardly budged

De-dollarisation theorists often point to the long-term trend with the USD share of global central bank FX reserves falling from 73% in 2001 to 55% in 2020. But this interpretation is skewed to obfuscate the fact that USD share of global FX reserves, hovering around 58%, has hardly budged since the G7-sanctions in early 2022.

There are several reasons why USD share has held its ground. First, a strong USD masks the decline in the quantity of USD held. In the short-term, PBOC and BOJ sales of USD reserves actually puts pressure on US interest rates to rise; widening the differential between US and Asian interest rates and adding to the selling pressure on Asian currencies. However, this is a short-term dynamic that will be exhausted when Asian currency sales reaches its limits; or is broken either by Asian central banks raising interest rates; or the Fed lowering interest rates.

Second, geopolitical allegiances play a major role in determining FX holdings. While the two largest holders have reduced their holdings, allies have made up for the losses.  Wolf Richter notes the combined holdings of China and Hong Kong fell by 6.6% from a year ago to $1.06 trillion (China accounts for $847 billion) and Japan’s fell by 10.1% to $1.09 trillion in May 2023. This has been offset by purchases by UK (3^rd largest holder at $667 billion, up 4.7%), European financial centers (collectively owning $1.48 trillion), Canada ($266 billion, up 17.9%), Taiwan ($240 billion, up 4.7%) and India ($238 billion, up 17%). “As the US debt has ballooned over the years, but foreign holdings have increased more slowly, the share of foreign holdings as a percent of the total federal debt has declined from the 33% range in 2014 to less than 24% in May 2023. In other words, the US debt financing has become less dependent on foreign holders”.

Barry Eichengreen adds “it has not been possible to update figures for Russia’s renminbi reserves, since the Bank of Russia has not reported reserve composition since the end of 2021. But with most of the bank’s other currency reserves having been frozen since early 2022, one would not expect significant changes in reserve composition since that time”. At the time, the Bank of Russia held nearly a third of total renminbi reserves which was estimated at 2.7% of global central bank reserves. “Remove Russia’s share on the grounds that the country faces exceptional financial and geopolitical circumstances, and the renminbi’s share falls to roughly 1.6%”. By the same token, if Russia’s reserves weren’t frozen, it was likely Russia would have switched most of its USD holdings to yuan.

Overall, the composition of central bank FX reserves is unlikely to change drastically in the medium-term. The major Western central banks are allied to US and are likely to support USD (and related currencies) and to minimise non-Western FX reserves (e.g. Yuan). Support for USD will be eroded over time as allies (e.g. Japan) face constraints in accumulating more dollars. It is worth noting that at some point when China finishes selling down its USD holdings, it is unlikely to resume being a big buyer.

The main driver of de-dollarisation will be the accumulation of yuan by Global South central banks, with the likely exception of India. However, the Global South do not have much capacity to accumulate significant amounts of yuan as FX reserves. The yuan share of global central bank FX reserves is therefore dependent on China’s growing bilateral relationships with the Global South, particularly with the sanctioned countries.

Third, central banks hold USD reserves because of complementarities with cross-border transactions of domestic banks and firms. Barry Eichengreen points out “cross-border use of the renminbi for global payments remains small, on the order of 2% of total cross-border transactions. Evidently, the complementarities supporting a continued global role for the dollar do not provide comparable support for the renminbi”. In any case, “China’s internationally traded assets and liabilities are just 4% of global totals” and “there are still not enough Chinese assets and liabilities to constitute serious alternatives to dollars”. Hence, central banks have tended to rebalance their reserve portfolios “towards nontraditional reserve currencies such as the South Korean won, Norwegian krone, Canadian dollar, Australian dollar, and Singapore dollar”. Evgeny Y. Vinokurov, Marina V. Grichik and Taras V. Tsukarev notes “the renminbi’s share in the global financial system is disproportionately small, compared to China’s share in global trade and the world economy. This might compel this currency to grow in the future. China accounts for 18% of global GDP and almost 11% of foreign trade turnover, but less than 3% of global foreign exchange reserves are kept in renminbi, and only 2% of all transactions on the international foreign exchange market are executed in this currency”.

Fourth, Evgeny Y. Vinokurov, Marina V. Grichik and Taras V. Tsukarev notes “certain macroeconomic constraints, however, still prevent the renminbi from assuming a role in the global financial system commensurate with that of the U.S. dollar or the euro. Within the Impossible Trinity hypothesis, China chooses a fixed exchange rate over the open capital account. Closed capital accounts limit investments in renminbi assets aimed at accumulating reserves. China relies on the suppression of domestic demand as its savings constantly exceed its investments. To enable the accumulation of renminbi reserves by other countries, China will need to give up its current growth model to build current account deficits…In order to make sure other countries can accumulate RMB reserves in amounts equivalent to their current U.S. dollar volume, China would need to increase its share in global reserves by $6.8 trillion, or 7% of global GDP and 39% of China’s GDP. Turning to the renminbi is not a panacea for other countries; they will still be dependent on one country, only now it will be China and not the United States”.

Overall, Barry Eichengreen, Camille Macaire,  Arnaud Mehl,  Eric Monnet and  Alain Naef argues explain “an enhanced role for the RMB as a reserve currency will not automatically eliminate that of the dollar. Rather, China will have to hold dollar reserves in order for other countries to willingly hold RMB reserves. The two reserve currencies will be complements, not substitutes”.

It also doesn’t make sense to hold FX reserves in perpetuality as this turns them into a deadweight. Some central banks may have built up excess USD reserves and may need to sell to manage their inventory risks. In this context, central banks should not miss out on the opportunity to reduce (sell) FX reserves when the USD is strong (at higher prices), otherwise the central bank could find itself disadvantaged (in buying) when the USD turns weak.

• Recent trends – USD remains dominant amid yuan’s progress

Simon White points out with USD “accounting for 40% of export invoicing, 45% of cross-border bank claims, 60% of FX reserves and 90% of FX transactions, it will take years before it’s dominance is seriously challenged”.

Bafundi Maronoti notes “the average turnover per day with the USD on one side of the transaction was $6.6 trillion – up 14% from $5.8 trillion in 2019…The USD was involved in nearly 90% of global FX transactions, making it the single most traded currency in the FX market…At least 85% of trading in the spot, forward and swap markets features the USD in one leg of the transactions…The euro – the second most traded currency – has a share of only 31%, down from its peak of 39% in 2010. A similar trend can be observed for the Japanese yen, while the British pound has maintained a largely constant share. The shift from these major currencies has been matched by a rise in the role of emerging market economy currencies such as the renminbi. The latter’s share in global FX turnover has increased from less than 1% 20 years ago to more than 7% now”.

Bafundi Maronoti explains USD’s dominance is due to several factors. “First, its use as a vehicle currency for FX transactions, meaning that non-US dollar currency pairs are not exchanged directly but via the dollar…this role of the USD drives just under 40% of its turnover in FX markets. Second is the dollar’s footprint in offshore funding markets…About half of all international debt securities and cross-border loans issued in these offshore funding markets are denominated in USD. As of the second quarter of 2022, the amount of debt and loans denominated in USD where neither the issuer/borrower nor the lender is a US resident is estimated to be 88% of total international USD-denominated debt and 65% of total international USD bank loans. Third is the currency’s popularity in international trade and global payments. Approximately half of global trade is invoiced in USD, although this share varies widely across regions. This disproportionately large reliance on the USD is in spite of the United States accounting for just over a 10th of global trade. These shares have hardly changed since 2019”.

Recent data points to yuan steadily gaining share at the expense of non-USD currencies. Julián Caballero, Alexis Maurin, Philip Wooldridge and Dora Xia points out “among the 39 currencies covered in the BIS Triennial Survey, the Chinese yuan (CNY) saw the fastest growth in FX trading between April 2019 and April 2022. CNY trading rose by over 70% after adjusting for exchange rate movements, to $526 billion per day. This rapid growth elevated the CNY to the fifth most traded currency in the world. Even so, CNY turnover remained low relative to the size of China’s economy: 3% of annual GDP, compared with 30% of GDP for USD and 6% for the median EME currency”. Elwin de Groot adds that SWIFT data reveal “the use of the euro has collapsed in the past nine months. It’s share in transactions dropped from 38% in January to 23.2% at the end of August, which is the lowest level recorded in, at least, twelve years”. Yuan activities may be understated though as it may not capture transactions outside SWIFT.

The People’s Bank of China (PBOC)[2] reported progress in yuan internationalisation. It expanded the scale of fund swaps with Hong Kong. Since 2022, yuan clearing banks have been established in Laos, Kazakhstan, Pakistan, and Brazil. Hong Kong is the world’s largest offshore yuan business hub. “As of end-March 2023, yuan deposits (including certificates of deposit) and outstanding yuan loans amounted to 950.6 billion yuan and 245.4 billion yuan respectively, increasing by 17.6 percent and 37.9 percent year-on-year. Around 75 percent of offshore yuan payments are processed in Hong Kong”. “By the end of 2022, the yuan-denominated deposit balance in major offshore markets reached approximately 1.5 trillion yuan, returning to historical highs…From January to September in 2023, the total yuan cross-border payment amount reached 38.9 trillion yuan, marking a 24 percent year-on-year increase. Among these, the proportion of yuan cross-border payments in the total cross-border payments in both domestic and foreign currencies for goods trade was 24.4 percent, a 7-percentage-point year-on-year increase and the highest level in recent years”. The PBOC also plans to “further enhance infrastructure construction for yuan cross-border investment and financing, as well as transaction settlements. Efforts will be made to expedite the transformation of the financial markets into a more institutionally open status, creating a more friendly and convenient investment environment. The central bank will deepen bilateral currency cooperation, support the healthy development of the offshore yuan market, and foster a symbiotic relationship between onshore and offshore yuan markets. A comprehensive framework for the integrated cross-border flow of domestic and foreign currencies will be established to enhance risk prevention and control capabilities in an open environment, and safeguard against systemic risks”.

