The fundamentals restricting greater global use of the Chinese currency have not changed, although it has made some incremental gains. If anything, Beijing is interfering more than ever with markets and the financial system.
For more than a decade, China has been promoting the internationalization of the renminbi to strengthen the country's role in the global financial system. Beijing wants to break free of what it calls “dollar hegemony,” the dominance of the US dollar in international financial flows.
That is no easy task. Whether as a reserve currency, for trade settlement or funding, the dollar dominates – and has staying power. For instance, in the fourth quarter of 2020 amid political tumult in the United States, the percentage of dollar reserves held by central banks fell to their lowest level in 25 years. Still, that figure was a commanding 59%. In contrast, the Chinese yuan made up just 2% of foreign exchange reserves.
The paramountcy of the greenback gives the United States considerable influence over global payment rails, much to the chagrin of countries like Russia, Iran and of course, China. A case in point: In December 2018, Canadian authorities arrested Chinese telecoms giant Huawei’s chief financial officer Meng Wanzhou at the U.S.’s behest. Meng is charged with bank and wire fraud and accused of misleading banks about Huawei’s relationship with Iran, a country that has long felt the sting of U.S.-imposed sanctions.
Meng’s arrest marked a major escalation of the U.S.-China trade and tech wars, as tensions spilled into the financial realm. Since then, China’s ruling Communist Party has accelerated efforts to reduce dependency on the greenback. Concern over the possibility of Washington imposing punishing financial sanctions is one of the primary reasons Beijing wants to use a digital fiat currency – which it calls digital currency, electronic payment (DCEP) – in cross-border payments. A digital renminbi traveling on alternative payment rails could theoretically circumvent the existing U.S. financial system, allowing China to transact with whomever it likes, free of concern over U.S. interference.
While the digital renminbi is in its infancy, China has experimented with an offshore renminbi market as part of the bid to internationalize its currency since 2007. Dubbed “one country, two markets” by Edwin L. C. Lai, a professor at Hong Kong University of Science and Technology (HKUST) Business School, this approach entails maintaining strict control of currency convertibility onshore but full convertibility in offshore markets like Hong Kong, London and Singapore. These cities have developed into hubs for trading the renminbi and issuing yuan-denominated bonds offshore, but their impact on overall renminbi internationalization remains limited because China refuses to let its currency float or open its capital account.
Unto themselves, the exchange and capital controls are an obstacle but not a dealbreaker to the renminbi's internationalization provided that they are gradually eased over time. The problem is that under the dictatorial and ardent Communist Xi Jinping, China is swinging hard to the left. To be sure, Xi’s revamping of erstwhile chairman Mao Zedong’s idea of "common prosperity" is not without merit; China has become one of the world's most unequal societies since economic reforms began 33 years ago. According to Credit Suisse, China's top 1% now control 31% of its wealth, up from 21% two decades ago.
However, Xi’s solution to the problem relies heavily on ham-fisted interference in private-sector companies and financial markets, such as the nixing of Ant Group’s IPO and the punishment of Didi Chuxing for going ahead with a listing on the NYSE against the wishes of regulators. Such moves, while par for the course in Xi’s China, will sow doubt about the country’s ability to play a larger role in global finance.
The duality dilemma
At the crux of China’s renminbi internationalization challenge is a duality dilemma: Beijing wants to both exert more control over the Chinese financial system and play a larger role in global finance. The two prongs of its strategy are inherently contradictory. Being a global financial power necessitates openness, not just being a large economy. The U.S. dollar could never have achieved its paramountcy if Washington had insisted on controlling the exchange rate, had maintained strict capital controls and arbitrarily interfered in financial markets.
To be sure, China has scholars, officials and businesspeople that well understand this reality. Before Xi Jinping became China’s leader, it was not uncommon for financial analysts to make specific predictions about when China would open the capital account; for instance, 2020 or 2025. At the time, informed observers were confident about the prospects for renminbi internationalization. Many assumed that Beijing would eventually relinquish some control over the Chinese financial system because the economic and geopolitical benefits of opening up were significant.
Analysts are hard-pressed to make such forecasts today, although some investment banks remain cautiously optimistic. In September 2020, Morgan Stanley forecast that the renminbi would become the world’s No. 3 reserve currency in a decade. The investment bank reckons that the yuan’s share of global foreign exchange reserve assets could rise from 2% to between 5% and 10% by 2030, surpassing the yen and pound sterling. It makes that prediction because it believes China’s investment portfolio inflows will reach US$200 billion to US$300 billion from 2021-2030, up from US$150 billion in 2020. Those investments will result in the yuan accounting for a greater share of global assets.
A report published in August by the International Monetary Institute (IMI), which is affiliated with China’s Renmin University, found that yuan-denominated financial assets held by overseas institutions and individuals rose roughly 40% annually in 2020 to reach RMB 8.98 trillion yuan (US$1.39 trillion). Meanwhile, the renminbi’s share of central banks’ reserves rose 14.8% to 2.25%, according to the IMI.
Xi Junyang, a professor at the Shanghai University of Finance and Economics, told the state-owned nationalist tabloid Global Times in August that Beijing may consider encouraging foreign investment in Chinese capital markets “via the Shanghai-London Stock Connect program as well as potential connects with the Tokyo and Singapore stock exchanges."
Such ideas will inevitably appeal to the large institutional investors who remain persistent China bulls, like the world’s No. 1 asset manager BlackRock or Ray Dalio, founder and co-chairman of Bridgewater Associates, the world’s largest hedge fund manager. On August 30, BlackRock began selling its own mutual fund in China through a local subsidiary. The BlackRock China New Horizon Mixed Securities Investment Fund intends to raise up to RMB 8 billion (US$1.24 billion). For its part, Bridgewater has about US$1.2 billion worth of stakes in at least 37 companies within its China holdings, according to its second-quarter filing.
Not everyone is so sanguine about China’s financial reform prospects. As HKUST’s Lai observed in a July commentary published in The South China Morning Post, “it seems difficult for a country without a mature legal system and a system of checks and balances to secure the confidence of the world on its currency.”
Lai believes that the renminbi’s share of global payments could reach 6.6% by 2030 (up from 1.5% to 2% today), but only if Beijing “greatly speeds up its financial development and capital account opening in the next decade.”
That seems unlikely. If Xi Jinping secures a third term (2022-2027) as expected, he is likely to double down on exerting greater state control over the economy and financial markets while trying to build alternate payment rails for cross-border use of the renminbi. Given the Chinese Communist Party’s perennial fears about money leaving the country, it is hard to imagine Beijing relaxing restrictions on capital outflows.
With that in mind, the renminbi is unlikely to challenge the dollar anytime soon. If it can challenge the yen or pound, that will already be a significant step forward.