Keywords

Geopolitical Risks, De-Dollarization, and RMB Internationalization

The global economy is currently on a path of de-globalization and geoeconomic fragmentation (GEF). Geopolitical risks are shaping global business environment and policy makers have to manage a diverse range of geopolitical risks. Some geopolitical analysts have termed this situation a new geopolitical risk “supercycle” (a term borrowed from astronomy). We are witnessing an emerging rebalancing of the international order, such as a new strategic balance in the triangle of US-China-Russia relations, NATO expansion, the Saudi-Iran diplomatic deal, escalation of the Ukraine-Russia war with an increased risk of nuclear accidents, US tech tariffs and industrial policies that adversely affect China and the EU, a wave of strikes and mass protests, and mega-elections in 2024 in countries with significantly different systems, the sudden return of a banking crisis in the US, EU, and Switzerland, and the rising prospect of recession, secular stagnation or stagflation with the likelihood of continued interest rate hikes by major central banks, which could create in a tipping point in systemic risk in the short-term. There are also “hidden risks” that could suddenly come to the surface and create a set of several overlapping crises (a “polycrisis”) that could have higher level of synergy and a greater impact on global economic development.

According to the latest IMF projections, “the baseline forecast is for growth to fall from 3.4% in 2022 to 2.8% in 2023, before settling at 3.0% in 2024. Advanced economies are expected to see an especially pronounced growth slowdown, from 2.7% in 2022 to 1.3% in 2023. In a plausible alternative scenario with further financial sector stress, global growth declines to about 2.5% in 2023 with advanced economy growth falling below 1%. Global headline inflation in the baseline is set to fall from 8.7% in 2022 to 7.0% in 2023 on the back of lower commodity prices but underlying (core) inflation is likely to decline more slowly. Inflation’s return to target is unlikely before 2025 in most cases. Tentative signs in early 2023 that the world economy could achieve a soft landing—with inflation coming down and growth steady—have receded amid stubbornly high inflation and recent financial sector turmoil. Although inflation has declined as central banks have raised interest rates and food and energy prices have come down, underlying price pressures are proving sticky, with labor markets tight in a number of economies. Side effects from the fast rise in policy rates are becoming apparent, as banking sector vulnerabilities have come into focus and fears of contagion have risen across the broader financial sector, including non-bank financial institutions. Risks to the outlook are heavily skewed to the downside, with the chances of a hard landing having risen sharply” (IMF, 2023a).

While China has good prospects for growth recovery, rising geopolitical tensions have intensified concerns about global economic and financial fragmentation (Aiyar and others, 2023). An increase in geopolitical tensions could have serious adverse effects on macro-financial stability (see more, in: IMF, 2023). Geopolitical tensions could also lead to financial instability through an adverse pattern of international capital flows (capital reversals), “sudden stops,” and financial market disruptions. These adverse shocks could lead to greater exposure of emerging and advanced economies to volatile cross-border flows and re-allocation of capital, portfolio rebalancing of cross-border banking groups with increased vulnerabilities of financial systems as a consequence.

Spillover effects are significant due to the globalized international financial system. Although it is fair to say that these adverse effects of geopolitical tensions on macro-financial stability could be “asymmetric,” depending on a country’s specific economic and governance structure, and regulatory environment, central banks could rebalance their portfolios or more specifically change the currency composition of their international reserves in an environment of rising geopolitical tension. Another issue related to rising geopolitical tension is the weaponization of financial instruments and currencies (imposition of economic and financial sanctions, unilateral seizure of international reserves holdings in foreign banks, etc.). The result of this is that countries will start to trade with their geopolitical partners and allies, invoicing in national (local) currencies and shifting cross-border flows toward local currency settlements, mostly via bilateral agreements between respective central banks, thus reducing US dollar transactions (on de-dollarization, see more in: Tett, 2023; Earle, 2023) and global reserves (see Aiyar and others, 2023 on the implications of geoeconomic fragmentation on currency composition of global reserves).

The process of de-dollarization has progressed with great stealth, but it is clear that there has been a decline in the dollar share of international reserves since the turn of the century (see more in, Arslanalp et al., 2022). According to the IMF's Currency Composition of Official Foreign Exchange Reserves (COFER) survey, the share of reserves held in US dollars by the central banks dropped by 12 percentage points since the turn of the century, from 71% in 1999 to 59% in 2021. This is the result of portfolio diversification strategies by central bank reserve managers. Of course, there is also the repositioning of the geopolitical balance of power. Due to the increased economic importance of China, geopolitical balance of power has shifted toward an inverted US-China-Russia triangle.