Alessia Amighini and Alicia García-Herrero notes “China is pushing the use of renminbi to pay for its imports…Nearly 30 percent of services imports are already denominated in renminbi, while China’s trade in goods denominated in renminbi stands at 23 percent, according to China’s State Administration of Foreign Reserves (SAFE). The latest phase of renminbi internationalisation has also benefited from elevated US interest rates since 2022. Given the higher costs of borrowing in dollars, many borrowers have turned to the renminbi for financing or refinancing, as shown by the sharp rise in the renminbi’s share of Chinese banks’ overseas loans and outstanding offshore bonds. Moreover, shocked by the Fed’s aggressive hikes and the continued tightening of dollar liquidity, the long-idle renminbi swap lines, which the People’s Bank of China had extended to the monetary authorities of 40 countries, have started to be withdrawn by those with dwindling foreign-exchange reserves…However, there are also areas in which the international use of renminbi remains stagnant or is even decreasing. This is mostly the case for investment, whether private or official. However, there does not seem to be a significant increase in the share of oil transactions in renminbi, which is somewhat surprising as China is the world’s largest oil importer and has specific arrangements for renminbi settlements with major exporters (from Russia to Saudi Arabia)”.

Gerard DiPippo and Andrea Leonard Palazzi add SWIFT data indicates while the renminbi share of global payments stagnated at around 2.2%, “the renminbi’s share of trade credit – lending to facilitate the cross-border movement of goods – increased to 4.5 percent in February from 2 percent a year earlier…this share jumped to roughly 23 percent of China’s total goods trade as of the first quarter of this year. However, it remains well below its peak in 2015, after which China’s exchange rate devaluation and subsequent strengthening of capital controls reduced many businesses’ willingness to settle in and hold renminbi. China’s central bank does not report the countries with which China is conducting trade in renminbi, but the increase in 2022 was likely because of Russia and perhaps a few other countries preferring the renminbi due to Western sanctions. Firms in advanced economies – which account for 57 percent of China’s trade – are already interested in using renminbi to settle trade with China. For example, during the first half of 2022, nearly a third of UK-China trade was settled in renminbi”.

Samuel Shen and Rae Wee note “the surge in their borrowing from Chinese banks has catapulted the yuan past the euro into becoming the second-biggest currency used in global trade finance…The yuan’s share as a global currency in trade finance jumped to 5.8% in September from 3.91% at the start of the year, trumping the euro for the first time, according to SWIFT…Regardless, it barely scrapes the dollar’s dominance at 84.2%”.

Samuel Shen and Rae Wee notes as funding costs elsewhere jump, rock-bottom yuan interest rates are attracting foreign companies and banks to raise “record amounts of cash through yuan bonds issued in mainland China and in Hong Kong, known as panda and dim sum bonds, respectively…Foreign companies such as German carmaker BMW and Crédit Agricole S.A as well as overseas units of Chinese firms raised a record 125.5 billion yuan ($17.33 billion) selling panda bonds during the January-October period, a 61% jump from the same period last year. The National Bank of Canada raised 1 billion yuan from the sale of a three-year panda bond at a coupon of 3.2% late last month, a bargain compared to rates of 4.5% at home. The issuance of dim sum bonds in Hong Kong also hit a record high, surging 62% from a year ago to 343 billion yuan during the first eight months. Issuance of yuan-denominated loans in the city also soared”. While PBOC has been asking banks to lend to offshore firms and broaden use of yuan outside China, “it’s still the case that more than half of cross-border transactions using the yuan are between the mainland and Hong Kong. This is a very local form of internationalisation”. “Within trade finance and payments, the yuan’s use is largely limited to developing countries friendly to China, such as those joining its Belt and Road initiative…Countries that are geopolitically aligned with the U.S. are showing no willingness to switch over to using the yuan. That suggests that global use of the yuan in trade will hit a low ceiling”.

It is worth remembering that the biggest global firms – mostly from the West – probably account for a large proportion of trade, financing and investment transactions and hold a large proportion of Western-currency denominated assets offshore. Thus, a major shift towards Global South currencies is dependent on the international expansion of home-grown multinationals and financial intermediaries.

De-dollarisation modalities

Zoltan Poszar[3] highlights that as the West reduce dependence on Chinese supply chains, the East focuses “on extracting themselves from the Western financial system and de-risking their relationship with the US dollar and Western financial institutions. If you go into a world where trade is not dominantly invoiced in dollars…it’s no longer a machinery where the dollars are getting created on the margin, the dollars are getting accumulated on the margin. And the question is how do you recycle the earned dollars back into funding and rates market?”

It should be noted de-dollarisation is not aimed at replacing the USD as the dominant global currency but to facilitate multipolar diversification so that “non-allies” can insulate their economies from Western sanctions and US monetary policy shocks (both QT and QE). To promote substitutability of the USD, non-Western assets must achieve qualities such as stability, safety and ubiquitousness (liquidity and substitutability) to gain wide acceptance. The pace and depth of de-dollarisation is thus dependent on the ability of Global South countries to financialise and support the leverage of non-Western currencies and assets.

Geopolitically, the starting point for de-dollarisation is to build on bilateral trade and investment relationships with countries or companies agreeing to use their mutual currencies. Gerard DiPippo and Andrea Leonard Palazzi point out China is pursuing “low-threshold internationalization” by encouraging trade to be “settled in renminbi to boost its currency’s standing as a bilateral currency and to reduce its reliance on the U.S. dollar”. While “Beijing has been pushing renminbi internationalization for over a decade, but Chinese officials have had to balance this goal with political imperatives to maintain financial and exchange rate stability in part through capital controls. The more renminbi assets there are offshore beyond the controls, the harder such financial management becomes. Consequently, Beijing’s renminbi push has been cautious and focused on bilateral uses, not true internationalization. Although China’s central bank has a network of currency swaps with other central banks, these are intended to facilitate bilateral trade with China, not between third countries…The implication is that China’s currency is unlikely to achieve widespread network effects absent a change in Beijing’s renminbi internationalization strategy and substantially more offshore liquidity in renminbi. Beijing’s interest in inking new deals for renminbi-based bilateral trade does not overcome this fact”.

Gerard DiPippo and Andrea Leonard Palazzi point out “a crucial determinant of whether the renminbi can go beyond low-threshold internationalization will be whether it can achieve sufficient network effects to be used in transactions not involving Chinese entities…Network effects are vital for full currency internationalization almost by definition. An international currency is not merely one that is used beyond the border of the issuing economy but also one used for transactions between nonresidents of that economy. To achieve this, nonresident entities must be willing and able to settle transactions with each other even if the issuing economy is not directly involved”. “While more of China’s bilateral trade is likely to be settled in renminbi going forward, China’s bilateral trade is not sufficient to approach the U.S. dollar’s share of trade settlement…For market and geopolitical reasons, it is hard to imagine advanced economies trading with each other in renminbi, and it is only slightly less implausible that advanced economies would switch to the renminbi for trade with emerging market and developing economies (EMDE) besides China. Those two groupings of trade flows account for 47 percent and 19 percent of global trade, respectively, based on IMF data. Currently, there is little evidence of renminbi-denominated trade settlement that does not directly involve China, except possibly between Russia and a few other countries. If it were to happen, some EMDEs would likely be interested participants”. They conclude the renminbi “will not replace the U.S. dollar globally, but it is already starting to replace the dollar in some of China’s trade relationships. Whether it goes further and reaches something closer to full, or high threshold, internationalization is in part Beijing’s choice. This kind of renminbi internationalization may achieve Beijing’s goals, including reducing China’s exposure to exchange rate fluctuations and mitigating China’s vulnerabilities to U.S. financial sanctions. Such progress is only incremental, as major Chinese banks are still largely reliant on the global dollar network for international finance and SWIFT for messaging international payments. Still, policymakers should not confuse maximalist claims about unassailable dollar dominance with Beijing’s more modest goals”.

Selwyn Parker notes China has twice extended Argentina a lifeline by allowing it to draw down on a bilateral currency swap line to pay in yuan the USD required to meet emergency loan obligations to the IMF while China was repaid in pesos. China Daily commented “the (yuan) has emerged as a safeguard of global financial stability, shielding an increasing number of developing economies from the spillover effect of drastic adjustments in the United States’ monetary policy” with the Argentinian deal “underscoring the currency’s potential in mitigating developing economies common challenge of a US dollar shortage and revamping the global monetary system”.

De-dollarisation is to be a slow journey as there are operational obstacles to establishing an alternative currency area operating on different infrastructure, rules, venues and intermediaries. The transition would take several years due to the need to sort out issues in relation to information (language, disclosures), usability (liquidity), reliability, security, legal framework and intermediaries (sanction-proof).

Jeff Pao notes Bank of Russia research recently highlighted “Russian exporters and importers suffer from currency risks when settling their trade in the non-convertible and volatile renminbi…not enough derivatives for traders to hedge the Chinese currency”. Hence, “Russia has been selling renminbi since the beginning of this year…in exchange for Western currencies…blamed Beijing for refusing to allow Russian companies and individuals to hold renminbi in cash…Although renminbi has become a leading transaction currency on the Moscow Exchange and China is now Russia’s biggest trading partner, the Chinese central bank does not want renminbi notes to be circulated overseas…Russia had held high hopes of being able to get yuan notes as a substitute of the dollars and euros but such hopes vanished…because of this, there is no room for the Russian central bank to ease the existing rule under which an individual in Russia can withdraw no more than US$10,000 worth of foreign currencies from bank accounts annually…China has promoted renminbi internationalization for more than a decade but, probably for anti-money laundering reasons, allows the use of its money notes only within its territories including Hong Kong and Macau”. “Since Beijing and Moscow started promoting the use of local currencies in trade settlement last year, Russia has accumulated about 251.5 billion yuan ($36.5 billion)…the Russian National Wealth Fund, a sovereign fund, has vowed to convert 60% of its foreign reserves into renminbi within the next few years but, in reality, it keeps selling renminbi assets…Russia held under 20 billion yuan of renminbi assets at the end of March”. Similarly, it has been reported Russia is also facing  difficulties using the Indian Rupee it accumulates from oil sales.

Barry Eichengreen, Camille Macaire,  Arnaud Mehl,  Eric Monnet and  Alain Naef argue “the renminbi can play a more important role in the future, even in the absence of full financial liberalisation. This process would involve trade invoicing and settlements, central bank swap lines, and offshore renminbi markets. This would not lead to the renminbi overtaking the dollar, but rather to a multipolar world of key currencies, including the dollar, euro, and renminbi”. “China must concern itself not just with providing RMB to the rest of the world. In addition, it must enable foreign countries to sell RMB for dollars when they wish”. “Since 2010, when China first authorised RMB trading in Hong Kong, offshore markets have opened in 24 other cities” to enable RMB exchange outside mainland China. But these markets remained small with RMB1.25 trillion ($200 billion) deposited in offshore accounts as of July 2021 as compared with $14 trillion offshore dollar deposits (Eurodollars) or close to 130% of national deposits in 2016.

