From the petrodollar to the blockchain: the yuan and the global currency system

18 September 2023 - 16:00

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In 2023, the yuan is expected to gradually surpass the British pound and Japanese yen in terms of payments, transactions and reserves.

From the petrodollar to the blockchain: the yuan and the global currency system

An international currency must have three characteristics: a unit of account, to regulate trade based on transaction demand; a payment function; and a depository function, to serve as a reserve asset for global central banks and a reliable asset for private investors, banks and other institutions.

The dollar has achieved supremacy by embodying these three functions, especially the role of a valuable asset. According to the International Monetary Fund (IMF), as of the end of 2022, the dollar accounted for 58.36% of the world’s foreign exchange reserves. This was followed by the euro at 20%, the yen at 5.5%, and the pound at 4.9%. The yuan rested at fifth place, accounting for 2.7%. As for global trade in 2022, 88% was traded in US dollars, 31% in euros, and only 7% in yuan.

Historically, the dollar’s supremacy has been supported by its economic strength and military power. The United States accounted for 50% of the global gross domestic product (GDP) in the post-World War II period (a share now down to 20-25%). When President Richard Nixon announced the decoupling of the dollar from gold in 1971, the dollar went in search of a new reference asset. The White House sent Secretary of State Henry Kissinger to the Middle East to secure a deal, with two goals: that oil transactions be settled in dollars and that dollars flowing to oil producers be deposited in American banks, to buy American bonds. In exchange, Washington would provide Saudi Arabia with military protection. This is how the so-called petrodollar was born. Since then, several commodities around the world have been settled in US dollars.

So far, the dollar has managed to maintain its dominance, with a relatively high rate of return on investments and unparalleled liquidity in terms of deposits. The United States remains the largest economy in the world, and global payment systems employ the American payment system.

Of course, the greenback is not without its problems.

Reasons for de-dollarization

Already in 1965, the then-French finance minister Valery Giscard d’Estaing denounced the "exorbitant privileges" of the dollar. The global financial crisis of 2007-08 further challenged dollar hegemony, as well as US monetary and fiscal discipline, and these concerns resurfaced with the Russia-Ukraine conflict.
In fact, there are currently two distinct types of efforts toward de-dollarization. After the outbreak of war in Ukraine, the freezing of Russia’s foreign exchange reserves was seen as an unprecedented tool of extraterritoriality. In response, Russia has sought to increase trade with China. Both countries have sought to use their economic clout and resources to dethrone the dollar and radically overhaul the global financial system.

The second group of countries, predominantly belonging to the Global South, is pursuing a broader concept of economic independence. When a country uses the dollar, it effectively cedes some of its economic sovereignty to Washington, which alone enjoys the right to print dollars and set U.S. monetary policy.

Yet these countries are largely not ready to abandon the dollar entirely. For example, Brazil – which has reached an agreement with China to use the yuan for trade – transacts with China in dollars before trading in both currencies. In other words, Brazil still relies on the dollar as a reference point, because it does not believe that the yuan is the most stable currency.

How is the yuan measured

Today, the yuan is the world’s fifth-largest payment currency, third-largest trade financing currency, and fifth-largest international reserve currency. Foreign currency transactions in yuan have increased to 7% of global market share, making it the fastest-growing currency in the past three years. However, the low percentage of yuan used in trading settlements does not fully reflect China’s status as a major trading nation.

In 2018, it established its own commodity exchange, the Shanghai International Energy Exchange (INE), for oil deliveries from countries such as Iran, Venezuela, and Russia. Contracts traded on the INE use only yuan. Saudi Arabia’s top oil exporter recently expressed openness to the idea of trading currencies other than the dollar. And this March, France reached an agreement to trade liquefied natural gas (LNG) with China and settle cross-border payments in yuan rather than dollars. The move set a precedent for US allies in Europe to pay in a different local currency. With the Russian invasion of Ukraine, the yuan significantly increased its role in Sino-Russian trade.

China has developed its own international payment platform - the Cross-Border Interbank Payment System (CIPS) - which is independent of SWIFT and accepted not only in Russia but by banks in Brazil and elsewhere too. As of January, yuan savings accounted for 11% of Russia’s total deposits, making it the country’s most traded currency. Of course, CIPS and SWIFT do not play the same role in international finance.

SWIFT is a global messaging system that provides banks with efficient, low-cost communications and does not transfer funds; while CIPS is a clearing and settlement mechanism denominated in yuan that usually requires SWIFT messaging for cross-border transactions.

However, the yuan has many drawbacks. Lack of convertibility remains an obstacle for many global investors. The ability to control capital flows remains extremely important for Chinese authorities. Without it, large amounts of capital will flow out of China in search of safety. A fully internationalized yuan is unlikely to be implemented unless Beijing allows greater monetary freedom and both domestic and foreign investment, and fully establishes the rule of law.

A possible catalyst for de-dollarisation lies in emerging technologies such as blockchain and digital currencies. Blockchain tools and digital currencies have key attributes such as neutrality, efficiency, and programmability, which can support new financial applications outside the traditional financial system. By using these technologies, countries attempting to build alternatives to US-controlled financial infrastructure can deliver benefits in terms of cost, efficiency, ease of use

However, diversification of international currencies is underway. According to the IMF, by the end of 2020, 46 economies had allocated more than 5 percent of foreign reserve assets to the yuan or to those outside the basket of "special drawing rights" currencies (dollar, yuan, euro, yen, and pound).

The yuan is undoubtedly among the best non-traditional currencies. If China’s economy can improve after the second half of this year, the yuan should gradually outpace the British pound and Japanese yen in terms of payments, transactions, and reserves. In the not-too-distant future, it could become the third largest international currency after the US dollar and the euro.

But if China’s growth continues to slow, the pace of the internationalization and de-dollarization of the yuan will also have slowed significantly.

Original article published on Italy 2023-09-05 08:00:00. Original title: Dal petrodollaro alla blockchain: lo yuan e il sistema valutario globale

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