The shift from dollars has gone in two directions: a quarter into the Chinese RMB and three quarters into the currencies of smaller countries that have a limited role in global economy and international reserves (so called, “nontraditional reserve currencies,” defined as currencies other than the US dollar, Japanese yen and British pound sterling). There are three determinants for such a portfolio rebalancing by central banks: growing liquidity of markets of those currencies; reserve managers seeking higher returns on their portfolios in low or negative interest rate environments as defined by the US Federal Reserve and ECB (zero or negative interest rates are the result of expansionary monetary policy, QE); and the fact that yields on bonds issued by governments of the “Big Four” (the US dollar, the euro, the British pound, and the Japanese yen) have fallen to zero, driving reserve managers to find alternative portfolios with higher yields. These developments have led to a more multipolar (multiple-currency) international monetary order and new international reserve system. Since its inception, the biggest potential rival of the US dollar has been the Euro, because it was accepted as a credible international reserve currency. All the while, the Euro's share of reserves has remained around 20%. But, as an alternative reserve currency, the Euro has its limits due to the inherent instability of the European Monetary Union (see more in Gros and Schout, 2023). This was clearly evident in 2012 when the ECB introduced a new emergency rescue instrument—Outright Monetary Transactions (OMT)—and in July 2022 again when the ECB was forced to introduce a quasi-fiscal instrument—Transmission Protection Instrument (TPI)—to prevent Eurozone (bond) market fragmentation. After the global financial crisis (GFC) of 2008, China pursued a policy of a cautious but steady decrease of dollar reserves, as part of an “implicit de-dollarization strategy,” and a policy of rebalancing the portfolio of the PBOC (decreasing risk of its exposure to US treasury bonds).

Internationalization of the RMB includes increasing the role of the RMB as a reserve currency. This was the main reason why China called for the inclusion of its currency into the SDR basket of currencies of the IMF. The SDR basket is made up of the Big Four currencies plus the Chinese RMB. However, it was obvious that making the RMB a reserve currency would be a long-term process, but that it could be the final phase in the gradual strategy of RMB internationalization, resulting in China declaring de jure capital account convertibility by formally accepting all legal conditions set by the IMF. In the meantime, the most important policy move has been to increase the role of the RMB as a trade settlement currency and increase the share of the RMB in the international reserves of central banks that are major trading partners of China. COFER data shows that Chinese RMB accounts for about one-quarter of this increase (as a share of non-traditional currencies in international reserves), while non-SDR currencies make up the remaining three quarters. The increase of non-traditional reserves has mainly been in the Australian Dollar, Canadian Dollar, Chinese RMB, and Swiss Franc which together constituted about 71% of the non-traditional reserves portfolio by the end of 2020. Other non-SDR reserve currencies are three European (Swedish Krona, Norwegian Krone, and Danish Krone) and four Asian currencies (Korean Won, Singapore Dollar, New Zealand Dollar, and Hong Kong Dollar). In summary, the decline of the US dollar share in international reserves could be attributed to the move by central banks to include more non-traditional currencies in their reserve portfolios, one quarter of which can be attributed to Chinese RMB.

But, what can be expected in 2023 and beyond? If the European Monetary Union remains a fragile and unstable monetary union due to increased geopolitical risk as a consequence of the Ukraine-Russia war, EU-Russia decoupling, and a potential US-EU “subsidy war” started by the US Inflation Reduction Act (see Vela and Moens, 2022), the Euro could possibly lose its attractiveness as an international reserve currency. The inherent instability of the European Monetary Union is under scrutiny by capital markets. There are three scenarios for the Eurozone that range from business-as-usual, to deeper monetary and fiscal integration, and break-up scenarios (see more in Gros and Schout, 2023). According to this analysis, business-as-usual is the most likely scenario in the near future. The same applies to the Swiss Franc as an international reserve currency. Even after the collapse of Credit Suisse (CS), the future of Switzerland as a safe haven and its currency as a credible international reserve currency may also eventually be reconsidered by central bank reserve managers. The collapse of CS was followed by the collapse of Deutsche Bank (DB) stocks on capital markets (see Foy and Oliver, 2023), which forced the ECB and the Eurogroup to reassure the markets that it will act as a lender-of-last-resort (LOLR) if and when needed and that the Euro is a credible currency.