Barry Eichengreen, Camille Macaire,  Arnaud Mehl,  Eric Monnet and  Alain Naef point out “in terms of historical comparisons, the RMB today is not unlike the dollar in the 1950s and 1960s. Convertibility of RMB into dollars today is limited by capital account restrictions, while convertibility of dollars into gold was restricted by US monetary law under Bretton Woods. The 1950s and 1960s were the decades of the Bretton Woods System, when the dollar had to be backed by gold but was not convertible into the metal in the US. The offshore gold market in London then and the offshore RMB market today are products of a similar phenomenon, namely the imperfect convertibility of an international currency (the dollar then, the RMB now) into the ultimate reserve asset (gold then, the dollar now). Just as the London gold market was a safety valve for dollar holders in the 1960s, the offshore RMB market in Hong Kong is a safety valve for RMB holders today”.

In the early phases, bilateral relationships will be the main driver of de-dollarisation. Countries facing the threat of Western financial sanctions are responding by growing trade and investment among themselves. China-Russia[4] bilateral trade in 2022 rose 34.3 percent year-on-year to a record high of 1.28 trillion yuan ($180.37 billion) in yuan-denominated terms, the first time that bilateral trade surpassed the 1-trillion-yuan threshold. Trading turnover in the yuan-ruble pair reaching 70.3 billion rubles ($993 million) on October 3, for the first time surpassing 68.2 billion rubles for the dollar-ruble pair on the Moscow Stock Exchange. Russian bourses expanded trading in Chinese companies to 115 and “plans to offer trading in more than 500 Hong Kong-listed Chinese shares in 2023 and expand to markets such as India, Brazil and South Africa”.

Russia is also strengthening economic relationships with other sanctioned countries. Pepe Escobar notes “Russia has become Iran’s largest foreign investor” with “$2.7 billion worth of investment to two petroleum projects”. “Russia-Iran bilateral trade amounts to only US$3 billion annually. But a boom is inevitable…The Iran-EAEU free agreement (FTA) is nearly finalized – including zero tariffs for over 7,500 commodities. In 2022, the EAEU traded more than $800 billion worth of goods…A realistic projection is that Tehran can expect $15 billion annual trade with the five members of the EAEU in five years, as soon as Iran becomes the sixth member”.

Multilateral schemes provide an umbrella for the establishment of trade settlement alternatives – including a multilateral-backed currency – to manage cumulative macroeconomic imbalances and to facilitate intra-regional reserve accumulation. Alasdair MacLeod notes Sergei Glazyev is a proponent of “forming the common EAEU exchange market, which, in particular, would involve the unification of exchanges’ information systems and the nomination of prices in national currencies. The agenda includes the transition to a new stable settlement currency based on a basket of national currencies and exchange-traded products, as well as the creation of our own stable pricing system. Such principles should be applied in work not only within the EAEU but also throughout the SCO“. A major problem is that “the inclusion of national currencies in some sort of daily fixing does not guarantee stability, and every time another SCO member decides to join a whole rebalancing exercise would have to take place. The same considerations apply to exchange traded products… refer to commodities traded between members…Only a gold-based currency fits the bill”.

Evgeny Y. Vinokurov, Marina V. Grichik and Taras V. Tsukarev notes the Shanghai Cooperation Organisation (SCO) – comprising nine member states and three observers from Eurasia with a combined $4.8 trillion international reserves in 2021 – were positioned to take a lead role in “reserve diversification and the introduction of new instruments”. “Previously, members of the SCO launched various dedollarization initiatives. For example, they founded the SCO Interbank Consortium in 2005, entered into bilateral currency swap agreements with China in 2011–2020, and developed a road map for expanding trade in local currencies in 2022. The members also considered establishing the SCO Development Bank on multiple occasions. Recently, Iran went as far as proposing a single SCO currency…Consequently, it seems plausible for the members of the SCO to expand bilateral currency swaps in the future, promote local currencies in trade and development finance, develop alternative payment and settlement systems, and eventually take action on reducing the U.S. dollar in their reserves”.

Multilateral currency arrangements, including an international reserve currency based on a basket of currencies are being explored in BRICs+. Michael Hudson thinks it is unlikely a BRICS Currency could be established as “providing such currency for a number of countries requires a common government, fiscal authority and legal system. If the currency is to be issued by a number of countries – like the euro – it therefore requires a political union empowered to allocate who gets how much of the currency. No such political foundation yet exists for the BRICS”.

Michael Hudson argues it is more feasible to establish a BRICS Bancor to address the balance-of-payments problem. “How can countries with chronic balance-of-payments deficits (like most Global Majority countries looking to an association with BRICS+) can run up debts to payments-surplus countries (like China and Russia), without being forced to impose austerity. How can inter-governmental debt be prevented from causing the problems that the US/Bretton Woods system and IMF conditionalities have created? The first step has been a stop-gap of making swap agreements. That enables countries to settle for trade and investment imbalances among themselves with their own national currencies. The advantage is that there is no need to involve hard line creditors such as the United States, and to avoid the risk of US/NATO countries simply grabbing their central-bank monetary reserves as they seized $300 billion from Russia”. “The first need is to create a vehicle to handle the inevitable payments imbalances…There will not be a new BRICS currency in the sense of a dollar or euro that could become a medium for trade, investment or international speculation. There will only be a mutual currency of settlement of payments imbalances among central banks joining the new system. And that system itself will be based on principles opposite from the financialized neoliberal model being promoted by the Dollar/NATO bloc”.

Commodity-backed currencies for trade settlements are attractive to the energy and commodity industry (producing and importing countries, intermediaries) and to gold standard and Islamic dinar advocates. The advantage of gold is that it is already recognised as a reserve (safe) asset and that it offers geopolitical neutrality (from US and China). This has revived a monetary debate that pits the growth and inflationary tendencies inherent in modern fiat money versus the too-tight disciplinary restrictions of the gold standard. While fiat money expressed through USD hegemony has reigned supreme but gold bulls think the time has come for their precious metal to shine.

Chinese and Russian efforts to revive the use of gold in international payments stems from their objectives of creating alternative value anchors for their currencies to protect their economies from a potentially large fall in USD purchasing power, from volatile Western monetary policy swings and more broadly from a potential collapse of the post-Bretton Woods fiat currency system. Even as the West remains uninterested, China and Russia are accumulating large official (and unofficial) gold reserves[5] of 25,000 tonnes (with 51,000 held by other agencies) and 2,300 tonnes (10,000 tonnes) respectively. The relocation of physical stock is complemented by the promotion of competing centers for price discovery and physical settlement.

China has established a two-tier infrastructure. Jan Nieuwenhuijs explains China has separated domestic gold trading which takes place in the Shanghai Gold Exchange (SGE) with imports and exports are strictly controlled by PBOC from international gold trading which is limited to the Shanghai International Gold Exchange (SGEI) in the Free Trade Zone (FTZ) and is not subject to import-export controls. “The SGEI facilitates offshore gold trading in renminbi and can play a crucial role in de-dollarization, as it allows countries to use renminbi as a trade currency that can be converted into gold without affecting China’s balance of payments. De-dollarization can be accomplished by using yuan to settle international trade and store surpluses in gold through the SGEI”. In this regard, “Renminbi reserve currency status is still far away because yuan held overseas can’t freely be invested in Chinese assets such as bonds and other securities due to China’s closed capital account. Renminbi can, however, be converted into gold without limits”.

PBoC interventions in the gold market often results in significant price differentials between China’s domestic and international gold market. Jan Nieuwenhuijs points out the unintended consequence of intervention is to undermine the integrity of price discovery on China’s gold market and to hinder its internationalisation. Success in restoring gold to its former glory is dependent on how China and Russia can garner intermediation support to move gold into the payments mainstream.

While the role of gold can be elevated, nonetheless there is unlikely to be a return to the gold standard as a single currency or asset class is unlikely to dominate in a multipolar regime. The journey is probably towards a broadening array of competing currencies and substitutes such as cryptocurrencies. In this context, the tokenisation of gold and other commodities – via stablecoins – can improve fungibility, lower friction costs and facilitate leverage. Evgeny Y. Vinokurov, Marina V. Grichik and Taras V. Tsukarev notes the use of private cryptocurrencies, digital currencies and central bank stablecoins “would require countries to revise key macroeconomic laws and financial security regulations as it generates significant risks for financial security and monetary policies. The impact of the central banks’ controls over inflation may decline because the key rate will affect only a portion of the national currency in circulation. It may lead to an outflow of deposits from the banking system for the benefit of savings in stablecoins, and a decline in the assets of banks”.

From a geopolitical perspective, Zoltan Pozsar sees commodity encumbrance[6] as supporting a transition from the petrodollar to the petroyuanover the next three to five years. He argues the US has sanctioned Russia, Iran, and Venezuela which account for about 40% of the world’s proven oil reserves and they are selling oil to China at a steep discount in exchange for renminbi. China is also courting the GCC countries, with a further 40% of proven oil reserves, to accept renminbi for their oil in exchange for transformative investments in downstream petrochemical industries and to use the Shanghai Petroleum and Natural Gas Exchange platform for renminbi settlement in oil and gas trade. The increasing use of renminbi for oil and gas purchases and investments in downstream petrochemical industries in the Middle East means that more value-added will be captured locally at the expense of industries in the West. This will lead to commodity encumbrance, or the East dominating the supply of commodities and rehypothecating them to the West for profit. The diversion of oil and gas resources to China and its trading partners will induce a shift away from USD in international trade and the emerging multipolar world results in smaller cross-currency bases and larger commodity bases, followed by higher inflation rates in the West.

