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Business Insight

Trade war could delay yuan challenge to dollar's global role

Beijing's disenchantment with U.S. currency's unique status is growing

The Chinese yuan has weakened rapidly in recent weeks, beset by U.S. President Donald Trump's threatened trade war. The currency hit a low of 6.69 to the dollar on July 3, from a recent high of 6.27 on April 14, and was trading at 6.61 on July 9, despite statements from central bank officials supporting a stable price.

The yuan's weakness has been compounded by concerns about a slowdown in China's economic growth and possible interest and reserve rate cuts. But the currency's vulnerability to external threats raises an issue of even greater long-term international importance -- its prospects of challenging the dollar as the world's principal reserve currency.

There is plenty of support within China for such a development. In remarks prepared for the Lujiazui Forum in Shanghai in mid-June, Chen Siqing, chairman of the Bank of China, signaled concern about the impact of the strong dollar on the economic fortunes of emerging markets. "Externally, the current emerging market turmoil has a lot to do with the strength of the U.S. dollar," he said, adding: "We need to accelerate the reform of the international governance system."

Noting that the yuan is part of the basket of currencies that underpins the International Monetary Fund's Special Drawing Rights, a backstop international currency, Chen called for "internationalization" of the yuan, greater diversification in the global monetary system, and easier access to international financial support for emerging market economies facing currency crises.

As Chen observed, "China has increasingly become an important force in global financial governance," since it was incorporated in the SDR basket in the fall of 2016. It is also clear that the yuan is the only currency that has the potential to challenge the dollar as the world's reserve currency.

Yet there has been little visible progress since 2016 in dismantling capital controls on the yuan -- an essential prerequisite for the internationalization of the currency. And while central bank and financial officials have in the past used the Lujiazui Forum to pledge support for liberalization, they displayed no such enthusiasm this time.

The reluctance of regulators to free the yuan is understandable. Fears of massive capital outflows and a meltdown in Chinese share prices in the summer of 2015 made Beijing wary of the possible impact of further liberalization. If controls were lifted overnight (a hypothetical issue, for the moment), most analysts believe the value of the yuan would drop to less than 7.00 to the dollar.

However, Chinese disenchantment with U.S. management of the dollar has been evident for a decade, and is growing. The dollar's reserve status meant that even though the 2008 global financial crisis was made in America, U.S. Treasury securities rallied in the wake of the crisis. China Investment Corp., Beijing's sovereign wealth fund, had invested $400 billion in Fannie Mae and Freddie Mac, two U.S. government-sponsored mortgage finance enterprises whose losses contributed to the crisis. As CIC President Tu Guangshao said at Lujiazui, the problems at those institutions still have not been fixed.

But it was the U.S. Federal Reserve's decision to undertake unconventional monetary policies, driving down interest rates and putting massive downward pressure on the dollar that really upset China and many other Asian emerging markets. In the wake of the Fed's quantitative easing volatile capital inflows triggered instability in Asian markets.

Asked in 2009 if he had a message for Washington, Gao Xiqing, then head of CIC, said: "It would be to remind the Fed that its monetary policy affects the whole world." Gao, who was speaking in the U.S. at a seminar at Duke University, was echoing the sentiments of both his countrymen and China's neighbors.

As U.S. central bank policies reverse, emerging markets are once again being jerked around as American money flows home across the Pacific, driven by rising interest rates in the U.S. But it would be a mistake to think that only emerging markets are disenchanted with the dollar's unique status. Bankers from numerous non-American banks that have paid multi-billion-dollar fines to U.S. regulators say they feel that Washington is extorting money, given the implicit threat to shut offenders out of the U.S. dollar payments system.

That is because that threat -- if acted upon -- would put them out of business. The disparity between the relatively minor penalties imposed on U.S. banks for offenses stemming from the mortgage-backed securities scandals and those imposed upon their foreign counterparts ($4.7 billion for Germany's Deutsche Bank according to the latest settlement) gives support to such claims. Enforcement of fines for violating U.S. curbs on money laundering are also seen as selective.

Interestingly, even as the Chinese government remains on pause in its campaign to promote the use of the yuan beyond its borders, other players are taking up the cause -- if only quietly. Progress in promoting the use of the Chinese currency is especially striking when it comes to payments. The yuan already "is the most widely exchanged currency for foreign tourism," said Rob Koepp, chief economist for the Economist Intelligence Unit in Hong Kong. Koepp added: "Through payments, the Chinese are internationalizing the yuan."

Among the speakers at the Lujiazui forum was Ge Huayong, chairman of China Union Pay, the leading credit card company in China. Today, he said, 50 countries accept Union Pay cards, while 26 million of its customers are outside China. Even metro travelers in Russia can pay with their Union Pay cards. More tellingly, the seven member countries of the Asian payments union have adopted the Chinese credit card company's technical standards. At the same time, 4 million merchants in the U.S. accept Alipay, another Chinese payments system -- largely from Chinese customers, at this point.

The jitters over trade friction with the U.S. that are roiling currency and stock markets across Asia will likely stiffen Chinese regulators' resolve to keep control of domestic financial markets and postpone the day when the yuan is allowed to float freely.

In the medium term much may depend on Trump: The consequences of a full-blooded trade war are impossible to predict, but a trade crisis that hurts growth and China's balance of payments could reignite fears of capital outflows and delay further yuan internationalization.

Short of such a catastrophe, however, the currency's ascension is only a matter of time. Its rise, in parallel with that of China itself, would be welcomed by many beyond its borders, not least because it might restore stability to a world financial system in danger of being mutilated by a U.S. president who appears to care nothing for the international implications of his America-first policies.

Henny Sender is the Financial Times' chief correspondent for international finance, based in Hong Kong, and contributes occasional columns to the Nikkei Asian Review. She has extensive experience of covering international finance.

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