The Future of the Yuan and Dollar in the Global Financial System

In several of my recent columns, I have elaborated on the challenges the United States might face following the appointment of Donald Trump’s new cabinet after his election as President. I have discussed how the likelihood of a new Cold War may escalate to the extent that America’s claim of being the “sole superpower” could come under serious threat. Ironically, the same Afghanistan that inflicted a crushing defeat on the Soviet Union, leading to its eventual collapse and establishing America as the sole superpower, has now left the U.S. in disgrace. Post its withdrawal from Afghanistan, the U.S. is now fighting its final battle to defend its global dominance in Ukraine.

Before taking his oath on 20 January, Trump issued threats on social media to the nine BRICS nations, warning them of a 100% tariff if they opted for a new currency to conduct trade instead of the U.S. dollar. He stated, “The notion that BRICS countries will move away from the dollar and we will simply stand by is over.” It’s worth noting that major global powers like China and Russia are part of BRICS, alongside Brazil, India, South Africa, Iran, Egypt, Ethiopia, and the UAE. During his presidential campaign, Trump indicated his intent to impose widespread tariffs, and his recent statements have increased in intensity. Leaders from Brazil and Russia have previously proposed creating a common BRICS currency to reduce dependence on the U.S. dollar in global trade. However, internal disagreements within the organisation have stalled progress on this proposal.

On his social media platform, Truth Social, Trump posted, “We will require guarantees from these countries that they will neither create a new BRICS currency nor support any other currency to replace the dollar. Otherwise, they will face 100% tariffs and should expect to say goodbye to trade with the U.S., finding alternative partners instead.” Some of Trump’s supporters believe these statements are a negotiating tactic designed to create leverage rather than firm policy intentions. When Republican Senator Ted Cruz was questioned on CBS about Trump’s recent declaration, he said, “Look, threats of tariffs against Mexico and Canada previously yielded immediate results.”

What are tariffs, and what could be their implications?

A tariff is an internal tax imposed by a country on imported goods. For example, if a $50,000 car is imported into the U.S. and subjected to a 25% tariff, an additional cost of $12,500 is incurred. Tariffs are a central aspect of Trump’s economic philosophy, which views them as a means to bolster the American economy, protect domestic jobs, and increase tax revenue. He has claimed in the past, “These taxes will hit the other country’s pocket, not ours.” However, economists consider this claim misleading, as the additional cost is borne by local companies importing the goods, not foreign ones. Essentially, tariffs function as a tax that domestic companies pay to the U.S. government. During his first term, Trump imposed several tariffs that were later upheld by the Biden administration.

Is an alternative to the U.S. dollar possible?

Before addressing this question, let’s understand how the dollar became the world’s dominant currency. At the end of the Second World War, the Allied nations recognised that their economies were in ruins and began deliberating on which currency would facilitate international trade during the recovery phase. Representatives from 44 nations convened for 22 days at the Mount Washington Hotel in Bretton Woods, USA, to negotiate the future of the global economy and trade. European economies were devastated by the war, while the U.S. held the largest gold reserves in the world.

Ed Conway, in his book The Summit, describes intense political debates and clashes during these 22 days, including a confrontation between Britain’s John Maynard Keynes, who advocated for a global currency, and the U.S. Treasury’s Harry Dexter White. The conference concluded with the decision to use the U.S. dollar for international trade. Institutions created during the conference, such as the IMF and World Bank, would provide loans to post-war economies exclusively in dollars.

Could the dollar be replaced?

Among Western currencies, the only viable alternative as a reserve currency could be the Chinese yuan. However, this would require significant changes from China, including reforms for transparency, encouraging savings, and lifting controls on capital flows. Liquidity is a major challenge, as China imposes restrictions on foreign investment in its financial markets and the export of its capital. Economists argue that if these restrictions were lifted, private capital would flow under its jurisdiction. While the yuan could gradually emerge as a reserve currency, substantial structural changes are required.

Recent research by American and European economists suggests that China is actively promoting trade settlements in its currency, resulting in yuan accumulation in the central banks of its trading partners.

According to experts, “China’s efforts to internationalise its currency will not ensure Yuan’s dominance. Instead, it might lead to a multipolar currency world where the Dollar, Euro, and Yuan coexist.” While this is plausible, it remains a distant reality. Having the ability to hold money in Yuan is one thing; desiring to do so is another. On the other hand, the Dollar’s liquidity and universal acceptance remain unmatched globally, while Yuan trading outside China is limited to Hong Kong and a few dozen smaller centres. This is why historian Niall Ferguson refers to the competition between the Dollar, Euro, and Yuan as a “tortoise race.”

