TOKYO — Depending on your vantage point, the last year has been the best or the worst of times for the US dollar.
Those on the former side of this Dickensian divide will point to new Bank for International Settlements data as showing the dollar is still on one side of 89% of currency transactions, meaning US hegemony is unstoppable. Those taking the latter side see the yuan’s share rising to 8.5% as a reason for Washington to watch its back.
The reality is complicated, given how global foreign exchange traders seem to be giving the dollar a pass on deteriorating US fundamentals.
From a national debt topping US$37 trillion to US President Donald Trump undermining the Federal Reserve’s independence to tariffs upending the global financial system, the dollar’s continued popularity is quite a curiosity. That gold’s powerful rally to all-time highs is happening simultaneously, adds to “Teflon dollar” lore.
At the same time, the yuan is now on a path to leapfrog over the pound to become the fourth-most-traded currency. Global trading of the Chinese yuan has increased to $817 billion a day, according to the BIS data. That extends a decade-long trend.
Yet given the scale of China’s $18 trillion economy, you can understand why US Treasury Scott Bessent’s team might take the yuan’s still paltry share of global transactions — just half of the Japanese yen — for granted.
“The international use of the yuan still does not match China’s size in the global economy and trade,” said analyst Miao Yanliang at China International Capital Corporation.
The dollar, it turns out, is a very hard habit to break for central banks, investment funds and oil-producing and commodity-exporting nations. Yet some of the explanation lies in China’s slower-than-hoped progress toward both implementing financial reforms and addressing cracks in its foundations.
The most obvious demerit is Beijing’s failure to make the yuan fully convertible. In 2016, the People’s Bank of China achieved its goal of having the yuan included in the International Monetary Fund’s “special drawing rights” framework, making it the fifth currency to do so.
At the time, PBOC officials recognized that outside pressure from the IMF would prompt the Communist Party to accelerate financial reforms.
Hardly. China has also been slower than hoped to increase transparency — both at the government level and the private level — and step closer to freeing the People’s Bank of China to conduct an independent monetary policy.
The lack of autonomy is evident in the PBOC’s current reluctance to cut rates. True, Nobel laureate Milton Friedman wasn’t entirely correct when he said that inflation and deflation are monetary phenomena. However, China could benefit from more yuan liquidity flowing into the economy, paired with bold reforms.
With China’s property crisis deepening and youth unemployment at record highs, Xi’s government needs to step up efforts to boost household spending. And to address plunging real estate prices to stabilize broader confidence.
China’s financial system has become less, not more, transparent, and the media have become less free to report on official and corporate shenanigans. Xi is steadily imposing Beijing-like opacity in Hong Kong, risking the laissez-faire ethos for which the city is renowned.
Keeping yuan internationalization on track means getting the cart-and-horse dynamic right. In recent years, Xi’s team has largely pursued a model that prioritizes size in building credibility in markets. It’s been slow, though, to do the heavy lifting on reforms needed to garner trust organically.
This means removing all currency controls and allowing for full convertibility, establishing a more credible credit rating system, and facilitating the dissemination of news and data crucial to China becoming a world-class financial destination.
As Morgan Stanley economist Robin Xing put it: “On the fundamental level, wider international use of yuan rests on a robust economy and further progress in capital account convertibility.”
Here, there’s tension between the short term and the longer term.
“Economic momentum is weak in the third quarter,” said economist Zhiwei Zhang, president at Pinpoint Asset Management. “Export activities have been surprisingly resilient so far this year and helped to partly offset the weak domestic demand.”
Lisheng Wang, an economist at Goldman Sachs, said that China’s “August slowdown in government spending growth, continued accumulation in fiscal deposits and the sharp decline in infrastructure investment during July to August suggest policymakers are not in a rush to step up stimulus amid still-resilient exports.”
In other words, exports are providing Team Xi with a cushion to push forward with efforts to deleverage the economy. Many argue that, in the short term, Beijing could accelerate growth with minimal effort.
Slower growth in August, Wang said, can largely be attributed to the fading effects of consumer goods trade-in subsidies for home appliances and electronics.
At the same time, September consumption could have slowed “more meaningfully” thanks to “unfavorable base effects,” and that “incremental and targeted easing” is necessary in the coming quarters.
As such, Zhang said “the slowdown is not a surprise to the markets.” Yet, even if Team Xi’s fiscal policy stance turns “more supportive on the margin,” large stimulus packages seem unlikely unless party bigwigs fear China may miss this year’s 5% growth target.
However, the bigger concern is that efforts to strengthen the underlying financial system haven’t kept pace with the waves of foreign capital flooding into China.
But this trajectory depends on the ability of Xi’s team to keep China on the reform path.
Economist Bruno De Conti, co-author of a new book on the New Development Bank, formerly known as the BRICS Development Bank, argues that for the yuan to eventually become an important reserve currency, additional steps are needed involving further deregulation of the Chinese capital account.
“Recent efforts by developing countries to diversify their currency reserves away from the US dollar have raised serious anxieties in the Global North as much as it has raised hopes about the new dawn for the economies of the Global South away from unfettered US dollar dominance,” De Conti argued.
However, De Conti said, “a possible transition from the US dollar as a reserve currency worldwide is far more complex as the emerging economies, especially Brazil, Russia, India, China, and South Africa (BRICS), have not necessarily embraced a singular stance beyond the general acceptance that the status quo can no longer hold.”
The yuan, of course, makes sense thanks to China’s scale and status as the world’s largest trading nation.
One major hurdle is restrictions on the movement of capital across mainland borders. The bigger problem, though, is how Beijing is putting the cart before the proverbial horse. As beneficial as opening up China’s financial system is, it does not, in and of itself, represent reform.
The yuan’s inclusion in the IMF’s top currency club nine years ago is an example of the problem. Great headlines aside, the milestone matters little if Xi’s team doesn’t roll up its sleeves to liberalize the capital account faster, accept the tactics of speculators and publish increased amounts of credible data on foreign exchange reserves and credit conditions.
The same goes for the 2017 inclusion of mainland stocks in the MSCI global index. Beijing must keep pace with the growing demand for mainland shares by strengthening corporate governance, making markets more transparent and encouraging CEOs to be more shareholder-friendly.
At the same time, Xi’s team needs to accelerate efforts to reduce the scale of state-owned enterprises that dominate the economy and continue reining in the multi-trillion-dollar shadow banking universe, which is riddled with risks.
All these changes require greater political will than Xi’s party team has displayed so far. Without it, the yuan’s designs on supplanting the dollar could be slower going than Beijing envisions, despite all the self-inflicted damage Trump is doing to the dollar and American credibility.
Follow William Pesek on X at @WilliamPesek