These developments could be a “window of opportunity” for China to increase the leverage of the RMB as an international reserve currency. There is also a parallel process of Chinese central bank portfolio rebalancing, while the share of the dollar in Chinese reserves remains about 58%, not far below the global average recorded by the COFER survey (see Arslanalp et al., 2022). China’s portfolio rebalancing can be viewed in terms of its reduction of China's US treasury bond holdings (UST). This could be attributed to two main factors: financial (low yield due to Federal Reserve monetary policy) and geopolitical (political tensions and trade restrictions between two countries) (see Leung and Tse, 2023). This reduction in US treasury bond holdings is a strategic option to reduce exposure to systemic financial risk by holding US dollar bonds in its foreign reserves portfolio and as a measure to hedge against increased geopolitical/geoeconomic risks. According to US treasury data, China's holdings of UST fell to USD 895 billion in January 2023, a 34.7% fall from its peak. Partial proceeds were reinvested into gold reserves, which jumped from 33.9 million oz in 2013 to 65.9 million oz in February 2023. Hong Kong, as the gateway to China's capital market, also reduced its UST holdings from USD 262 billion in early 2020 to an 8-year low of USD 179 billion in September 2022. The reduction of UST holdings by China is systematically driven by geopolitical determinants. But it is fair to say that the negative impact of the Sino-US rivalry on China's trade and FDI has been minimal so far. There is a strong interdependence between China and US as their two economies were successfully integrated in the process of globalization. This is the geopolitical framework for RMB internationalization in 2023 and beyond, and the reasons why we support a gradual strategy for RMB internationalization in an orderly manner.

The Chinese Approach to Capital Account Liberalization

The People's Republic of China (PRC) has been an active player in globalization. Comprehensive economic reforms entailed internal and external liberalization and the consistency between Reform and Opening Up enabled opening up to the outside to become a basic national economic strategy. Entry into the WTO was a landmark even in this process. The PRC liberalized its current account by accepting Article VIII of the IMF Articles of Agreement and set out a road map for capital account liberalization. However, the Asian Financial Crisis of 1997 stopped this process of capital account liberalization and the global financial crisis in 2007–2008 was a second episode in globalization that strongly influenced the speed and sequencing of China's capital account liberalization. Spillover effects from the US banking system brought China to the brink of massive capital losses in its foreign exchange reserves, especially in terms of its US government-sponsored enterprise (GSE) bonds. The fact that the PRC had fallen into the dollar trap meant that the PRC had to be satisfied with low returns on its foreign exchange reserves and shoulder large capital losses. This was the consequence of US-China economic interdependence and the export-led economic model of the PRC. Diversification was the exit strategy and China’s leadership started to consider possible strategies for stabilizing its PBOC reserves and domestic financial system from external shocks.

Interest in RMB internationalization surged rather suddenly in 2009, marking the beginning of a long-term process of external readjustment with intensive discussions on the sequencing of external reforms in China. This issue was and still is crucial for the success of economic reforms. RMB internationalization was accepted as an external reform strategy that could benefit the country in reducing exchange risks, reducing the need for holding more foreign reserves, lowering transaction costs in foreign trade, and improving the competitiveness of currency issuance in the country's financial sector (according to Yu, 2014). The PBOC implemented a so called “reversed coercive path” in RMB liberalization as a strategy for integrated gradual reforms of exchange rate regimes and capital account convertibility (He, 2015). For this to succeed, “recycle mechanisms” were highly important and the success of RMB as a currency widely accepted for trade settlement and establishing efficient offshore RMB markets was at the core of recycle mechanisms and this original innovative capital account liberalization strategy. There were different potential strategies for RMB internationalization and the PBOC adopted a “functional approach” (a term coined by Yu Yongding); that is, to promote the RMB as a settlement currency and investment currency (The Belt and Road Initiative was beneficial for this aspect of RMB internationalization), and finally, to make the RMB a viable foreign exchange reserve currency for central banks of other economies, in particular emerging market countries.

