The Paper Dragon: Can the digital yuan become the world’s leading reserve currency

Against the backdrop of dollar inflation and sweeping sanctions against Russia, experts have begun discussing more actively possible changes to the global monetary system. The yuan, specifically its digital version, has already laid claim to the role of reserve currency instead of the dollar.

ForkLog has analysed how justified the talk of the “death” of the dollar is and why some countries advocate dedollarisation of their reserves.

How the dollar became the reserve currency

In 1944 forty-four countries signed the Bretton-Woods Agreement. By its terms, the value of each participant country’s currency was tied to the dollar, and the dollar itself to gold.

The dollar was chosen because the United States was then the world’s leading economy and possessed the largest gold reserves. Moreover, it was the only major country at that time not directly affected by World War II.

The end of the “gold standard” for the dollar in 1971 was brought by U.S. President Richard Nixon. Officially — to combat “speculators”. The real reason, in economists’ view, was that by that time the volume of dollars in circulation had grown too large because of spending on the Vietnam War and social programs, and Washington simply did not have enough gold reserves to back the currency.

Nixon’s decision proved historic. A world of free currency conversion emerged, and prices of currencies came to be determined more by the open market.

However the dollar continues to dominate as the global monetary unit in which states, organisations and ordinary people hold their reserves, and on which international finance and trade operate.

What the reserve currency status affords

For the United States, the dollar’s dominance among reserve currencies means virtually unlimited demand for it. This, in turn, allows the United States to run up national debt, which it uses to fund the economy—from federal programs to widespread subsidies for municipalities—driving growth for the entire country.

In 2011, after the first major wave of “printing” that followed the 2007 financial crisis, the national debt stood at $14.8 trillion. But since then it has grown to $29.1 trillion in 2021. This is more than 120% of GDP, though the recommended threshold is significantly lower.

Nevertheless, no default occurs in the United States: any amount of debt can be covered by issuing currency. After all, the dollar’s stability is simply believed, because the whole world economy runs on it.

The dollar’s influence on the debt market is not limited to the United States alone. Other economies also often borrow through dollar-denominated bonds, while issuing obligations in their own currency mainly for the domestic market. According to the BIS, in Q3 2021 the total external debt exceeded $13.4 trillion.

Clearly, the United States’ exceptional position does not please everyone, and loud criticism of this system began even during the Bretton Woods era. Thus, in the 1960s the French economy minister succinctly described the phenomenon of unlimited U.S. government debt as an “undue privilege”, and since then the term has become entrenched in academic circles.

The inflation threat

The dollar has been the main reserve currency for more than 80 years. But its history in this role has not been so smooth.

In the late 1970s the United States experienced uncontrolled inflation. Its level is closely linked to the currency’s stability and confidence. Rising inflation reduces its attractiveness.

In 1979, following painful economic reforms, the annual inflation rate reached a record, exceeding 13%. It later fell, but in some years it could rise again. As a result, the dollar’s share in global reserves declined from 85% in 1977 to around 45% in 1991.

Then the dollar’s importance in global finance rose again — the USSR collapsed, the United States became the ultimate leader, and the world was predicted the “end of history.”

By 1999 the dollar’s share in global reserves rose to more than 70%, but then a second event occurred — the euro appeared. Since then its share has declined: central banks actively diversify holdings.

Today the global monetary system is already quite diverse. According to IMF report, by 2021 the dollar’s share in global reserves fell to a 59% 25-year low. Next comes the euro, whose share hovers around 20%, then the Japanese yen (5.6%) and the British pound (4.8%).

And only behind them sits the Chinese yuan with a 2.8% share. Despite China being the second-largest economy in the world, its currency is not viewed as an effective store of value or exchange (China is the world’s largest exporter). At least for now.

The yuan is not the main reason for the wobbling confidence in the dollar; it is fear of inflation rising.

In spring 2020, in response to the pandemic, the U.S. authorities launched the largest stimulus program in history. Over the year the Fed added several trillions of dollars into circulation. In the short term the stimulus worked: instead of a crisis, stock markets surged, and the cryptocurrency market joined the trend.

However, excess liquidity collided with the deficit caused by the pandemic, and led to a sharp rise in commodity prices. In the U.S. in particular, the rise in prices for building materials, notably lumber, became meme material.

Spiking prices pushed up inflation in the dollar, and in February its value reached 7.9% on an annualised basis. This was a record since 1982.