Gerard DiPippo and Andrea Leonard Palazzi argue “talk of renminbi-denominated oil trade has spurred speculation of the petroyuan overtaking the petrodollar. But if Saudi Arabia – China’s top source of imported oil – accepted renminbi for all the oil it sells to China, renminbi-denominated oil futures contracts would only account for 7 percent of the global total. If China and Saudi Arabia settled all their bilateral trade in renminbi, the renminbi’s share of worldwide trade settlement would increase by about 0.2 percentage points, based on IMF data. Even if all of China’s bilateral trade were settled in renminbi, that would only bring its share of global trade settlement to 12 percent, far below the dollar’s share”.

The Global South is exploring the establishment of alternative information networks to bypass the USD-dominated  payment systems. Pepe Escobar notes Russia and China have “been trying to interface their banking messaging systems for years now. The Chinese CBIBPS (Cross-Border Inter-Bank Payments System) is considered top class. The problem is that Washington has directly threatened to expel Chinese banks from SWIFT if they interconnect with Russian banks…In terms of sovereignty, it is clear that China will not accept US restrictions on how to move its own funds. In parallel, the BRICS in 2023 will delve deeper into developing their mutual financial payments system and their own reserve currency. There are no less than 13 confirmed candidates eager to join BRICS+ – including Asian middle powers like Iran, Saudi Arabia, and Indonesia. All eyes will be on whether – and how – the $30 trillion-plus indebted US will threaten to expel BRICS+ from SWIFT…It’s enlightening to remember that Russia’s debt to GDP ratio stands at only 17 percent. China’s is 77 percent. The current BRICS without Russia are at 78 percent. BRICS+ including Russia may average only 55 percent”. He adds that the Central Banks of Russia and Iran have already agreed to connecting their interbank transfer systems with “52 Iranian banks already using SEPAM, Iran’s interbank telecom system, are connecting with 106 banks using SPFS…the share of ruble and rial in mutual settlements already exceeds 60 percent” and Iran is supporting “the ruble as the main currency in all regional integration mechanisms…The SEPAM-SPFS agreement starts with a pilot program supervised by Iran’s Shahr Bank and Russia’s VTB Bank. Other lenders will step in once the pilot program gets rid of any possible bugs”. “The Central Banks of Iran and Russia are also working to establish a stable coin for foreign trade, replacing the US dollar, the ruble, and the rial. This would be a digital currency backed by gold, to be used mostly in the Special Economic Zone (SEZ) of Astrakhan, in the Caspian Sea”.

Zoltan Poszar thinks China and GCC countries will engage in currency swap cooperation and advance the m-CBDC Bridge project to facilitate direct settlement of international transactions between central banks and domestic intermediaries which would bypass the Western correspondent banking network. He thinks if countries have the option to pay for commodities in different currencies such as renminbi, or gold, it could reshape the FX swap market, the demand for dollars and reduce the need for central banks to maintain large dollar reserves.

Long-term influences reshaping the global currency landscape

Many countries have long chafed at USD hegemony, complaining about its exorbitant privilege[7] – seigniorage or transfer of resources (cheap financing) that enables the US to run large current account deficits. Michael Hudson notes cynically “the vast majority today’s central-bank reserves are still foreign holdings of US dollar securities…The US Treasury…spent dollars into the international economy, headed by US military spending in an increasingly aggressive and belligerent way. One could think of foreign dollar reserves as their bearing the costs of US military encirclement of the globe”. He points out though that is it hard “to create an alternative economic system to the present legacy of World War II…There is no way that a viable and resilient economy for Global South countries and their arrangement for central banks can take shape without repudiating the overhang of US dollar debt. This unpayably high foreign-debt burden is a legacy of US-sponsored financial colonialism. As long as this debt is kept on the books, countries will remain obliged to use their trade surplus and sales proceeds from selling off their property to foreign investors to pay their former colonial powers and post-colonial creditors”.

The yuan is the leading candidate to challenge USD hegemony but it needs to overcome its own deficiencies. Alessia Amighini and Alicia García-Herrero explains the renminbi is little used internationally because “first and foremost, the renminbi is not fully convertible, which means it cannot move freely in and out of China. Second, the legal framework surrounding renminbi payments is uncertain. In particular, investors continue to lack confidence about the rule of law in China. Third, China’s financial markets, especially the Treasury market, are less liquid than US markets, and there is no expectation that this will change any time soon”.

In this regard, countries aspiring to have their currencies gain reserve currency status face a Triffin dilemma[8], the willingness to cede domestic objectives to fulfil international demands for its currency. Evgeny Y. Vinokurov, Marina V. Grichik and Taras V. Tsukarev points out “countries whose securities will substitute for U.S. Treasury bonds will face the same negative impacts as the U.S. economy: Reduction of the current account surplus or widening of the current account deficit, strengthening of the national currency, a growing budget deficit, and/or increased unemployment…Germany, Japan, and Korea as examples: their central banks did not encourage massive purchases of the countries’ debt securities and took action to curtail foreign investment inflows”.

Daniel Lacalle points out “China and Russia are much more demanding and rigorous lenders than many politicians think. It seems that some emerging market politicians think that joining China and Russia will be a kind of free money panacea. Another problem with creating a BRICS currency is that, logically, neither China nor Russia has the slightest intention of losing their national currency to dilute it alongside a group of issuers who have a doubtful track record in controlling their monetary imbalances”.

“Over the past ten years, the currencies of the BRICS guest countries have depreciated significantly against the U.S. dollar. The Argentine peso has fallen by 98%, the Egyptian pound by 78%, the Indian rupee by 35%, the Ethiopian birr by 68%, the Brazilian real by 55%…and the Iranian rial has collapsed by 90%…Putting together weak currencies does not create a strong currency”. “China and Russia are going to have major difficulties imposing fiscal and monetary policy restrictions on their partners. Let us not forget that several of these partners have joined the group, thinking that from now on they will be able to continue printing money and spending without control, but their monetary imbalances will be distributed to other nations”.

Daniel Lacalle notes “China, however, can increase its control over all these countries by implementing rigorous monetary and fiscal policies. It is the strongest lender of all the BRICS, but it is unlikely to take on the role of the euro’s Germany, willing to absorb the excesses of others in exchange for a common project. China is going to increase its control over the countries in the group, but it is not likely to jeopardize the stability and security of its enormous population by sinking the currency. The Chinese government is probably analysing how the euro is losing monetary prudence and reaching the conclusion that it cannot take that same risk with some of these new partners. However, China will probably make the most of its financial strength to lend, increase their domestic and international growth options, and access abundant and cheap commodities…The Chinese government probably knows that many of its partners are going to continue increasing their imbalances, and this may allow China to strengthen its leadership position. However, I find it hard to believe that China will agree to the creation of a currency that others can use to trigger inflationary imbalances”.

Nonetheless, the shifts in economic power in favour of the Global South means de-dollarisation will gradually build momentum.

• With deglobalisation and improvements in the international payment and settlement networks, central banks will not need to maintain such high levels of USD reserves. Hence, central bank FX reserves are unlikely to grow the way it did during the Goldilocks era. In addition, there will be long-term pressure on central banks to diversify their reserve portfolios by reducing geopolitical risk exposures (Western reserve currencies) in favour of nontraditional assets.

• The US, EU and Japanese central banks are over-extended and, of late, they have been shrinking their balance sheets via QT. However, given the size of their fiscal deficits, at some point they will be pressed upon to resume QE. When this happens, the risks of owning USD-denominated debt will be elevated by lengthening maturities and the risks of a sharp dollar reversal.

• Foreign central banks reaching their limits in absorbing USD debt is giving rise to liquidity congestion. This means QE-generated liquidity will tend to circulate within the domestic economy and co-exist with global USD liquidity shortages. Only “allied” central banks will continue to buy USD as they can rely on the Fed to provide emergency liquidity access in times of shortages. “Unfriendly” countries, without access to USD liquidity support, will continue to deleverage and minimise their USD exposures. As financial conditions tighten, Western central banks will likely attempt to “circle the wagons” to withstand the pressure of large domestic fiscal deficits and over-supply of financial assets. But there are growing risks a central bank may lose control of the situation and this can trigger contagion effects.

Unless a war breaks out, the pace of de-dollarisation will be dictated by the speed of financialisation in the Global South. In this context, Western domination of global capital markets – product creation, intermediaries and venues, depth of liquidity, clearing and settlement infrastructure, information regulation and intermediaries and debt resolution – has been a bastion of USD strength. The Global South depend on Western financing, investment and intermediaries to financially leverage their economy. In the Asian Crisis of 1997, the Global South vulnerabilities arising from the lack of domestic and international intermediation capacity were badly exposed when Western capital and services were withdrawn. Recovery was then dependent on wooing the global investors and intermediaries to return.

Unlike before, the Global South are no longer waiting for Western capital to return. Instead, Global South intermediaries and businesses are already actively exploring opportunities to fill the vacuum left by the Western exit. The key question is the extent to which the Global South is capable of operating independently of the West. Many Global South countries have built their regulatory architecture, markets and intermediaries. It is not yet at par with the West but it is at decent enough levels. Due to lack of legacy, they are able to leapfrog on technology. Most of all, there is already evidence of expanding intra-Global South business and finance.

From an economic viewpoint, Global South countries like China and Russia have relatively higher GDPs relative to the West based on purchasing power parity (PPP). Their PPP advantage reflects their low levels of financialisation was the main constraint limiting domestic leverage and liquidity. Hence, the development of cross-border finance and investment is key to unlocking nominal growth.

In terms of intermediation capacity, Alessia Amighini and Alicia García-Herrero notes “China’s financial sector is now the largest in the world, with $60 trillion in assets, equating to 340 percent of China’s GDP. Chinese banks also top the list of the largest globally systemic financial institutions, with increasing interrelationships with the rest of the global financial system”.

Evgeny Y. Vinokurov, Marina V. Grichik and Taras V. Tsukarev notes “almost 20 Sovereign Wealth Funds (SWFs) operate in nine SCO countries (not including public pension funds) with assets of $2.9 trillion. We believe that sovereign wealth funds could revise the way they operate. For example, countries could create a special fund focusing on investments in foreign markets of friendly countries to generate highly diversified investments, both in instruments and geography, including strategically important investments. Another option is to expand the shift of investments towards top priority national economy projects. The third scenario, in the case of developments proceeding along a multilateral track, involves the formation of regional funds that would accumulate resources of several countries, building sanctions resilience”.