Another crucial aspect is that the search for an alternative to the Dollar is being driven primarily by America’s adversaries. In contrast, developed democracies and America’s allies exhibit no “allergy” to the Dollar.

Since the mid-20th century, the US Dollar has dominated the global financial system, and over the decades, numerous predictions have been made about its decline, collapse, or weakening. After the Euro’s introduction on 1 January 1999 and during the global financial crisis originating in the US in 2008, concerns regarding the Dollar were raised. Similarly, after Russia’s invasion of Ukraine last year, talk of the Dollar’s demise resurfaced. Yet, the Dollar continues to maintain its status as the primary global currency.

But let us examine the developments of the past decade and assess whether the current predictions about the Dollar’s decline merit attention. Three key points have been highlighted in discussions about the Dollar’s future:

China, the US’s major rival, has surpassed the European Union in terms of economic and trade volume and is now setting its sights on the American market.

Political disputes within the US undermine its reputation as a highly reliable borrower and lender, as evidenced by the risk of default seen last month.

The US is increasingly using Dollars to penalise nations it perceives as threats to itself or its allies. Instead of engaging directly in warfare, the US relies heavily on financial leverage to achieve its goals.

However, these factors, which are often cited as reasons for the Dollar’s declining dominance, are not particularly compelling. Last month, the US averted a potential default, reaffirming its position as the world’s primary and most dependable creditor. So, why are there lingering doubts about the Dollar losing its global appeal?

The Dollar serves two critical functions that establish its supremacy as the world’s principal currency:

Reserve Currency: Those with surplus funds prefer to hold them in Dollars.

Settlement Currency: Not only in the US but globally, goods and services are predominantly transacted in Dollars.

Despite attempts by China, Russia, Brazil, India, and other emerging economies to trade in Yuan or other local currencies, the Dollar’s position as the preferred settlement currency remains strong. Before delving into these reasons further, let us explore the Dollar’s role as a reserve currency in more depth.

By the end of last year, approximately $12 trillion in global currency reserves had been accumulated. About 60% of these reserves were in US Dollars, roughly 20% in Euros, 3% in Yuan, and the rest in other currencies. However, according to the latest IMF data, the Dollar’s share in reserves has been declining and is currently at its lowest point since 1995.

A heated debate surrounds the extent and pace of this decline. Some experts attribute it to unprecedented financial sanctions against Russia, claiming these actions have heightened tensions in global currency dynamics.

Currency experts at Morgan Stanley and the IMF argue that the Dollar is losing its status as a reserve currency faster than previously anticipated. They estimate that since 2016, the Dollar’s share in reserve markets has dropped by 11%, a decline that has accelerated since 2008.

However, many other currency experts disagree, asserting that little has changed in the reserve currency landscape since Russia’s invasion of Ukraine.

Analysts at the Council on Foreign Relations challenge the notion of a significant decline in Dollar reserves. They argue that the recent shift in Dollar reserves, as reported by the IMF, is not due to countries abandoning the US currency in response to sanctions against Russia. Instead, it reflects a reassessment of the value of US government bonds, where Dollar reserves are predominantly held.

The value of these bonds has declined due to rising interest rates on US debt, a trend that accelerated in 2022 compared to other major currencies. This has reduced the Dollar’s share in reserves. However, when viewed alongside the IMF’s data, this does not indicate a mass exodus from the Dollar. Furthermore, in 2022, no other major currency saw as much global demand as the Dollar.

The historian of the financial system, Neil Ferguson, states that the end of the dollar’s dominance has been discussed for more than half a century. During his recent visit to China, the Brazilian president was asked multiple times, “Why does everyone trade in dollars? Who decided this?” The reality is that during the 20 years of the euro’s circulation, the dollar has only lost 10% of its share in global reserves. In other words, at the beginning of the 21st century, the dollar made up about 70% of reserves, and now it is around 60%. This relates to the stock, and as far as calculations go, nothing has changed, and the dollar is still the dominant currency.

According to the Bank for International Settlements, over the last three decades, the dollar’s share has remained between 80% and 90%. It has remained popular over the last decade, and in 2010, the dollar accounted for 85% of all international payments, rising to 88% in 2022. The reality is that the dollar is the central currency for accounts, which strengthens its position as the central reserve currency, because the world believes that it is prudent to save this currency for hard times.

