In global trade, the U.S. dollar remains the reserve currency of choice. Used in 85% of international currency transactions, King Dollar reigns supreme.
But for how long? Over the past several years, a prince among currencies has been growing in stature and influence, keenly intent on one day usurping King Dollar’s throne.
That prince is the Chinese yuan, which has been rapidly growing in use in intra-regional trade in Southeast Asia. Now, a recent development in Russia could be the Chinese yuan’s first step toward expanding its influence outside of Southeast Asia.
USD beware… the Chinese yuan is on the rise.
Russia: The Yuan’s First Inter-Regional Conquest
“Over the last few weeks there has been a significant interest in the market from large Russian corporations to start using various products in [Chinese] renminbi and other Asian currencies,” head of Deutsche Bank Pavel Teplukhin informed the Financial Times.
Some of Russia’s largest corporations are seriously considering switching from USD to yuan “amid fears that western sanctions may freeze them out of the US dollar market,” FT explains, as sanctions by Western governments threaten to block currency transactions of several influential Russian politicians, businesspeople, and corporations.
“If something happens,” speculated one Russian manufacturer currently transacting 70% of his international trade in USD, “we are ready to switch to other currencies, for example to the Chinese yuan or the Hong Kong dollar.”
A European banker interviewed by FT opined that Russia’s move to “reduce its dependency on the dollar” is “an entirely reasonable thing to do.”
“There is no reason why you have to settle trade you do with Japan in dollars,” he illustrated.
Alexander Dyukov, chief executive of Gazprom’s oil division — one of the world’s largest oil exporters — indicated his company is already considering redenominating its sales contracts from dollars to yuan. Russia’s Norilsk — one of the world’s top nickel and precious metals producers — revealed it is discussing yuan-based contracts with its Chinese customers.
For now, the switching of currencies in trade contracts is only being explored. Andrei Belousov, economic adviser to Russian president Putin, downplayed the chances of an official national change in reserve currency: “As long as Russia is not subject to systemic sanctions, which could bring an artificial limit to our economy’s access to dollars, then I don’t think Russia will take any steps in order to bring about artificial de-dollarisation.”
However, Mr. Teplukhin of Deutsche Bank said, “It looks like this is not just a blip; this is a trend,” summarizing the increased leaning of Russian corporations toward the yuan.
The Impact of a Russian Switch
If economic sanctions imposed on Russia by Western governments do become systemic, affecting the entire nation as a whole, and if the trend of currency switching by some Russian corporations spreads across the entire Russian economy, how much of an impact will there be on the U.S. dollar’s strength?
Certainly the reduced demand for dollars should have some effect on its value. Yet not by much. The only way to try to quantify the impact would be to consider Russia’s percentage of global international trade — excluding domestic trade, which would naturally remain denominated primarily in the Russian ruble.
According to the CIA World Factbook, 2013 imports by all countries worldwide combined for a total of $18.09 trillion of trade, while total exports amounted to $18.48 trillion, equaling $36.57 trillion of total global international economic activity. Russia’s portion of global international trade amounted to $341 billion worth of imports and $515 billion in exports in 2013 — totaling $856 billion, or 2.34% of global international economic activity.
Thus, even if every Russian company conducting international trade were to stop using the USD and use the yuan instead, the impact on the USD’s demand and value would be negligible.
The actual effect would, in fact, be even less considering that only transactions with Eastern regions — such as China, Japan, and Hong Kong — are in the process of switching to the yuan. It is unlikely that Russia’s trade with the Americas would abandon the USD, implying an even less-than-negligible effect on the USD’s demand and value.
For now, that is. Indications are that things are already changing. According to a 2012 paper by the World Trade Organization, the Chinese yuan is gaining ground and may one day close in on the USD’s lead.
The Characteristics of a Global Currency
The paper “Use of Currencies in International Trade: Any Changes in the Picture?” released by the World Trade Organization’s Economic Research and Statistics Division in May of 2012, reveals that a shift in currency use in international trade is indeed taking place.
“The paper reviews a number of issues related to the use of currencies in international trade,” the publication specifies its purpose in its preface. While reviewing the reasons behind “the current dominance of the US dollar and the euro in international trade,” the paper ultimately discovers that “in the medium-to-long term, the RMB [Chinese renminbi, the basic unit of which is called yuan] will become a major currency of settlement in international trade.”