However, US stockmarket capitalisation continues to dwarf other countries. As at August 2023, the combined market capitalisation of NYSE and Nasdaq market capitalisation totalled $46.7 trillion and is far ahead of any other country. As a matter of comparison, the combined market capitalisation of China’s Shanghai and Shenzhen and Hong Kong’s Stock Exchange totalled $14.4 trillion[9].

Ruchir Sharma notes “a widely followed index that ranks 165 nations by capital account openness puts China at 106th, tied with tiny states like Madagascar and Moldova…China is less comparable to emerging markets such as Brazil and Thailand than to frontier markets like Kazakhstan or Nigeria – and should not be part of a standard EM portfolio. Often it is not. Foreigners own about 5 per cent of stocks in China, versus 25 to 30 per cent in other emerging markets, and about 3 per cent of bonds in China, compared to around 20 per cent in other developing nations”.

De-dollarisation will progress slowly as it will take several years to overcome legal, language, technology and intermediation impediments. The de-dollarisation take-off point is probably around 2027-28 depending on the Global South’s ability to manage:

• Trade flows. From a macroeconomic perspective, the speed of de-dollarisation will depend on the extent to which Global South countries wean themselves off reliance on US and Western consumption. If they continue to be dependent on Western consumption to drive economic growth, then the position of the USD will remain strong. They need to build intra-Global South trade to reduce dependence on Western consumption and therefore Western currencies. De-dollarisation has two other corollaries. One is that Global South countries will find it difficult to internationalise their currencies if they remain export-surplus oriented and must seek to increase consumption eventually. The other is that the US will find it difficult to continue to be the world’s largest consumer and to secure external financing for its deficits. The possibilities then are for the US to either reduce consumption or to increase exports (post-reindustrialisation) through competitive devaluation.

• Savings recycling and MNC expansion. De-dollarisation requires Global South to recycle savings amongst itself rather than to reinvest in the West. In relation to this, if the export surpluses are being recycled by Western MNCs, then leakages to the West will be high and the Global South economies will remain exposed to Western sanctions. Therefore, a precondition to quickening de-dollarisation is to redirect the savings flow to Global South and to accelerate the international expansion of Global South MNCs.

• Intermediation capabilities, safe assets, market development and efficiencies.  While commercial trade provides a base, de-dollarisation cannot progress further if the export surpluses continue to be intermediated by Western firms and end up being re-invested in Western safe assets. In tandem with this, China and others need to cooperate to create a sufficient supply of “safe” assets (safe from Western sanction and Global South risks) and build intermediation capability to market-make risks in non-Western currencies and assets. In this regard, countries need to at least gradually liberalise capital controls. Otherwise, local intermediaries would never develop international intermediation capabilities and eventually domestic customers would find ways to seek out Western intermediaries and bypass controls. The Global South needs to prioritise capital market development through strengthening transparency, governance and regulatory oversight to strengthen market integrity and product safety. They should fast track the growth of financial intermediaries especially investment banks, asset managers, and information intermediaries such as rating and index agencies. Financial regulators should focus on improving non-USD transaction efficiencies (transaction and hedging costs, settlement and legal frictions) across bilateral and multilateral platforms and ensure transaction costs for non-USD currencies are competitive relative to USD-denominated transactions.

Western governments attempting to enforce their will by imposing financing and investment restrictions and sanctions on Global South countries are finding their actions backfiring. The West is unlikely to stem defections from their financial information network. De-dollarisation will shrink the size of and degrade the quality of the Western financial information network; and cause the dominant gatekeeper to lose access to data outside its system.

In addition, Western financial intermediaries are generally retreating due to geopolitical risks (sanctions, decoupling), domestic vulnerabilities (asset overhang and write-downs, funding mismatch), and tighter regulations. The lack of appetite for international expansion underlies  the receding levels of global bank intermediation is a major factor impeding the intermediation of excess domestic USD liquidity across borders. Credit Suisse and several American banks had to be rescued. Citibank and HSBC have reorganised/downsized their global operations while global banks are bracing for digital disruption where efficiencies from platforms, real-time settlement, CBDCs and cryptocurrencies will erode their margins on their cross-border businesses.

Currency landscape in 2030

The emergence of the unipolar currency system was driven by the logic of globalisation which created a world economy that was highly integrated, interdependent and connected. The USD emerged as the dominant currency, superseding the gold standard[10] and currency or monetary unions[11] such as the sterling area[12] and CFA franc[13]. The euro, launched to foster regional economic integration, is the most successful currency union. The euro is widely used but disappointed its supporters by its inability to mount a meaningful challenge to USD hegemony.

Geopolitical conflict has changed the logic to deglobalisation and economic fragmentation. The weaponisation of currency has put the Global South on notice and this means that the current phase of USD deleveraging is unlikely to be followed by USD releveraging. Simon White notes after decades of steady increase, dollar-denominated credit to EMs “is now falling at the fastest annual rate yet seen outside of the GFC. We are also seeing dollar aversion in commodities…Also unusual is the behavior of cross-border banking claims denominated in dollars…dollar structural short. When the dollar begins to rise, it ultimately forces weak borrowers to deleverage, which they must do by buying dollars to pay back lenders. Normally, some of the deleveraging is reversed once the dollar begins to weaken again, but that has materially failed to happen so far: instead there has been further deleveraging despite the dollar’s selloff…Whether continued dollar weakness will eventually kick-start demand for dollar-denominated reserves, credit and commodities remains to be seen. But the lack of reaction so far is telling”. He points out “demand for the dollar is not rising as it normally would in response to the currency’s near-10% decline since October. Typically, declines in the dollar coincide with greater demand for FX reserves, as other countries try to limit their currency’s appreciation. But this has singularly failed to happen so far in this cycle. That corroborates the narrative of especially EM countries desiring to lessen their exposure to dollars should they ever face Russia’s fate and see their reserves frozen”

We are at the beginnings of a shift from a unipolar currency regime to a multipolar (multi-currency and multi-asset) regime. There is no comparable historical precedent. I think the multipolar landscape is likely to have these features.

First, since currency weaponisation has destroyed the concept of safe assets, emergent currency areas will be shaped by geopolitical loyalties. The lead challenger is the yuan with China seeking to replace USD in its trade, investment and financing relationships. The yuan is the first “non-ally” currency competitor as compared with earlier challengers such as sterling, euro and yen. Thus the rivalry will be more intense as the US could easily influence policies in those countries but not those of China.

Second, while attention focuses on USD and yuan, the long tail of marginal substitutes will further lengthen. The secondary Western currencies (e.g. euro, sterling, yen, Swiss franc, Aussie dollar) offer reasonable international liquidity and freedom from capital controls. But their status as a neutral portfolio diversification choice has been tarnished by enforcement of US sanctions while their competitiveness has declined. The Western currencies will thus be squeezed between the USD and yuan as well as face competition from multiple currencies (rouble, rupee, dirham) and assets (gold, cryptocurrencies, oil). It will be interesting to see which non-USD/yuan currency and assets will gain the most ground.

Third, the currency areas will operate like constellations – with Western currencies revolving around the USD and Global South currencies and commodity-based assets revolving around the yuan. Fourth, the new feature is that these currency areas will operate under a floating currency regime rather than a fixed exchange rate regime and thus there will be more moving parts.

Fifth, the non-Western currency alternatives are likely to be trade- and commodity-based  and will operate with relatively low leverage and economic growth multipliers. In the meantime, the shrinking size of the USD currency area imply liquidity and multipliers associated with the USD will also contract due to loss of scale. Lastly, the most important unknown are the interoperability rules between the different currency areas. Flows between the USD and yuan currency areas will be subject to a multitude of rules and checkpoints on both sides. The principal of reciprocal treatment is likely to prevail.

De-dollarisation has significant economic consequences. Zoltan Pozsar senses “the market is starting to realize that the world is going from unipolar to multipolar politically, but the market has yet to make the leap that in the emerging multipolar world order, cross-currency bases will be smaller, commodity bases will be greater, and inflation rates in the West will be higher”. De-dollarisation is likely to be the nail in the coffin for the Goldilocks and Modern Monetary Theory (MMT) economic paradigms that protected governments and central banks from the consequences of their fiscal and monetary irresponsibility. In a multipolar regime, policy errors are likely to prove much more costly.

• Currency shares in 2030[14]

How far will de-dollarisation progress by the end of this decade? Currency wars are a war of attrition with large shifts only apparent after decades. In the medium term, the main de-dollarisation drivers are the expansion of intra-Global South trade and investment, and China’s ability to close the yawning gap between its high share of global trade and low international use of yuan. Structurally, shifts in currency shares can be modelled based on differences in economic growth rates, debt and deficits, central bank and private sector balance sheets and exchange rates.

In the current phase, a strong dollar is backstopping the USD share of the global currency market from sliding downwards. In calculating currency share, cross-border deleveraging shrinks the denominator while a strong dollar has a positive impact on the denominator. In conjunction with this, currency weakness is shrinking the share of Western currencies like euro and yen while slowing the gains made by the yuan.  

The next phase involves a lengthy period of USD weakness. The exchange rate conversion effect will result in a corresponding fall in USD share and a rise in yuan share. There are other indirect effects. A weak greenback increases the Global South share of world GDP and trade (via higher purchasing power). A strong yuan and low yuan-denominated interest rates is likely to boost yuan-denominated international financing and investment activities

Among the different categories, the least affected will be central bank FX reserves as it is geopolitically-sticky. The mainstream projection is for the USD share to fall from 59% in 2020 to below 50% (due largely to USD depreciation) in 2030 and for the yuan’s share to rise from 2.3% in 2020 to around 10%. This would place the yuan third behind USD and euro. Other Western currencies are likely to lose ground due to the trend towards localisation of liquidity[15] and their shrinking shares of global GDP. Depending on China’s progress in financial liberalisation, building its currency networks and expanding its international intermediation capacity, the share of the yuan in global payments, funding and investment should rise from negligible levels (at 5% currently) to beyond 10% largely at the expense of euro and USD in 2030. Long-term (2050) trends favour the continuing convergence of USD and yuan shares.