Moreover, all payments in dollars are made through the largest American banks, and U.S. authorities have the ability to monitor the movement of this currency.

The question is, if there is a risk of the dollar’s demise, why is the world still trading in dollars? Stephen Lejeune argues that the dollar will eventually lose its role as a settlement currency, but this is not a near-term issue. He emphasizes that, because there is no alternative to U.S. financial markets in terms of size, stability, or openness, competing with the dollar is difficult. A clear example of this is oil.

India can make payments for Russian crude oil in rupees, and China can make payments to Saudi Arabia for oil in yuan, but despite all this, the global oil market’s dominant currency is still the dollar, because the volume of financial agreements for oil is much higher than direct trade between a few countries. Among developing nations, only China can challenge the U.S. as the financial centre of the world. However, for this, it needs to create an open and liquid market for trade financing agreements.

Even if Saudi Arabia, the world’s largest oil exporter, were to agree to sell all its oil to China, the world’s largest oil buyer, in yuan, the share of the Shanghai Energy Exchange in the global oil market would only rise from its current 5% to 7%. If this is the case, then is the U.S. itself afraid because of the dollar?

Former U.S. Treasury Secretary Larry Summers says it is important to remember how the dollar replaced the pound as a reserve currency. He states, “History is clear: the dollar can lose its status as a reserve currency, but when that happens, the world will face many other serious issues. The only way the dollar will lose its global standing is if the U.S. loses its influence in the world. It’s not enough that the U.S. either wants to or doesn’t want to support the dollar’s dominance. The dollar has tremendous advantages as an international currency, mainly due to large, liquid, and well-functioning financial markets.”

“If the U.S. continues to make new mistakes and stops learning from history, there will come a time when the world moves away from the dollar. Many countries are already trying to move away from it, but they are not succeeding.” Countries like China or Saudi Arabia, with large trade surpluses, have nothing else to store their savings. There is no easy or liquid alternative to storing trillions of dollars in assets. Some well-known experts even argue that the dollar’s dominance is detrimental to the U.S. because being the issuer of the world’s most important reserve currency is not a privilege, but rather a burden.

The demand for dollar-denominated assets allows the U.S. to cover its large trade and budget deficits. Michael Pettis, an American economist at the Carnegie Centre in Beijing, says, “This is not good. The foreign capital entering the U.S. doesn’t lead to more investment. It is just stored as savings and adds to national debt. Financial markets only help the economy up to a certain point, after which they end up benefiting banks rather than the country.” According to him, “A weakened dollar would benefit the global economy, but it would be extremely painful for countries with trade surpluses.”

Now, the question is: Is there any alternative to the dollar in these circumstances?

Historian Ferguson has a great quote on this. In fact, this is the same quote advocated by former U.S. Treasury Secretary Larry Summers, whose signature appears on dollar bills. According to them, “What you have, you cannot exchange for what you do not have.” There is no alternative to the dollar because “Europe is a museum, Japan is a nursing home, China is a prison, and Bitcoin is an experiment.”

The only alternative to Western currencies for holding reserves could be the yuan, but for this, China would need to make significant changes. Reforms and transparency, incentives for savings, and the removal of controls on the movement of capital are necessary. Liquidity is a major issue because China imposes restrictions on foreign investment in both its financial markets and capital exports.

If these restrictions were lifted, private capital would flow within their jurisdiction. However, economists acknowledge that the yuan could gradually become a reserve currency. According to a recent study by American and European economists, China is actively promoting the use of its currency in trade settlements, causing yuan to accumulate in the central banks of its trading partners.

However, experts also say that China’s attempt to internationalise its currency will not ensure the dominance of the yuan, but rather create a multipolar currency world where the dollar, euro, and yuan coexist. This is true, but such a scenario is still a long way off. Holding money in yuan is one thing; desiring it is another. The ability to buy and sell dollars worldwide is unlimited, while yuan trade outside China takes place only in Hong Kong and a few dozen small centres.

Nevertheless, for these reasons, historian Ferguson’s statement is closest to the truth that the race for dominance between the dollar, euro, and yuan could be described as a “tortoise race,” and it is also true that while America’s rivals are seeking an alternative to the dollar, developed democracies and America’s allies have no allergy to the dollar. However, it is also a fact that for the dollar’s decline, world peace must be established, and the American war establishment will not allow that to happen.