In recent years the Chinese government has made a concerted effort to internationalize the yuan and challenge the US dollar for monetary supremacy. It has taken multiple steps to increase its use as a central bank reserve currency and further its adoption in international trade. Most notably, it will likely become the first major country to introduce a sovereign digital currency, which is being billed as a technologically-superior form of money.
Through these actions, and Beijing’s openness in stating its intentions to unseat the dollar, it has become popular to refer to China’s efforts at internationalizing the yuan as a Currency Cold War. At first glance it can be easy to make this comparison. Like the actual Cold War fought between the United States and the Soviet Union, this alleged struggle is being waged off the traditional battlefield. Additionally, it involves two global powers, one which happens to be communist, that have diametrically opposing viewpoints about how the world should be governed.
That said, while tensions are certainly growing between the two countries, a Currency Cold War is not the right way to explain recent Chinese behavior regarding the yuan for several reasons. Most notably, there is currently only one actively engaged party in this dynamic. America has been passive when it comes to protecting dollar primacy, and despite some calls to action, that stance does not appear to be changing anytime soon.
So, if this is not a Cold War, what is it? The answer (in my view) is that China is waging a digital currency insurgency on the global financial system, and specifically the primacy of the dollar. Like all insurgencies, it is animated by a core belief—namely the conviction of Chinese officials and citizens alike that the country is ready to claim its rightful leadership place in the world, not only politically and militarily, but also when it comes to commerce and finance Yet as an insurgency, it uses unconventional tactics and weapons whose effectiveness may not be fully appreciated by the incumbent power. In this case, China’s superiority in fintech and its forthcoming sovereign digital currency are just such weapons.
Thinking of China’s efforts as an insurgency helps explain its tactical approach and overall strategy, and it underscores the substantial challenges that it continues to face in trying to unseat the dollar as a financial hegemon and safe haven of last resort. Using the right framework to evaluate China’s strategy and progress can provide investors with guideposts to identify whether or not the yuan will assume this mantle in the future.
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Not a Cold War
One key reason why Cold War analogies are misguided is that unlike the post-World War II period, there remains a profound imbalance of power between the two currencies. For instance, although the renminbi (RMB) is the fifth most active currency for global payments by value, according to Swift’s monthly RMB tracker, in August 2020 its market share was just 1.91%. This was actually down from August 2018. Conversely, the dollar reigns supreme with a market share of 38.96%. For another example, as of this past May the US dollar constituted 62% of central-bank reserves around the world.
When power imbalances are this great the strategic calculus and decision-making on both sides changes. The smaller party tends to fight tactical battles that it believes it can win, while avoiding directly inviting the larger counterpart into open conflict. Conversely, the larger party tends to be slightly more passive (or even oblivious) and rests on its laurels, as the US has done as it continues to take the continued primacy of the dollar for granted.
It’s easy to see how the U.S. might be lulled into this mistake. The dollar seems to have a teflon coating. Any time there is global strife, such as when pandemic-panicked markets crashed back in March, taking bitcoin and other cryptocurrencies with them, money rushes to the safety of the dollar. To the extent that the US government is concerned about protecting its position in the world’s financial plumbing, it seems most focused on the continued effectiveness of financial sanctions that it uses against rogue nations and individuals.
Characteristics of a Currency Insurgency
According to the declassified 2011 Central Intelligence Agency’s Guide to the Analysis of Insurgency, insurgent warfare is “designed to weaken government control and legitimacy while increasing insurgent control and legitimacy”. This characterization perfectly explains Chinese behavior when it comes to internationalizing its currency.
First, China is laying the groundwork for future control through economic development programs and proactive influence campaigns like getting it included in the International Monetary Fund’s Special Drawing Rights basket. For instance, it has actively taken steps to internationalize the yuan through swap agreements, appointment of yuan-clearing banks in 20+ countries around the world, and using economic development packages such as the ‘Belt and Road Initiative’ to drive further adoption of the currency.
Second, and perhaps most importantly, it has been leading the charge of central bank digital currencies with the development of its ‘digital yuan’, which will shortly become the first sovereign digital currency issued by a major economy. Although we still do not have a confirmed launch date for the digital currency, it appears to be soon. Additionally, the digital yuan has been making substantial headway. For instance, as of October 5th it has been used for more than 1.1 billion yuan (US$162 million) worth of transactions as part of a series of ongoing pilot programs taking place around the country. In one of the newest trials, authorities in Shenzen are going to be giving away $30 worth of the currency to residents through a lottery program for use at almost 4k merchants in a local district.
This matters for a few reasons. First, a successful launch will further burnish China’s reputation as the global leader in financial technology, earned through the global expansion of major technology platforms such as Alibaba
Second, the potential benefits that would come from a widely-used digital currency, such as better control over the economy and more targeted stimulus measures will buttress its economy as it recovers from the pandemic. Finally, completion of these two steps would provide ample messaging opportunities to discredit the US and expand China’s global footprint.
Who Will Win?
Most insurgencies fail because they falter from within, cannot expand their base behind core followers, or they are beaten by their adversary. Those that succeed often do not proceed to victory in a linear path, and investors need to anticipate an uncertain path.
There are roadblocks, potholes, and challenges along the way. For instance, it must have been disheartening to Chinese officials to see investors and central banks across the globe rush into the dollar when markets crashed in March. Additionally, right now China has been plucking the low-hanging fruit—like the initiation of swap agreements and issuance of RMB-denominated loans to emerging markets—when it comes to internationalizing the yuan. The hard stuff will come later, when it will face pressure to relax control over its capital markets and financial sector to build investor confidence. These types of transitions can be very difficult, especially in a one-party state with an economy that remains under duress and relies on economic prosperity for legitimacy. Additionally, China’s global reputation has been battered, especially among developed economies, in light of widespread criticism for how it has handled the pandemic.
On the American side, conversations are continuing to gather momentum when it comes to revitalizing its payment system and perhaps creating a ‘digital dollar’, some of which have been accelerated due the desire for fast responses to the pandemic. However, it is still hard to see anything that amounts to the laser-focus coming out of Beijing. Additionally, when it comes to concern about digital currencies, western governments seem more concerned with private-sector alternatives such as Libra.
All of that may change if the digital yuan makes substantial headway, but for now it seems that the digital yuan will have some freedom to grow.
How to Play It?
One day the dollar’s hegemony will be ended, either by the digital yuan, bitcoin, libra, another form of money, or some combination of the above. It is important to recognize these patterns so investors can anticipate where money will flow during times of strife.
The most likely outcome is that when the dollar falls the financial system becomes a multipolar world, suggesting that investors will require additional diversification in its ‘safe haven’ portfolio. The yuan may certainly deserve a place in this portfolio, especially as the Chinese economy continues to recover, its bond market offers higher yields than other places around the world, and the yuan continues to appreciate (as it has YTD).
Making these determinations will require a close eye active management. By treating Chinese currency strategy as an insurgency, we have a better template to follow its progress.
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