• Exchange rate outlook

Changes in exchange rates have a decisive bearing on the calculation of currency and economic shares over the long term. For example, a constant 5% depreciation per annum over next 6 years would imply a 27% currency devaluation. A devaluation of this magnitude would seriously affect US or China’s share of the global economy and FX reserves and transactions. Foreign holders of USD- or yuan-denominated assets will be hit by exchange and interest rate valuation losses and consequently suffer purchasing power (from inflation and devaluation) losses as well. If the US exchange rate loses too much ground against the yuan, this will fast forward the timing when the nominal size of China’s economy will match that of the US and considerably boost the yuan share of the global currency market. A large yuan devaluation will have converse effects and set back China’s aspirations to become the world’s largest economy.

One trend that needs further explanation is the current co-existence of the strong dollar with high inflation[16]. This is considered a paradox as high inflation is typically associated with a weak currency. There are several explanations. First, the strong dollar-high inflation paradox arises from the tension between tight monetary (rising US interest rates) and loose fiscal (fuelling inflation) policies. Second, recent dollar strength is driven by shrinking USD-denominated global liquidity due to de-risking and deleveraging and rising hedging costs. Third, geopolitical conflict, beggar-thy-neighbour policies, supply chain relocation, resource nationalism, worker activism and pandemic and climate disasters contribute to supply shocks and add to inflationary pressures. Fourth, in tandem with cross-border deleveraging, portfolio and capital flight from the Global South also contribute to USD strength.

The strong dollar-high inflation paradox should be regarded as a transitional phase as US and European central banks attempt to navigate from inflation-growth to deflation-recession. Due to pressure from huge fiscal deficits or market tantrums, the decision by the Fed to restart QE and ease interest rates would likely trigger a pivot from a dollar bull cycle to a dollar bear cycle. Of course, the US could cut fiscal expenditures to maintain a strong USD but this doesn’t seem to be on the cards. The extent of the dollar weakness will depend on where the Fed decides to peg its interest rate targets but the target rate should be pegged higher relative to other economies to ensure continued net foreign inflows into USD-denominated assets. This puts a floor on how far US interest rates can be allowed to fall.

There are risks the USD retreat could turn into a long-term rout.  First, USD strength arose from one-off adjustments from cross-border deleveraging and capital flight from Global South countries which may not recur in the future. Second, external demand for USD is likely to be weak as central bank “allies”, and global intermediaries and fund managers do not appear to have enough capacity to absorb the forthcoming supply of US debt. Third, the G7 share of global GDP and trade is likely to continue declining while decoupling and de-dollarisation are likely to impede future global re-leveraging of USD.

Currency geopolitics

The geopolitical aspects[17] of currency policies cannot be ignored. Exchange rates have symbolic meanings in geopolitical narratives. The collapse of the rouble was supposed to provide proof of the effectiveness of the Western financial sanctions. Similarly, the current weakness of the yuan is supposed to reflect the loss of investor confidence in China’s government policies. Yet, the rouble has managed to defy doomsday scenarios while the narratives on China’s economy seem to have run ahead of itself. Hence, currency policies cannot avoid being tainted by perceptions of geopolitical conspiracies.

Alasdair Macleod relates beliefs the Asian crisis of 1998 was “planned by the Americans for their own benefit…Major General Qiao Liang, strategist for the Peoples’ Liberation Army…in April 2016, when he laid down what has become China’s version of events: “What was the hottest investment concept in 1980s? It was the Asian Tigers. Many people thought it was due to Asians’ hard work and how smart they were. Actually, the big reason was the ample investment of U.S. dollars. When the Asian economy started to prosper, the Americans felt it was time to harvest. Thus, in 1997, after ten years of a weak dollar, the Americans reduced the money supply to Asia and created a strong dollar. Many Asian companies and industries faced an insufficient money supply. The area showed signs of being on the verge of a recession and a financial crisis. A last straw was needed to break the camel’s back. What was that straw? It was a regional crisis. Should there be a war like the Argentines had? Not necessarily. War is not the only way to create a regional crisis. Thus, we saw that a financial investor called Soros took his Quantum Fund, as well as over one hundred other hedge funds in the world, and started a wolf attack on Asia’s weakest economy, Thailand. They attacked Thailand’s currency Thai Baht for a week. This created the Baht crisis. Then it spread south to Malaysia, Singapore, Indonesia, and the Philippines. Then it moved north to Taiwan, Hong Kong, Japan, South Korea, and even Russia. Thus, the East Asia financial crisis fully exploded. The camel fell to the ground. The world’s investors concluded that the Asian investment environment had gone south and withdrew their money. The U.S. Federal Reserve promptly blew the horn and increased the dollar’s interest rate. The capital coming out of Asia flew to the U.S.’s three big markets, creating the second big bull market in the U.S. “When the Americans made ample money, they followed the same approach they did in Latin America: they took the money that they made from the Asian financial crisis back to Asia to buy Asia’s good assets which, by then, were at their bottom price. The Asian economy had no capacity to fight back. The only lucky survivor in this crisis was China.”

Alasdair Macleod add in April 2015, Qiao Liang further explained “the U.S. enforces the dollar as the global currency to preserve its hegemony over the world. And he concluded that the U.S. would try everything, including war, to maintain the dollar’s dominance in global trading…He described US’s actions with respect to foreign national debts. Qiao made the case that both the Latin American crisis in 1978-1982, and the Asian crisis in 1996-1998 were engineered by America. By reducing dollar interest rates to below their natural level they would weaken the dollar and encourage an investment boom in the targeted jurisdictions, funded by dollar credit. They then increased interest rates and strengthened the dollar to create a financial crisis. These events did, indeed, happen, but perhaps driven by the cycle of bank credit, as much as by foreign policy. The relevance of Qiao’s analysis is that today, the same conditions appear to be targeted not against China, which does not borrow dollars, but at the dollar indebted nations around the world with which China trades – the BRICS nations. Informed by Qiao’s analysis, it must appear to China that America’s persistent strategy is to continue to raise interest rates even after the inflation dragon is slain, and by bankrupting them the US will attempt to bring the nations seeking to join BRICS back under her control…That being the case, China will have weighed up the consequences for her export trade against the likely sanctions America and her allies could threaten and decided that the real threat is against the emerging economies in Africa, Latin America, and elsewhere which have received substantial Chinese investment. In financial terms, it is therefore imperative that this threat be addressed in a pre-emptive attack on the dollar, which can only be achieved by exposing the dollar’s weakness as a fiat currency. At least since the Lehman crisis, China and more recently Russia have had the power to do this. Furthermore, the New Development Bank, which is headquartered in Shanghai, will be able to provide credit either in yuan or the new BRICS currency at lower interest rates to offset the undoubted strains imposed on BRICS members as a result of rising US interest rates. Therefore, China is fully prepared to counter what General Qiao Liang described as the American strategy of harvesting assets in foreign countries. It is important to understand what China believes and motivates her, not whether Qiao is right or wrong. But given that his view is inculcated in the Chinese government, China is ready with Russia to mount an attack on America’s fiat currency by returning to a gold standard for trade, and ultimately for their own currencies”.

Prior to the yuan, other challengers to USD hegemony had appeared. In the mid-1980s, Japan was the main challenger. But the Japanese challenge faded after it was pressured to sign the Plaza Accord[18] in 1985 which mandated coordinated action for a sharp appreciation of the yen. At that point in the pre-universal banking days, Japanese banks and securities firms were expanding internationally to compete with the Western global banks and the internationalisation of the yen were symbolised by the issue of Samurai bonds. But the Japanese financial intermediaries were badly hit by the subsequent crash of the Japanese stock and property markets. The high volatility of the yen-USD exchange rate may also have affected Japan’s recovery. With the onset of the Japanese lost decades and the retreat of Japanese intermediaries, the yen eventually became marginalised.

The euro was next. Yannis Dafermos, Daniela Gabor and Jo Michell notes “the introduction of the euro saw rapid growth in euro-denominated cross-border positions, apparently challenging the dollar for the role of international settlement currency. The aggressive expansion strategy of European banks saw a rapid increase in euro-denominated bank lending during the 2000s: euro-denominated cross-border bank assets (claims) grew rapidly, reaching levels almost equal to dollar-denominated claims by 2008…The architectural flaws of the Eurozone and the mishandling of the Eurozone crisis tempered the viability of the euro as an international currency: since 2008, cross-border interbank positions shrank substantially, but euro positions shrank even more dramatically than dollar positions”. “As global banks came under regulatory pressure to shrink investment banking activities, shadow banks (institutional investors, asset managers and others) became the engine of cross-border financial activity, driving a structural shift towards securities-based lending: bank claims on non-banks have driven the rise in cross-border dollar lending, with dollar-denominated claims rapidly recovering from the 2008 crisis, while euro-denominated claims declined. The rise in cross-border holdings of dollar-denominated debt securities is not only more pronounced in rich countries but also visible in EMEs, starting from a lower level. At the same time, banks have reduced their holdings of cross-border securities, which are increasingly held by non-banks”.

Over the period, the currency landscape has undergone major changes. Yannis Dafermos, Daniela Gabor and Jo Michell point out “currency dynamics no longer primarily reflect trade in goods and services, but capital flows arising from both local entities borrowing in foreign currency, and from non-resident investments in local assets (e.g., portfolio flows into local currency sovereign bond markets). This structural shift increases pressures on central banks to shift from currency interventions that protect exporters to providing insurance against depreciation for investors, a derisking logic that accompanies the increasing Americanisation of local financial systems. The US Federal Reserve reinforces such derisking pressures by explicitly warning that its swap lines should only be used for temporary dollar liquidity relief but not fund mercantilist exchange rate interventions. Put differently, the Fed is willing to act as a dollar LOLR as long as its emergency dollar liquidity is deployed for market-based management of countries’ exposure to the global dollar financial cycle”.

Yannis Dafermos, Daniela Gabor and Jo Michell argue “in a world of liquid and deregulated FX markets, (shadow) banks do not need to match the currency denomination of their assets and liabilities. From around 2000 onwards, a gap opened up between total dollar assets and dollar liabilities on bank balance sheets. It is typically assumed that this gap is covered off balance sheet via the FX swap market. The overall funding gap declined substantially in the wake of the global financial crisis from around 12.5% of dollar-denominated assets to around 6%. From around the middle of the 2010s, however, the gap widened, reaching almost 15% by the final quarter of 2019…Although the structure of forex trading by currency has changed little, the aggregate dollar funding gap is distributed unevenly across banks of different nationalities”. In addition, “post-GFC regulation has, however, restricted the ability of US banks to rely on leverage in order to engage in arbitrage activities and supply dollars: previously, divergence between money market rates and FX swap rates would induce banks to borrow in the money markets and supply dollars in the FX swap market. Basel III increased capital requirements on derivatives, introduced a capital charge for mark-to-market losses of over-the-counter (OTC) derivatives and raised liquidity requirements. Moreover, the Volcker rule has prohibited US banks from engaging in proprietary trading in FX forwards and swaps. Although the US Fed added large amounts of dollar liquidity to the US onshore banking system, this more stringent regulation has increased the hoarding of these additional reserve balances by US banks”.

