Finance

Executive Summary

China has been trying for more than a decade to carve out a bigger global role for the

yuan, or renminbi (RMB). Beijing initially had little to show for its toil.

However, in recent years, it has changed its approach and

stepped up its efforts, driven by concerns that dependence

on the dollar – and the dollar-based global financial system

– is a strategic vulnerability that stands in the way of China’s

geopolitical ambitions.

This report charts the most recent phase of this campaign. It sets out the rationale

behind why Beijing wants to transform the yuan into an international currency, how

it’s striving to make that transformation, why it might prove unattainable, and what

progress we can expect over the next five years. It also discusses how US policymakers

should respond to the challenge.

The Chinese Communist Party is pursuing RMB internationalization for four main

reasons:

• To shield China from the fallout of what Beijing judges to be damaging US

economic policies. China views America’s deteriorating fiscal conditions, the

rapid expansion of the Fed’s balance sheet, and the unrestrained money printing

in response to the Covid-19 outbreak as evidence that the US exercises monetary

policy solely in its own interests. In doing so, Beijing believes, the US risks undermining

the legitimacy of the dollar, the world’s principal reserve currency.

• To insulate China from the potential weaponization of the dollar. The US

has been increasingly willing to sanction foreign individuals and institutions by

denying them access to US financial markets and dollar payments networks, the

fulcrum of the international financial system. China is aware that one day it could

be on the receiving end of the same sort of punitive financial sanctions that Washington

has imposed on Russia in response to its invasion of Ukraine.

• To support efforts to build a geopolitical sphere of influence. Bringing other

countries into China’s economic orbit requires financial integration, and that is

only possible once they start using the yuan.

• To help realize Beijing’s great power ambitions. China wants to change the

global governance infrastructure to better accommodate China’s interests. A globally

accepted yuan could bolster its claim to represent a viable alternative order to

the one led by the US.

At its core, China’s goal is fairly simple. It wants to be able

to purchase what it needs from other countries using its

own currency and its own payments systems. It wants to

reduce its dependence on the dollar and achieve greater

financial self-reliance.

But China does not necessarily want the RMB to supplant the dollar as the dominant

global currency. Rather, Beijing envisions a multi-currency order, one where the yuan

co-exists alongside the dollar and the euro as a regional currency. It’s unlikely that China

can realize any of its goals within a decade.

China launched its RMB internationalization effort in response to what it saw as the

West’s bungled response to the Global Financial Crisis.

Stage 1 of its campaign (2009 – mid-2015) laid the foundations, making it possible to

transact in yuan overseas and creating opportunities for foreigners to use the currency.

During Stage 2 (mid-2015 – mid-2017), it became clear that the yuan’s progress over

the previous period was the result of firms taking advantage of the yuan's appreciation

against the dollar, and arbitrage opportunities arising from differences between onshore

and offshore yuan markets. During these two years the yuan’s cross-border use

declined, prompting Beijing to reassess how to proceed.

The result is the current phase – Stage 3 (mid-2017 – present). It is focused on giving

foreigners reasons for using the yuan that are based on its merits as a medium of exchange,

store of value, and unit of account – the characteristics of a global reserve currency.

At its most basic, Beijing is trying to create a permanent

and sustainable cycle of yuan flowing out of China into the

global economy, then flowing back in again. Beijing is trying

to ramp up outflows by concentrating its efforts on trade.

Meanwhile, the main channel for inflows is investment into

China’s financial markets.

However, there are deeply entrenched barriers that stand in the way of foreigners

embracing the yuan. The dollar is cheaper than the yuan to obtain globally - and more

readily accessible - because of the huge pools of dollars that exist outside of the US.

The yuan is not going to be able to close the gap until it becomes an international currency.

Consequently, Beijing is exploring ways to get foreigners to use yuan regardless

of transaction costs.