Capital account liberalization is at the core of the RMB internationalization strategy and remains the most important and most controversial policy of our day. There are different academic views, but also there are different implications for the desirability of liberalizing capital flows. Capital flows are drivers of cycles in market economies and it is fair to say that capital controls can help macroeconomic policies in open economies, because their systems are inherently unstable. Excessive capital inflows could lead to rapid rise of lending-led booms and asset price inflation, leaving open economies exposed to capital reversals and sudden stops. External imbalances could lead to balance-of-payments crises and cause asset bubbles to burst, as well as systemic instability and financial vulnerabilities. Cyclical dynamics are clearly related to the “financial cycles theory” or “inherent financial instability theory” (see more in Minsky, 2008). The main element in cyclical dynamics is the development of the boom phase, accompanied with an expansionary credit cycle and asset price inflation. These cyclical patterns are based on endogenous behavior of the agent's risk perception and expectations. Asset price bubbles inflated in the process and balance sheets of the financial institutions becomes vulnerable to sudden changes in international flows of capital. When a downturn starts, the contraction process begins and the process of this bubble bursting leads to a credit crunch and deleveraging, with debt-deflation crises as an inevitable consequence of the preceding expansionary policies. The basic idea of capital controls is to smoothly manage capital flows in order to prevent Minskyan cycles and to secure financial stability and macroeconomic equilibrium of domestic economy. This is an important lesson for China.

The Chinese approach to capital flows was gradual, selective, and targeted (see more in MacKinnon, 1993; Prasad and Wei, 2007; Yu, 2008; International Monetary Institute, Renmin University, 2021; Eichengreen and others, 2022; People's Bank of China, 2022), while capital controls have been implemented as a policy instrument against suboptimal structure of capital inflows and disruptive consequences of capital outflows by the residents and capital reversals by non-residents. This is a strategy of partial and controlled gradual liberalization of capital accounts, in accordance with the main principles of economic reforms to achieve sustainable growth and macroeconomic stability. It is a genuine economic strategy formulated by China's economic decision-makers in government and the PBOC, based on incremental and gradual capital flows measures (CFM/MPMs), based on a policy of “trial and error.”

China’s capital inflows have generally been dominated by FDI, which was a preferred form of inflow as they are stable and associated with other benefits, such as the transfer of technology and modern management practices. However, FDI has been targeted by market-type measures into manufacturing and less into real estate. Since 2001, there was an increase of FDI outflow as a part of partial capital account liberalization while debt-creating inflows were mainly restricted as a major element of capital account management and a balance-of-payments policy measure. International reserves substantially increased due to a mercantilist strategy and the trade surplus in China's current account of balance of payments. Reserve accumulation was a consequence of the Asian financial crisis, because it could support a fixed exchange rate regime and limited liberalization of capital account flows. We assume that the larger part of China's foreign exchange reserve holdings are in US dollar-denominated instruments, with the remainder in Euro-denominated instruments and monetary gold reserves. The high level of central bank reserves in treasury bonds from industrialized countries could expose PBOC to vulnerabilities should there be changes in the yield curve and an upward shift in the yield curve could significantly reduce mark-to-market values of PBOC holdings in treasury instruments of industrialized countries.

However, it is fair to say that these potential capital losses in mark-to-market terms should not be of concern for the central bank as long as it holds these instruments (bonds) to maturity. This argument is valid only if the central bank has no need to liquidate treasury bonds before maturity. In 2022–2023, central banks, in particular the US Federal Reserve, had to implement monetary tightening that will lead to an upward shift in the yield curve of treasury bonds. Consequently, the holders of the affected treasury instruments that are in need to overcome liquidity risk by selling such instruments will have to deal with mark-to-market losses. In fact, a similar situation triggered the banking crisis in the US in March 2023. Meanwhile, international markets are under stress from a new global financial crisis, with the potential to spill over from the US and the EU to other markets.

Our understanding is that the capital controls of the PBOC will successfully insulate China from negative spillover effects from international capital markets. However, certainly this will have negative effects as potential vulnerabilities of the domestic economy and financial system. The main benefit of capital account management is that China's monetary authorities are able to determine the composition of inflows and prevent the possibility of capital reversals, while preserving macroeconomic stability with limited capital account openness. China's approach to capital account liberalization has been an unconventional, or rather an unorthodox strategy of external liberalization, which is detrimental to the conventional strategy of removal of capital controls in order to achieve full capital account liberalization in accordance with IMF rules and policies. The truth is that this is a strategy of de facto capital account convertibility for RMB, with limited de jure capital account liberalization.