The rise of the yuan takes place at a time when Western financial intermediaries are in retreat and this threaten the durability of the dollar hegemony. Hence, the US policy reactions to domestic challenges and threats to their currency hegemony are likely to have a decisive bearing on future events.

• US policy choices

As the currency hegemon, the Fed’s policy choices shapes liquidity and economic conditions in the US as well as for the rest of the world. If the Fed opts for QE and low interest rates, then the risk is a weaker USD and a build-up in inflationary pressures. At this point, the Fed chose to prioritise the fight against inflation by pursuing QT and raising interest rates. The widening interest rate differentials between US and other countries caused the USD to strengthen and global USD-denominated capital to retreat into the US which resulted in a global shortage of USD liquidity.

From a geopolitical lens, there are advantages from synchronising a strong USD and global recessionary conditions until the US “reindustrialisation” projects come onstream. I think the Fed’s intention of keeping interest rates on hold is not only based on its fight against inflation but also on the consideration that tight global financial conditions can stall de-dollarisation by weakening and therefore discrediting competing currencies, economies and markets. Thus the current strong USD phase can be viewed as a “positional” move to accumulate small strategic advantages in the currency war. The US economy is in reasonably strong shape but the high interest rates is posing a threat to its market and financial stability. In particular, QT and high US interest rates, as it takes its toll on the global economy, is turning into a contest of economic stamina between US and China. While the Chinese economy and yuan are on the backfoot but it is not likely to be a knock-out punch.

The real test for rival currencies comes in the next phase when the US – whether forced to or not by domestic conditions – restarts QE and lowers interest rates. This will narrow the interest rate differentials between the US and the rest of the world and lead to an unwinding of long USD positions (carry trades against currencies like the yen, euro and yuan). This would lead to a devaluation of the USD which would make the US exports competitive. The US economy, with its deep financial markets and “control” over global financial intermediation has the resilience to withstand the interest and exchange rate volatility unleashed by the volatility of the tight-loose US monetary policies. If the Fed adopts a throughput-based strategy to deliberately flood the global system with USD, other economies would struggle. Textbooks suggest if other countries allow their currencies to appreciate sharply, they risk hollowing out of their export manufacturing capacity (the Dutch disease) or suffer from Japanification (which refers to Japan’s ability to maintain exports but at the cost of a prolonged deflation). Hence, the resumption of QE can be used to keep other countries in line, to challenge their ability to conduct independent monetary policies, and to prevent non-Western currencies or assets from getting a foothold; in other words to call the de-dollarisation bluff. As US treasury secretary John Connally proclaimed in 1971, “the dollar is our currency, but it’s your problem”.

But this assumes the QE-created USD debt can eventually find a home abroad. It is true in the past that other countries welcomed US expanding fiscal debt issuance because it financed US consumption which supported exports and economic growth. This experience may not be repeated in a de-dollarised landscape for several reasons. First, USD hegemony is dependent on the global expansion of Western firms and intermediaries. However, Western intermediaries and firms have been forced by sanctions and geopolitical pressure to withdraw from several Global South markets. Within the West itself, trade expansion has been hobbled by protectionism. Western financial intermediaries have also been affected by geopolitical conflict, domestic vulnerabilities, rising regulatory burden and technological disintermediation and have

lost their appetite for their global expansion. The question then is that whether QE can return to boost global liquidity given the lack of Western private sector capacity to re-leverage the dollar in international markets. Second, if the Global South is intent on de-dollarising, this means that the US can only count on its allies to circle the wagons and mutually support each other’s currencies and deficits. In this regard, India can play a crucial part in replacing China as the main source of demand for Western debt. While US and Western currencies will become more competitive after being devalued but unless Global South countries choose to re-invest their surpluses in the West, then the outcome is that the West must either increase exports, shrink imports or/and reduce deficits.

The discussion is incomplete without reviewing other landscape-changing options. One option is for the US to recognise the end of its hegemony and to manage a de-facto shift to a multi-polar currency regime by acquiring “ally”-denominated debts as forex reserves. Hence, G7 economies and “allies” such as India can adopt a cross-holding approach to managing their FX reserves. The other possibility, while still a low-likelihood event but can no longer be totally discounted, is the freezing of China’s Western currency-denominated assets and ejecting Chinese banks from SWIFT. The extension of the nuclear scenario is too devastating to imagine in a globalised, financialised and informationalised economy. Cross-border commerce and finance will freeze overnight; ownership, intellectual property rights and legal agreement will no longer be recognised; and lawsuits will mushroom. This would lead to the implosion of

tightly coupled networks and would overnight lead to the complete fragmentation of the global economy into separate trade, currency, legal and information spheres.

Overall, regardless of the US policy choice, it is unlikely to stop the steady progress of de-dollarisation. In this context, the US is at a disadvantage because it caught between the conflicting objectives of domestic stimulus and international decoupling. At a time when it needs global support to finance its domestic stimulus, the US chose to decouple. Decoupling leads to de-dollarisation which implies reducing international demand for USD. This means USD liquidity will stay largely trapped within its own borders. In the meantime, shrinking USD global liquidity has contractionary implications for US MNCs, intermediaries, corporate profits and asset prices with potential adverse effects on monetary stability

• China’s policy choices

China’s policy path for the yuan is more predictable. It is managing a shift from export-led to a more balanced, quality-focused “dual-circulation” growth. It is pursuing gradual liberalisation and strengthening financial stability at the same time. It is accelerating de-dollarisation to guard against the volatility of US exchange rates and both inward and outward capital flows and to sanction-proof as much of its international trade and finance as possible.

This year, in tandem with rising US interest rates and a strong dollar, the US has widened the scope of and sharpened its containment actions to put the heat on the yuan and Chinese economy. William Pesek explains “the capital outflows China is experiencing are as much a product of rising US bond yields as concerns about Xi’s economic strategies…Chinese FDI fell nearly $12 billion in July-September year on year, the first quarterly drop since…1998…exports dropping to $274.8 billion, Beijing’s trade surplus is now $56.5 billion, a 17-month low”. There are perceptions about its weak fundamentals such as its slowing growth, a property fallout, debt overhang (property and provincial governments, youth unemployment, aging demographics and deflationary pressures. Higher US interest rates is also choking off the global economy which is dampening external demand for Chinese exports.

On the geopolitical front, Western investors and firms increasingly regard China as uninvestable due to rising anti-China sentiment and the adoption of “de-risking” policies in the West, China’s aggressive reactions (including new national security laws, crackdown on foreign consultants, and restrictions on cross-border data flows) and its earlier private sector clampdowns. The weak yuan also reflect additional pressure from a pick-up in domestic capital flight. Western firms are noticeably repatriating profits and diverting capital from China to “allies” notably Japan and India. To a large extent, the Western pull-out is also due to the massive over-capacity and competition that is causing an industry fall-out and consolidation. Chinese firms are themselves venturing abroad in aggressively. William Pesek notes “in the first 10 months of the year, China’s non-financial outbound direct investment (ODI) increased 17.3% year on year to 736.2 billion yuan (US$104 billion)”.

China has followed its Asian crisis playbook to defend the yuan. This includes curbing the repatriation of earnings and money transfers, and banning domestic funds from investing abroad. Capital controls are being tightened to squeeze out currency shorts (speculative attacks via round-tripping). William Pesek notes news of “Beijing’s national team buying shares in top banks and loading up on exchange-traded funds to boost investor confidence”, China’s biggest state-owned banks are “swapping yuan for dollars in onshore markets and selling those dollars in spot markets” and providing financial support to a list of 50 property builders.

William Pesek explains “there are a few possible explanations for why China is putting a floor under the yuan. One is to reduce default risks among property developers servicing offshore debt. Another is to avoid fresh trade tensions with Washington. Beijing also wants to stanch the capital outflows now making global headlines”. Despite weak exports and competition from an even weaker yen, William Pesek observes “China is calming fears for the year ahead that it might engage in a race to the bottom on exchange rates…reassuring traders worried Beijing might chase the falling Japanese yen lower”. “An argument can be made that Xi’s real goal is staying focused on longer-term retooling, not short-term economic sugar highs”.

We need to take a step back to understand the historical context of the adversarial relationship between the Chinese government (and other Asian governments) and Western fund managers since the 1997 Asian crisis. Initially, the Western (hedge) funds flood their targets with speculative capital and cause their markets and economies to overheat. A few years later, when the target economy and markets are most vulnerable, the funds suddenly withdraw their investments and coordinate a shorting campaign; often triggering a run on the currency, balance of payments and culminating in a debt crisis. During the Asian crisis, the hedge funds attacked several Asian economies (Thailand, Korea, Indonesia and Malaysia). The attack ended following coordinated intervention by China, Hong Kong and Malaysia. There were rumours some global funds had to be rescued after the intervention. This experience motivated the Asian economies to beef up their USD forex reserves to guard against such attacks and it explains their reluctance to remove capital controls.

On the flip side, investors generally don’t like government interventions (except as a put to falling asset prices) because these interventions can cause them to lose money makes them feel the game is rigged. Most governments need the international investment community support and are normally more acquiescent. This is not the case with China. Global investors find they can hardly ignore nor bully the world’s second largest economy and more often than not they are on the receiving end. Despite this, foreign investors flocked into China-related stocks despite the lack of clarity and circumvent the restrictions. In recent years, they suffered losses from the private sector clampdown in China’s socialism big bang[19] and defaulting property debt. The combination of a historically adversarial relationship and Western pressure to ostracise China (including persuading international index firms to reduce China weightings) has caused many long-term foreign investors to sell off their investments.

Recently, China seems to have launched a charm offensive to woo foreign investors. I think this is intended to prevent the negativity from spiralling further rather than to change opinions (which is unlikely).