Outflows – payments and pricing

Beijing is trying to institutionalize yuan outflows by changing the underlying factors

that determine the currency used for cross-border trade. We’ve identified four areas

that Beijing is targeting:

Commodities: Futures exchanges in the US and London set the benchmark prices

for most of the world’s commodities. Consequently, global trade in commodities is

almost entirely carried out in dollars. Beijing hopes to be able to shift the epicenter

of global commodity futures trading to China in order to make the yuan the dominant

currency for settling commodity transactions.

Industrial/processed goods: China’s economy is running up against a number

of constraints – labor has grown expensive, water is scarce, energy demands huge,

agricultural land limited. Beijing hopes to use Chinese capital to build factories in

BRI countries that will produce goods that will be sold to China. The hope is that

those goods will be priced and settled in yuan.

Supply chains: Asian supply chains usually transact in dollars. That’s because

the end consumer of the components they produce is the US and other developed

economies. Beijing wants to make yuan the settlement and invoicing currency of

choice by transforming China from a processor of goods produced in Asia into a

consumer. In short, Beijing wants to establish China as the economic anchor of an

Asian trade bloc, thereby giving it greater say over what currency is used throughout

the region.

E-commerce: Beijing hopes that it can circumvent traditional trade settlement

patterns by using new technology and processes to increase the yuan’s use.

Inflows – financial markets

Beijing is trying to increase inflows of yuan by encouraging foreign investment into

China’s financial markets. Its strategy has two prongs.

Capital account liberalization: Beijing is gradually removing curbs on foreign

investment. There is no longer a limit on how much foreign investment Beijing is

willing to accept, although there are still restrictions on who can invest.

Crucially, most of that investment has to enter China using the yuan. In recent

years, Beijing has established multiple channels through which foreigners can invest

in stocks, bonds, and a range of other financial products, but almost all of them

require that the investments be made in yuan sourced from outside of China.

Financial market reform: To increase yuan inflows, it’s not enough to remove

restrictions on foreign investment. Beijing also needs to give foreigners a reason to

invest in China’s financial markets. Those markets are currently underdeveloped.

To enable RMB internationalization, they eventually need to display many of the

qualities that make US financial markets so dominant. Specifically, China’s markets

need to provide investment opportunities that aren’t available to people in

their home economies.

To create a more favorable investment environment, Beijing is striving to make China’s

capital markets deeper, broader, and more liquid. ⁠

• To make them deeper, the rate at which companies are going public on the Shenzhen

and Shanghai stock exchanges has accelerated. Moreover, new exchanges

have been launched catering to small companies and tech firms in order to broaden

the range of firms able to list.

• To make them broader, Beijing is introducing a wider range of financial products

that span the spectrum of risk-return.

• And to increase liquidity, Beijing is using reforms to pensions, the housing sector,

and wealth management products to direct more funds into the equity and

bond markets.

Financial infrastructure

In an effort to make the yuan cheaper and more convenient to use, Beijing is improving

the payments system used to transact in yuan. The two main elements of its efforts

are the launch of a digital currency – the e-CNY – and the development of CIPS, China’s

cross-border trade settlement and communications platform.

The e-CNY has fanned talk that Beijing wants the yuan to leapfrog the dollar by harnessing

new technology, thereby burnishing the currency’s global credentials. Meanwhile,

there’s been speculation that Western financial sanctions against Russia will give

the yuan a boost as Russian firms turn to CIPS as an alternative to SWIFT.

Both the e-CNY and CIPS will be useful tools to support

RMB internationalization, but neither is capable of driving

the process. Their value is dependent on the success of the

type of reforms outlined in this report.

But if China manages to deploy the e-CNY for cross-border payments successfully in

coming years, this could promote RMB internationalization by making Beijing more

willing to open China’s capital account.

Barriers to RMB internationalization

There are reasons to believe that Beijing’s goals may prove unachievable. There are

significant – potentially insurmountable – barriers in the way of the yuan being adopted

as an international currency.