As history shows, inflation is dangerous for the reserve status of the dollar, because it essentially “eats away” at savings. Investors have repeatedly voiced concerns about this scenario. Perhaps the loudest call to abandon investments in the dollar (and fiat in general) is from Ray Dalio. And billionaire Elon Musk, in a half-ironic manner, said that due to inflation threats he will continue holding cryptocurrencies, and advised investing in “physical assets”.

Financier Stanley Druckenmiller also fears that the long-term stability of the dollar is undermined by regulatory mistakes in the U.S. economy. According to his forecast, the American currency will cease to be a reserve within the next 15 years.

“I can’t find a single period in history when monetary and fiscal policy were as far from economic realities,” he says.

Paradoxically, even against the backdrop of a sharp inflation surge, the dollar’s value relative to other currencies has not changed. The famous DXY index, which tracks the dollar against a basket of currencies (the euro, the Japanese yen, the British pound, etc.), has by 2022 returned to the late-1990s level. In other words, dollar inflation accelerated, but the same happened with other major currencies.

One way or another, but in the latest month inflation was joined by another risk — political.

Dedollarisation as a response to sanctions

On February 24 Russia invaded Ukraine. Since then, more than 40 developed countries have imposed various economic sanctions to halt Moscow’s aggression.

One of the most extensive measures, as ForkLog reported, was the freezing of Russia’s international reserves.

The Russian central bank stores a significant portion of state wealth in reserve currency—the dollar. The regulator explained that this is ordinary practice enabling it to prepare for possible financial crises:

“In difficult situations they (the reserves) ensure the payment of foreign currency debt, critical imports, stabilise the currency market. Keeping reserves domestically or spending them domestically is the same as not having any reserves, no protection from external crises.”

These funds were held in Western banks, and it was these reserves frozen by Western authorities in response to the invasion — around $300 billion, roughly half of Russia’s state reserves.

Because of this, Russian authorities lost the ability to influence the ruble through standard methods, and it began to plunge. The threat of hyperinflation emerged, which was only prevented thanks to unprecedented restrictions on foreign currency circulation inside Russia.

In addition, the Russian state could lose the ability to settle foreign debt obligations from frozen accounts, risking default.

Such measures were introduced for the first time, but experts talked of the “weaponisation of finance.” For authorities in other countries, especially those unfriendly to the United States or to some of its allies, this could be a signal that using the dollar is no longer safe for them. Moreover, among the closest American allies are issuers of other reserve currencies, such as the United Kingdom, Japan or Australia.

An obvious step for states that feel political risk is to cut the share of the dollar and allied currencies in their reserves in favour of another asset. For instance, the currency of the world’s second-largest economy and a political rival of the United States — China.

Primarily this concerns China’s trading partners. Back in 2019 Venezuela, whose economy was wrecked by Maduro’s usurpation and U.S. sanctions, proposed to pay for its oil shipments in yuan. The idea was never implemented.

Russia has had more success. In recent years the Kremlin, pursuing political aims, has steadily increased trade with China. Russia exports mainly raw materials — oil, gas and coal — to China, while it imports technological products. Earlier this year the Russian government said it planned to raise annual trade with China to $200 billion by 2024.

These countries not only trade more with each other, but also settle increasingly in their own currencies. As Russia’s trade envoy to China Alexey Dahnovsky reported, the share of settlements in rubles and yuan between Russia and China has grown from 1% to more than 10% over the last six years.

In the West, greater concern was sparked by reports that Saudi Arabia, a traditional U.S. ally in the Middle East, is negotiating with China to sell part of its oil exports to the PRC in yuan.

The phenomenon of large oil exporters trading with China not in dollars has been dubbed the “Petroyuan.” This trend is unlikely to stop: as early as 2017, China became the world’s top oil importer, overtaking the United States, and its fuel needs are rising.

In response to Western sanctions, the Kremlin seeks to abandon the dollar in its trade with other countries. From the European Union it “demands” to pay for gas in rubles, and it offers India to trade in national currencies as with China.

The role of the digital yuan

Moving away from the dollar and the euro in foreign trade for Russia and any other country is a way to reduce dependence on foreign currency and its share in international reserves. However using different currencies carries additional complexities.

On the one hand, this risks depreciation of savings due to exchange rate movements, and the currencies of most developing countries are weak. On the other hand, this implies more complex “logistics” for monetary operations, as the global financial system is set up for trade mostly in the American currency.

This is where China can offer a technological edge with the digital yuan (e-CNY, DCEP). Moreover, this is the world’s largest exporter, supplying products to almost all countries: in 2020 the value of China’s exports of goods and services exceeded $2.3 trillion.

Digital currencies are not just fiat in electronic form. They are programmable assets, the features and accessibility of which the state can regulate flexibly. In addition, digital currency offers far more capabilities in terms of tracing.