As a matter of perspective, it is worth noting it is the USD that is doing all the running, pushing other currencies in one direction or the other. The USD is like an elastic band that is being over-stretched by over-shooting and putting it at risk of snapping at some point or another. It should be noted China’s policies are characterised by strategic patience. When the enemy attacks, it retreats. It is focus on strengthening defences and addressing internal weaknesses. After all, the effects of the capital outflows are one-off rather than a recurring flow. Once it is completed, China can rebuild from there. At some juncture, the Fed will ease interest rates and restart QE. When this happens, the USD will begin to weaken but how does this translate into yuan strength. Short-term, the yuan will appreciate as the short-yuan carry trades are unwound. The more interesting question is whether foreign long-term capital will return to China. This suggests upside pressure on the yuan will be moderate at best which is suits China’s preferences as it means PBOC will not need to sterilise inflows by accumulating USD.   

Through the cycles, China can choose among two currency policies. The first is to pursue a cheap currency to maintain its export competitiveness; particularly relative to competitors such as the euro, yen and won. China has acknowledged it can no longer rely on cheap exports to drive its economic growth and that it would focus more on growing domestic consumption, promoting high-quality finance and restructure industry value-add through technology, innovation and branding. Overall, I think the 1930s competitive devaluations no longer apply in today’s globalised, financialised and informationalised economy and may actually be a disadvantage because prevents an economy from moving up the value-add ladder while causing high-value add activities to migrate abroad.

In my view, China is more likely to pursue the alternative: a strong, or more precisely, a stable currency. China will want to avoid Japan’s experience in the 1980s when it was forced by the Plaza Accord[20] to simultaneously revalue its currency and liberalise capital controls. Japan’s economy suffered from the volatile swings in its exchange rate. I think China will adopt Singapore-type currency policies to guide the yuan through a steady appreciation path (capping exchange movements to between 5% to 10% on either side) with emphasis on stability rather than absolute levels. This means in the medium-term, China is unlikely to give up capital controls as it needs tools to curb hot money flows and exchange rate volatility. China has sufficient experience and defences to control the exchange rate downside while the geopolitical conflict will work in its favour by limiting a return of Western capital inflows.

Overall, China’s currency policy should be viewed in terms of the passive role intended for the yuan. There is sufficient room for China to enhance the international role of the yuan. Unlike in earlier decades, where the world was unable to shake off their dollar dependency, China now stands ready to provide an alternative currency at least for commercial purposes. China’s international trade relationships already span the globe and its firms offer sophisticated and competitively priced products and services that used to be only available from Western firms. China is also in a position to provide yuan-based liquidity, routed through its financial intermediaries for trade or infrastructure projects, and to provide relief to countries stricken by USD shortages. China will use bilateral currency arrangements to lock in the trade relationship and perhaps offer its trading partners an opportunity to convert the yuan at a more favourable price in their onshore market.

Conclusion

De-dollarisation is an important aspect of the global reset. The transition to a multipolar currency regime has begun and its progress is unlikely to be halted; any more than the Western financial sanctions can be unwound. Though its dominance will be eroded, the USD will remain the leading currency among competing currencies and assets for several decades. Nonetheless, the potency of US financial sanctions will be diminished. In the meantime, Global South intermediaries, assets and venues would likely gain ascendency at the expense of Western ones.

The implications of a multipolar landscape are far-reaching. De-dollarisation will accentuate deglobalisation and deepen economic fragmentation; possibly  splintering the world into a regime of trade blocs and currency areas running on parallel payment networks and rules. The global recycling of savings will be re-mapped. This is negative for the global economy due to losses from de-leveraging and inefficiencies. The Global South countries can recoup some of the de-dollarisation losses by capturing value add from the West but the West will find that as usage of their currencies shrink, they would come under pressure to rein in consumption and deficits.

De-dollarisation is in progress, yet there is little inkling of how a multipolar regime should function. It seems evident there will be a reduction in asset substitutability due to the additional frictions. Pricing differentials will be evident among the different currency areas (e.g. oil, gold and offshore-onshore currency markets). Physical delivery will become an important aspect of arbitraging price differentials while futures and derivative trades will become more costly. Cross border intermediation between currency areas will likely become more inefficient and costly.

Will the Global South financial ecosystem be able to operate independently of the Western one? Could US and its allies remain indifferent to the threats to their global currency franchise and how to they plan to respond to the competition from other currency areas? Hopefully, we will not see extreme responses such as a broadening of sanctions on non-conforming countries or even worse a war.

It is clear there will be a looming battle to shape the new rules of financial engagement between the West and Global South. But fortunately, we are unlikely to witness a repeat of the 1930s-style beggar-thy-neighbour competitive devaluations. This is because the US and China both have large domestic economies and require strong currencies to contain inflationary pressures. More likely, it will be the Fed that is cornered by the large fiscal deficits into restarting QE– which suggests an extended period of weakness for the USD. A strong yuan and a weak USD are complementary and hopefully this can provide grounds for cooperation rather than competition between the two countries.

Last but not least, theories suggest that countries generally cannot conduct monetary policy independent of US monetary policy. This makes sense in the USD hegemony but will this theory hold in a multipolar currency regime. The broad implication there is pressure for monetary policies to align within a sphere and for policies to diverge between spheres. This will particularly be the case when world’s two largest economies are pulling in different directions – which is the focus of the next article.

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Ruchir Sharma (21 June 2022) “Commentary: Why China is not rising as a financial superpower”. Channel News Asia (CNA). https://www.channelnewsasia.com/commentary/china-yuan-renminbi-currency-flow-us-dollar-finance-2758231

Samuel Shen, Rae Wee (17 November 2023) “Cheap yuan catapults China to second-biggest trade funding currency”. Reuters. https://www.reuters.com/markets/currencies/cheap-yuan-catapults-china-second-biggest-trade-funding-currency-2023-11-17/

Selwyn Parker (28 November 2023) “Commentary: China seeks to lessen developing countries’ reliance on the US dollar”. Channel News Asia (CNA). https://www.channelnewsasia.com/commentary/china-yuan-us-dollar-dominant-currency-swap-deal-argentina-3948331

Simon White (25 May 2023) “Vanishing demand shows why Dollar’s star has peaked”. Bloomberg. https://www.zerohedge.com/markets/vanishing-demand-shows-why-dollars-star-has-peaked

Song Lin (28 October 2023) “China’s central bank reports progress in yuan internationalization, pledges support for growth of offshore yuan market”. Global Times. https://www.globaltimes.cn/page/202310/1300745.shtml

Tyler Durden (17 July 2023) “Zoltan Poszar on the global financial system’s monetary divorce from dollar hegemony”. Zero Hedge. https://www.zerohedge.com/markets/zoltan-poszar-global-financial-systems-monetary-divorce-dollar-hegemony

Tyler Durden (24 October 2023) “US still dominates the world’s largest stock exchanges”. Zero Hedge. https://www.zerohedge.com/markets/us-still-dominates-worlds-largest-stock-exchanges

William Pesek (1 November 2023) “PBOC in a liquidity dilemma of crucial proportions”. Asia Times. https://asiatimes.com/2023/11/pboc-in-a-liquidity-dilemma-of-crucial-proportions/

William Pesek (23 November 2023) “Yuan rally thickens China’s capital flight plot”. Asia Times. https://asiatimes.com/2023/11/yuan-rally-thickens-chinas-capital-flight-plot/

Wolf Richter (19 July 2023) “Time to look at foreign demand for the incredibly ballooning US national debt”. Wolfstreet. https://wolfstreet.com/2023/07/19/time-to-look-at-foreign-demand-for-the-incredibly-ballooning-us-national-debt/

Yannis Dafermos, Daniela Gabor, Jo Michell (19 October 2022) “FX swaps, shadow banks and the global dollar footprint”. Environment and Planning A: Economy and Space. https://journals.sagepub.com/doi/full/10.1177/0308518X221128302

Zoltan Pozsar (27 December 2022) “War and commodity encumbrance”. Credit Suisse.

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[1] “The Great Economic War (GEW) (Part 3: The financial nuclear bomb)”.

[2] See Song Lin.

[3] See Tyler Durden.

[4] See Global Times.

[5] See Alasdair Macleod.

[6] Encumbrance refers to the use of collateral in specific trades, which can limit its use in other trades and potentially lead to scarcity of collateral.

[7] Term coined by Valery Giscard d’Estaing. See Gary Richardson and Cathy Zhang

[8] https://en.wikipedia.org/wiki/Triffin_dilemma

[9] See Tyler Durden.

[10]From 1870s-1930s and 1944-1971 (under Bretton Woods).  https://en.wikipedia.org/wiki/Gold_standard

[11] https://en.wikipedia.org/wiki/Currency_union

[12] The sterling area emerged after England left the gold standard in 1931, with many countries, mostly belonging of the British Empire, chose to peg their currencies to sterling instead of gold and held a large portion of their foreign currency reserves as sterling balances in London. The sterling area collapsed with the end of fixed exchange rates in 1971. https://en.wikipedia.org/wiki/Sterling_area

[13] There are two CFA franc schemes – the West African CFA franc used in eight West African countries, and the Central African CFA franc used in six Central African countries. Both CFA francs are pegged to the euro and member countries deposit half their foreign exchange reserves with the French Treasury. The West African CFA franc is to be terminated and replaced by a new regional currency called “eco”. https://en.wikipedia.org/wiki/CFA_franc

[14] See “Global reset – Monetary decoupling (Part 7: Currency wargame scenarios)”.

[15] 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.

[16] See “The Great Economic War (GEW) (Part 5: Global economic breakdown and monetary disorder)”.

[17] See Ozge Akinci, Gianluca Benigno, Serra Pelin, Jonathan Turek on “The Dollar’s imperial circle”.

[18] The 1985 Plaza Accord, signed by France, Germany, US, UK and Japan, was an agreement to weaken the USD relative to the yen and Deutschmark in order to reduce the huge US trade deficit. From 1980 to March 1985, the USD had appreciated by over 47.9% and after the accord, the dollar depreciated by as much as 25.8% percent in two years. https://www.investopedia.com/terms/p/plaza-accord.asp See also “Global reset – Monetary decoupling (Part 4: Lessons from Plaza Accord)”.

[19] “Global reset – Economic decoupling (Part 1: China’s socialism big bang)”.

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