• China may struggle to maintain robust economic growth. China’s population

is aging rapidly and is about to start shrinking, constituting a major drag on

growth. Meanwhile, Beijing is trying to restructure the economy so that it’s no

longer dependent on housing and infrastructure, but rather on domestic consumption,

tech innovation, and advanced manufacturing. There are no guarantees

that the transition will be successful.

• The culture of the Chinese Communist Party may stand in the way of necessary

reform. The Party is willing to tolerate free markets up to the point where

it’s happy with the outcome. At that point it intervenes, often in ways that ignore

the interests of foreigners and investors. Over the past couple of years, China has

been labeled “uninvestable” by some in the globally investment community, specifically

for this reason.

• Geopolitically, China may struggle to find countries willing to join its

sphere of influence. China has a track record of using economic coercion against

trading partners that cause offense. Were the yuan to become a regional currency,

that would give China additional tools to wield against its neighbors. While large

Asian economies will want to maintain their trade relationship with China, they

may prove reluctant to commit to overly-restrictive financial links.

The next five years

Regardless of whether Beijing is able to achieve its goals, RMB internationalization

will undoubtedly make progress over the next five years. We anticipate further relaxation

on investment into China, and more reform of China’s financial markets.

Some of China’s biggest ambitions will take longer than our five-year window to gain

traction, specifically changing the way global commodities are priced, and changing the

invoicing habits of Asian supply chains. However, we expect China will make progress

in new areas – areas that haven’t been important to Beijing’s RMB internationalization

strategy until now.

We expect Beijing to make progress in three main fields:

Offshore market: The flow of Chinese savings into Hong Kong’s financial markets

will increase significantly, resulting in the issuance of more yuan-denominated

securities in Hong Kong and attracting foreign firms and institutions to raise

capital there – in yuan.

Safe assets: Beijing will make the technical adjustments necessary for Chinese

government bonds to be used as collateral for cross-border financial transactions,

sparking a surge of global demand for those instruments.

Financial services: As part of their ambitions to become international financial

centers, Shanghai, the Greater Bay Area along the Pearl River, and Chongqing will

develop financial services industries that start to generate demand from companies

in BRI countries.

Policy implications

Incremental increases in the yuan’s cross-border use don’t threaten US interests. Both

the yen and pound are used far more globally than the yuan, and their relatively prominent

role hasn’t translated into geopolitical influence for Japan or the UK. It will be

some time before the yuan’s global use exceeds that of either currency.

The US shouldn’t try to prevent minor progress in the yuan’s

global use – which won’t translate into geopolitical

gains any time soon – but rather should focus on ensuring

that the dollar order serves the interests of those countries

that share US principles.

If the US wants to retain its geopolitical role in the Indo-Pacific it needs to maintain

its military presence throughout the region and deepen its economic ties. In particular,

the Federal Reserve could extend dollar swap lines with the countries that the White

House has labeled “leading regional partners” in its Indo-Pacific strategy paper, thereby

helping minimize any damage caused by US monetary policy.

Additionally, the US should strive to minimize the degree to which its own financial

system is intertwined with that of China, perhaps by disincentivizing US financial firms

from investing in China.

Substituting the dollar for yuan in ways that bolster China’s economic security and

regional influence will require fairly radical changes to the way China’s economy

operates. But even then, it’s not enough for Beijing to simply implement all the right

reforms. Success depends on whether attitudes toward the dollar among foreign companies,

financial institutions, and central banks change in ways that allow the yuan’s

share of cross-border transactions to increase.

Whether the yuan is capable of becoming a truly international

currency is a question that will be settled years in the future.

In the meantime – and certainly over the next five years

– we expect Beijing to remain committed to the macroeconomic

and microeconomic reforms outlined in this report.

Not only are many of those reforms necessary to achieve yuan internationalization,

they are also needed to address pressing domestic challenges: accommodating China’s

aging population, developing a vibrant tech sector, and supporting more equitable

wealth distribution.

Regardless of whether the yuan eventually becomes an international currency, the

changes that Beijing is pursuing will resonate globally, alter the functioning of trade

and markets, and create new challenges for policymakers in the US and other developed

nations.