Why there will be a slow and limited de-dollarization – 04/17/2023 – Why? Economês in good Portuguese

In March, Brazil and China announced an agreement to use local currencies in their bilateral trade. China is the country’s biggest trading partner, being the destination of more than 30% of exports and origin of more than 20% of imports. Given the trend of surplus flows on the Brazilian side, it is assumed that Brazil will accumulate reserves in renminbi (RMB or Yuan).

Last December, China and Saudi Arabia conducted their first yuan transaction, following Saudi statements that they were looking to diversify away from the US dollar. At the Russia-China summit in March, Putin said that business transactions between Russia and countries in Asia, Africa and Latin America would be done in RMB. Adding Iran, another country grappling with US sanctions, soon “petrodollars” will be replaced in the discussion by “petroyuans”.

Also worth noting is the purchase by French company Total Energies of liquefied natural gas (LNG), settled in yuan, from Chinese state-owned CNOOC.

The financial sanctions on Russia after the invasion of Ukraine had already generated an expectation that the armed use of access to reserves in dollars, euros, pounds and yen would provoke a division in the international monetary order. China would tend to reinforce its own international payments system and accelerate the establishment of the local currency as a rival reserve currency, so as to reduce its vulnerability to movements of a similar nature against it. Countries at geopolitical risk in their relationship with the United States and Europe would seize the opportunity.

Strictly speaking, since the global financial crisis, China has sought to extend the use of the yuan in international trade and as a reserve asset at other central banks. It pursued a proliferation of currency swap lines with central banks in other countries – including Brazil.

It is not surprising, therefore, how “de-dollarization” of the global economy, “multipolarity” or “bipolarity” of international monetary have become fashionable words in recent months. However, it is important to understand the real scope of what is happening.

First of all, it is necessary to take into account the difference between the use of a currency to settle transactions —that is, as a means of payment– and its role as a store of value. Of course, from the point of view of a central bank that needs to be ready for such payments, the use in transactions leads to the constitution of reserves in the corresponding currency.

It should be noted in this context that the volumes of foreign exchange transactions are primarily of a financial nature, not trade in goods and services. The size acquired by Chinese foreign trade constituted a giant basis for the potential use of its currency, but not on the financial transaction side.

In 2015, when the RMB was approved to be part of the Special Drawing Rights (SDR, the accounting currency issued by the IMF) special basket of base currencies, along with the dollar, euro, yen and pound, it was able to do so for for the sake of commerce, not for criteria as to their use in financial markets.

Commercial transactions, as well as reserves from central banks and other global public investors, could bolster the renminbi’s position as an alternative currency to the dollar, euro, yen and sterling. However, the qualitative leap towards the internationalization of the Chinese currency as a reserve currency will only occur when confidence in its convertibility is sufficient to convince unofficial (private) investors to keep reserves denominated in it.

And central banks need to have reserves in currencies with which they can operate in the various exchange transaction areas. Not by chance, currency swap lines with China have been little used, while those of countries with the Federal Reserve from the United States have been activated in times of need to stabilize flows.

The issuer of reserves has to accept that large amounts of assets in its currency circulate around the world and, therefore, that foreign investors have some weight in determining long-term interest rates and the exchange rate. By all indications, Chinese financial authorities do not appear to be considering the abdication of controls as a priority on the immediate horizon. They will likely seek to expand the use of the renminbi as this can be done without relinquishing controls and therefore without the ambition to construct some regime parallel to or a replacement for the existing one.

“Dollar dominance” shows in its weight in global markets. The shares of the US dollar in foreign trade bills, as well as debt and international non-banking, are well above what the country’s percentages in international trade, international bond issuance and cross-border lending would suggest.

The dollar’s dominance has remained despite the decline in the share of US GDP in the global economy. From the 1970s, it survived the end of convertibility into gold and the regime of fixed exchange rates inherited from Bretton Woods. Its presence in banking and non-banking even grew after the 2007-08 global financial crisis.

IMF data show a reduction in the degree of its “dominance”, with a drop in the dollar’s share of central bank reserves since the turn of the century, from 71% in 1999 to 58.4% at the end of 2022. Not in favor the pound sterling, the Japanese yen or the euro —despite the rise that the latter experienced during its first decade of existence—, but rather the so-called “non-traditional reserve currencies” (Australian dollar, Canadian dollar, Swiss franc and others), in addition to the renminbi, which reached 2.69% of the total.

Four gravitational factors favor the continuation of the dollar’s central position in international financial markets, in commercial invoices and payments, as well as in public and private foreign exchange reserves –call them “network effects” or complementarity and synergy. The relative expansion of other currencies depends on how successful they are in compensating for these factors.

First, the larger installed base for dollar-denominated transactions favors it. The increase in liquidity and the reduction in transaction costs in the “non-traditional” exchange markets –including through technological improvements in platforms– helped to reduce this disadvantage.

In addition, no other monetary system offers as many “investment grade” government bonds as the United States, which central banks can accumulate as reserves and private investors use as a “safe haven”.

Third, it is also worth noting that “non-traditional currencies” benefited from a partial search for return on reserve management. Central bank balance sheets –of advanced and emerging economies– have taken on large proportions in recent times. Now, some of them separate what would be the adequate slice for “liquidity management” (the reason for the existence of reserves in liquid and low-risk assets, with the purpose of stabilization), from another “investment” slice (capable of being allocated in less liquid but more profitable assets). The pursuit of diversification has helped “non-traditional” reserves.

The fourth gravitational factor in favor of the dollar would be the absence of regulations restricting liquidity and asset availability, including capital controls. Despite the sanctions already applied in cases such as Iran, Venezuela and Russia, as well as other restrictions on foreign investment, here lies, as we noted earlier, a difficulty for Chinese bonds compared to those in dollars and the other three major currencies.

There is visibly a global “de-dollarization” underway, albeit slow and relatively limited.