But before the RMB can become as dominant as the USD and euro, it must satisfy four requisite characteristics of a global reserve currency as outlined in the 1996 paper by Princeton University Economics Professor Alan Blinder, vice-chair of the Federal Reserve from 1994-96.
According to Blinder, a reserve currency must be:
a) an international currency accounting for a preponderant share of the official reserves of central banks,
b) a currency used “hand-to-hand” in foreign countries,
c) a currency in which a disproportionate share of international trade is denominated, and
d) a dominant currency in international financial markets.
One key to satisfying these requisites is liquidity. There must be an awful lot of it in circulation to allow for easy, low-cost transferability. Think of the bid/ask spread of a stock. The higher the trading volume is, the narrower the bid/ask spread is, and the less you lose when trading it.
A second key to a currency’s widespread acceptance is stability, with minimal fluctuations in value compared to other currencies. “In a seminal paper, Goldberg and Tille (2008) showed that exporters are eager to limit the fluctuations of their prices relative to that of the goods of its competitors, when the goods are substitutes, and hence for this reason would opt for the invoicing currency of their competitors (the so-called coalescing effect),” explains the WTO.
In other words, international merchants prefer to use the currency most in-use by its competitors to avoid losing to their competition in the case of currency fluctuations.
For these two reasons — liquidity and stability — once a currency becomes the dominant money, everyone flocks to it, which keeps it all the stronger.
Explaining this power of “inertia” in a 1980 paper, Professor Paul Robin Krugman of Princeton University “argued that the more a currency is established, the more difficult it is for users to shift to other currencies,” the WTO references. “There are clearly lower transaction costs in using a widely available and liquid currency.”
Yet recent policies in China focusing on the yuan’s “liberalization” — which includes allowing it to circulate more freely — “have revived the discussion on currency use in international trade, a discussion that is now further fed by the creation of an off-shore market for the renminbi, and the large appetite of the market for local currency financing of trade in the Chinese currency,” the WTO explains.
“This is not only the current direction of [Chinese] government policy but also that of markets, as evidenced by the rapid expansion of off-shore trade payments in that currency.” The yuan is gaining in use.
The Rise of the Chinese Yuan
Since a currency’s liquidity is vital to keeping trade costs low and its stability is crucial to the preservation of value, the recent financial crises in the West have turned many Eastern governments and corporations away from the USD and euro toward the yuan.
“Another motive for regional currency diversification [toward the yuan] is linked to the recent financial crisis involving the financial sector of the United States and other developed countries,” the WTO paper explains.
“Between the fall of 2008 and mid-2009, the US money market has been under stress as a result of a lack of confidence between banks operating in it.”
As a result, liquidity dried up, as banks had already lost way too much in the housing implosion and were reluctant to lend. Money was not circulating.
“In a tight market,” the WTO expounds, “the demand for US dollar re-financing of short-to-medium-term claims has been exceptionally high, from both resident and non-resident banks. This created a shortage in US dollars in off-shore markets,” including Southeast Asia.
But it didn’t end there. “This first episode of US dollar shortage was followed by a second episode at the turn of the year 2011,” the WTO continues, “when banks prepared for the implementation of new prudential rules known as Basel III” — requiring banks to increase their cash reserves, tying up more U.S. dollars in their vaults and effectively removing them out of circulation, “resulting in a new surge of demand for US dollars,” which was driving up its price.
To feed the increasing demand and bring the price of the USD back down, the U.S. Federal Reserve thus embarked on its quantitative easing measures to pump more dollars and liquidity into the markets.
But the damage had been done. “These episodes have only strengthened a growing sentiment in Asia of vulnerability toward access to US dollars in periods of stress,” the WTO furthers. As such, “the demand for local currency invoicing and settlement has increased.”
China, Southeast Asia, and now Russia are fed up with the low liquidity and rising costs of dealing in the USD and euro, not to mention the still-present risk of repeat crises. In response, the yuan is growing in use and dominance, not only within the Southeast Asia region, but also penetrating outside of it.
“The success of RMB’s use triggers new questions as to the future panorama of currency use in world trade and the event of a multi-currency environment in the future,” the WTO foresees. The USD may not remain the de facto reserve currency for long.
Joseph Cafariello
