At the end of the 19th century the British pound looked unassailable. The United Kingdom was the largest exporter of capital, the majority of global trade was denominated in sterling and the currency accounted for nearly two-thirds of global foreign exchange reserves.
But sterling has fallen far from such heights and now accounts for just 4% of global foreign exchange reserves and 6% of global payments. This was driven by multiple factors but two were paramount: first, the catastrophic impact of World War Two on the British economy and the US-led financing of the subsequent reconstruction; and second, the U.K.’s declining relative economic status through the 20th century.
Now sterling’s sorry tale may seem irrelevant when considering the future of the dollar vis-à-vis the renminbi, but it does highlight three important factors: first, relative economic size and financial links matter, especially the extent to which a country is a source of capital; second, even with a significant disruptive shock, changes to established global orders tend to be multi-decade affairs given the inertia inherent within global finance; but third, this inertia should not be confused with permanence, and once trends start, they can rapidly become self-reinforcing.
As context, the dollar remains the de facto reserve currency – although its share of global foreign exchange reserves has fallen to 59% in 2021 from a peak of 73% during 2001 – and is still the primary currency used for trade, accounting for 87% of all trade financing. In contrast, the renminbi is still a bit player in global finance accounting for just 3% of global reserves, 2% of all global payments and 2% of trade financing.
Decline then fall?
But there are three reasons to believe that the renminbi will assume a more important role within global finance, including as a reserve currency, and that this will inevitably erode the dollar’s current hegemony.
The first is the changing geography of the global economy, especially in terms of the growing importance of Asia and other emerging markets. This shift will accentuate China’s growing economic and financial influence given its core status within the Asian economic system – it is the leading export market for most Asian countries – and its strong financial links with emerging markets as the single largest lender to such countries.
This growing influence relates to the second factor – that there is already evidence of a developing renminbi bloc within Asia. Over the last decade, for example, the various Asia-Pacific and Chinese foreign exchange markets have become increasingly connected as seen in tighter co-movements. In fact, for many Asian currencies including the Korean won, Malaysian ringgit and Taiwan dollar, the renminbi is now a more important reference currency than the dollar.
The paradox of course is that while Asian currencies are increasingly influenced by the renminbi, China’s exchange rate regime remains anchored to the dollar which, in turn, explains its sizable dollar-denominated foreign exchange reserves. But this brings us to the third factor which is that China is acutely aware that to be a peer rival to the U.S., it cannot remain dependent on the current dollar financial system.
Accelerated decoupling
In particular, China’s efforts to build alternative financial structures and institutions to reduce its dollar reliance will have received significant impetus by the sanctions placed on Russia. And in the same manner that the U.S. used its economic might to dollarize trade flows and the international financial system, it has to be expected that China will use its relative size to encourage greater use of the renminbi, especially in Asia.
Despite these powerful trends, however, there is a persistent view that broader renminbi adoption will be constrained by China’s capital account controls and its apparent obsession with current account surpluses.
But this understates the extent to which China is already open to international capital flows with both significant inflows and outflows. It is true that the main challenge facing the country is how it should liberalise capital outflows through a greater variety of channels, but it would be wrong to suggest that capital cannot flow in and out of the country. It also has to be assumed that China’s desire to be a reserve issuer recognises the longer-term risk of current account deficits as renminbi reserves are accumulated.
What is more important is the renminbi’s credibility as a reserve currency, especially in terms of its policy stability, as a store of value and the size of China’s financial markets. In fact, it could be argued that the dollar’s dominance is not so much a reflection of its inherent attractiveness but, until recently, a lack of credible alternatives. And given longer-term economic, financial and policy trajectories, it is easy to conclude that the Chinese currency will become such a credible alternative over the decades to come.
A fragmented new order
This is not to say that the renminbi will fully replace the dollar’s current role; such an idea is wishful thinking. But as the current dollar hegemony is inevitably eroded, we will move towards a period in which there will be no dominant international currency. Instead the dollar, euro and renminbi will co-exist, each with their clearly defined blocs. Ironically, this may actually be a better outcome for many countries which have struggled to benefit from the dollar financial system given different stages of economic development.
The only real question revolves around the associated timelines of this financial fragmentation, especially as the emergence of the dollar as the de facto reserve currency took decades. But the rise of the renminbi is gaining momentum given the underlying forces. Therefore, unless there is a complete reversal of China’s rise, the renminbi’s upward trajectory, the erosion of the dollar’s global hegemony and the fragmentation of the global financial system, will be the defining trends for global finance over the decades to come.
William Bratton is author of “China’s Rise, Asia’s Decline”. He was previously head of equity research, Asia-Pacific, at HSBC.
