The yuan’s Long Road To Hegemony

Talk of the yuan replacing the U.S. dollar as the global reserve currency is mostly idle because China neither provides the conditions for this to occur nor appears to desire this outcome over the short term. Nevertheless, over time, the U.S. dollar’s hegemony is fraying, leaving a vacuum which will be filled by alternative currencies.

The conditions for a currency to establish itself as the dominant global instrument for trade transactions and storing wealth are shown by history. First, reserve currency status is a function of a country’s dominance of economic output (GDP), trade and net creditor status. Second, certain arduous requirements need to be met:

• Trustworthiness
• Institutional strength (rule of law, property rights)
• Large economy and reliable trading partner
• Free movement of capital and strong banking system
• Large and liquid sovereign bond issuance providing safe assets
• Willingness to provide global currency liquidity

No previous reserve currency has had the scale or scope that the U.S. dollar has had over the past seventy years, being generally limited by the country’s geographic hegemony. For example, the British pound was the leading reserve currency for a century (aprox. 1814-1914) because of its global empire and naval domination but it still left much of the world uncovered and faced competition from European rivals (France, Germany).

Post W.W. II U.S. dollar hegemony was secured because of America’s near total economic dominance. However, over time this has changed dramatically. The following chart from the IMF, which measures GDP, trade and net creditor status, shows the evolution over time: the U.S. goes from absolute dominance in the 1950s to a much weaker position today. By this measure, China has already surged and is poised to assume more influence.

The following three charts show this in detail: 1. Share of global GDP; 2. Share of global trade; 3. Net creditor status. The first two are shown for both the U.S. and China; the third shows the evolution of the U.S. net creditor position, from 20% positive in 1950 to over 80% negative in 2022 (China’s positive net creditor position is estimated to be about 15% of GDP, similar to the U.S. position in the 1950s).

On the other hand, with regards to the “institutional” and policy characteristics required to establish reserve status China lags far behind.

• Trustworthiness – Though trust in the U.S. has declined in recent years because of the heavy-handed use of “sanctions diplomacy” it retains considerable advantages over China. China has antagonized a great many potential partners by engaging in provocative “wolf warrior” diplomacy. Moreover, China is even more prone to sanctions diplomacy than the U.S., as shown recently by retaliations against Korea, Australia and Lithuania for criticizing China’s policies.
• Rule of Law – China’s lack of due process and judicial independence makes it a poor safe haven. Though the recent freeze on Russian assets held abroad by the U.S. and other western countries have created a terrible precedent, by and large investors still expect to be treated fairly by U.S. courts.
• Large economy and reliable trading partner – This is China’s strong point and where it can increasingly contend with the U.S..
• Free movement of capital and strong banking system – China fails on both counts. It has strict capital controls, mainly to keep domestic capital from fleeing. Also, it remains fully committed to managing its currency to preserve export competitiveness. Its banks are agents of the state and can be considered “highly liquid but insolvent.”
• Large and liquid sovereign bond issuance providing safe assets – China is improving quickly on this count, but is still way behind the U.S., and the lack of rule of law and the presence of strict capital controls will impede progress.
• Willingness to provide global currency liquidity – This is the biggest impediment for China to move forward on reserve currency status. The global economy needs a constant and predictable increase in the volume of the reserve currency. Under the British Gold Standard gold output increased by over 2% a year to keep the system liquid. Under the U.S. fiat currency system, the U.S. has run persistent current account deficits to feed dollars into the global economy. Since 1980, the U.S. has run annual current account deficits of on average -2.7%. This global liquidity is the counterpart to the growth in the U.S.’s negative net creditor position. Meanwhile, since 1980 China has run current account surpluses of 2% of GDP, allowing it to build its net creditor position. There is no evidence at this time that China would  change the mercantilist policies that support its export competitiveness and sustain current account surpluses, and until it does the yuan cannot increase its global hegemony.

Conclusion

Over the past twenty years China has become the primary buyer of global commodities. For example, China has replaced the U.S. as the biggest importer of oil. This raises the possibility that the dollar’s stranglehold on the pricing of most commodities may not persist. U.S. sanctions diplomacy against major oil producers such as Iran and Russia have already thrown these countries into the arms of China and reportedly have resulted in a significant amount of Chinese imports being invoiced in yuan. At the same time, China has established close diplomatic ties with Saudi Arabia which may be considering similar arrangements. A deal with the Saudis would be a watershed event, given how important the U.S.’s deal with the Saudis in 1974 was in securing the dollar’s hegemony  in the 1970s. However, unlike the Iranians and the Russians, the Saudis have options. In the end, the Chinese will need to convince the Saudis to invest in the Chinese capital markets which brings us back to the inadequacy of the yuan as a reserve currency for the reasons listed previously.