From the user’s perspective, transfers should be cheap and fast. In the current financial infrastructure this is almost impossible, since a large number of intermediaries are involved in each transfer. In other words, cross-border transfers require high transaction costs.

Moreover, the global banking infrastructure is represented by such organisations as SWIFT or BIS, which are also located in Western jurisdictions. For the Chinese DCEP, according to its white paper, there is no obligation to open a bank account.

At the same time, the document’s authors acknowledge that applying the e-CNY in international trade will be difficult, and this asset is intended primarily for domestic use. Yet in practice Chinese authorities are still testing cross-border payments with the digital yuan. One such experiment involving Hong Kong became known in spring 2021. A few months later the new phase started.

Moreover, there is evidence that China will begin using the e-CNY in the Belt and Road project, which envisages PRC investments in infrastructure across Eurasia and Africa.

China rarely signals plans to make the yuan a new reserve currency. The last time this was openly stated in autumn 2021 by the People’s Bank of China (the central bank). There they stressed that the right to issue digital currencies will become a “battlefield between states,” and China must win by issuing its CBDC first.

Developing the digital dollar

This is precisely the scenario described above that worries the United States, so some policymakers call the digital yuan nothing less than a threat to national security.

Experts also share this view. According to fintech consultant Richard Turrin’s forecast, China will use its status as the main exporter and try to substitute the dollar with DCEP in international trade:

“If we talk about the outlook for the next 5-10 years, yes, the digital yuan could play a substantial role in reducing the dollar’s share in international trade,” he says.

While China has been developing the digital yuan since 2014, the United States began work on its CBDC relatively recently. Only in February this year did MIT, in collaboration with the Fed, release a white paper and the source code for the digital dollar.

Gradually, the White House is beginning to recognise the importance of this project: in early March, Joe Biden ordered federal agencies to strengthen work on regulating cryptocurrencies and to assess the need for issuing a digital dollar.

CBDC would help the United States maintain the dollar’s reserve status, Bank of America asserts. They forecast that the e-USD will appear between 2025 and 2030.

The stability factor

China’s economy is large, and issuing CBDC could give a serious technological edge. But that is not all that the yuan needs to reach reserve currency status.

The key criterion is global trust in China’s economy, the state and prospects of which determine the currency’s attractiveness. China’s economy has shown rapid growth for decades, but many experts forecast a serious crisis in the PRC caused by accumulated problems.

The economy of China, based on manufacturing, is characterised by extremely high indebtedness. Debt estimates vary, but according to some data in 2020 it exceeded 330% of GDP. The bulk is not state debt but corporate debt. Yet given China’s authoritarianism, drawing a line between business and state is difficult.

Concerns also relate to the opacity of the Chinese economy. Experts believe authorities hide the real scale of indebtedness — in particular local government debt, which has reached nearly half of GDP. Large infrastructure projects such as high-speed rail are a significant source of debt.

Extensive, unchecked rapid development has led to the emergence of ghost cities in China, with millions of empty homes. And a consequence of high indebtedness was the default of Evergrande, China’s largest property developer, whose assets were valued in 2020 at more than $300 billion. This is not the only company that could collapse under the weight of its debt.

China has exhausted another economic advantage — a large number of residents willing to work for low wages. The average income of Chinese in 2019 was higher than in all BRICS countries except Russia. China’s population is among the fastest-aging in the world, and the birth rate in 2021 fell to a 60-year low. Labor productivity in the PRC grows slower than the economy and remains at a low level.

All of this are problems that weigh on China’s long-term prospects, hence also the yuan. Unfortunately for the PRC, time and history are on the side of the United States: its economy has weathered crises and remained the leading economy for more than 100 years.

Imperfections of digital currencies

Although digital currency is a step forward compared with modern money, both systems share one trait — centralisation. A CBDC is the same money issued and controlled by a single state body — the central bank.

There is an alternative — cryptocurrencies, notably Bitcoin. These are private money that do not belong to any single organisation. A few years ago, the value of Bitcoin was recognised only by marginal figures. Now it is an attractive asset that penetrates deeper into the financial system.

And in 2021 El Salvador became the first country not only to legalise Bitcoin but also to start storing its reserves in it.

This is a small, but real step towards Bitcoin continuing to spread as a reserve asset. Among states, as predicted by analysts at major investment firm VanEck.

In finance, Bitcoin has long been an alternative to the dollar and other currencies: as Mike Novogratz put it — a hedge against government missteps. It is possible that in the future this quality could allow Bitcoin to undermine fiat currency hegemonies — digital or not.

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