Capital account liberalization is closely linked to the exchange rate regime. In accordance with an IMF report on China (IMF, 2023), the de facto exchange rate regime has been classified as an “other managed” arrangement, effective March 3, 2022. The de jure exchange rate arrangement is “managed floating” with a view to keeping the RMB exchange rate stable at an adaptive and equilibrium level based on market supply and demand with reference to a basket of currencies to preserve the stability of the Chinese economy and financial markets. On each business day, the trading band of the RMB against the US dollar in the interbank foreign exchange market allows the trading prices of the RMB against the US dollar in the market to fluctuate within a band of ± 2% around the midrate released that day by China’s Foreign Exchange Trading System (CFETS). In 2015, PBOC increased flexibility of the RMB-to-USD exchange rate, enhancing the role of the FX market. Capital controls apply to most capital account transactions, but use of the RMB in international transactions has expanded over time. Effective October 1, 2016, the RMB was determined to be a “freely usable currency” and was included in the SDR basket.

In essence, exchange rate regime has been gradually changed from a fixed system (pegged to the US dollar) to more flexible arrangements (pegged to a basket of currencies), with the intention to enhance the flexibility of the exchange rate system, but in the same time to enable stability of the system (with narrow trading bands or “intervention points” in relation to the central parity of the RMB and FX interventions of the central bank). We could classify such a system as an “intermediate regime” or a floating exchange rate regime, supported with an inflation targeting monetary strategy and extensive use of capital controls (for more on intermediate exchange rate regimes, see: Williamson, 2000). The open economy trilemma was the most important constraint in China's policy options, but China was successful in determining its policy trilemma as a synchronized and complex strategy of limited capital account liberalization, enhanced flexibility in exchange rate regime and independent monetary policy of the PBOC. This was crucial for the success of the economic reforms in China.

De Facto Convertibility of RMB

The ultimate goal of RMB internationalization is to acquire de jure status as an international reserve currency. But, this is a long-term process that requires full capital account convertibility and removal of all capital controls in accordance with the IMF Articles of Agreement. RMB internationalization and full capital account convertibility should be preceded by deep structural reforms, especially in the banking industry. This would not lead to RMB dominance in the international financial markets, but it could create a multipolar world of key currencies, in which the dollar, the euro, the RMB, and other major currencies participate in international capital transactions. Such a multilateral process has been magnified in light of the geoeconomic fragmentation and huge geopolitical risks appearing in 2023. All these show that the process of de-dollarization is accelerating in both depth and breadth. A multipolar world of key currencies will have a certain hierarchy of reserve currencies and the RMB could play a greater role in international capital markets as an alternative to major reserve currencies. The main elements of full capital account convertibility include the ability to make international transfers (payment infrastructure) and free conversion to other reserve currencies that have full capital account convertibility (external convertibility). Transferability and conversion are the most important elements of de jure and de facto capital account convertibility. China's central bank maintains extensive capital controls on capital account flows and their removal is not possible in the near future. In addition, due to the increased geopolitical risks and geoeconomic fragmentation, many countries with monetary independence could also opt for the introduction of new capital controls in the near future, aiming to prevent spillover from a new global financial crisis and China is not an exception. The PBOC has to balance between development and security, between post-Covid growth acceleration and macroeconomic/financial stability. But is this possible? A group of economists developed a set of new arguments that claim a different route is possible (Eichengreen and others, 2022). In a nutshell, they support the RMB internationalization strategy of the PBOC, which combines limited capital account liberalization with the development of financial payment infrastructure to make the RMB an international liquid currency, while maintaining managed access to the Chinese domestic market.

To secure liquidity of RMB holdings, the PBOC has several instruments in place including bilateral swap arrangements with other central banks as well as bilateral currency exchange arrangements with 39 central banks. However, these are not permanent and unlimited, like Federal Reserve swap lines. New evidence on the use of PBOC swap credit lines can be found in new research study by the Kiel Institute for World Economy (see more in Horn et al., 2023). Another channel for RMB liquidity is the Chiang Mai Initiative Multilateralization (CMIM), which is a regional currency swap arrangement between ASEAN countries plus China, Japan and Korea (ASEAN + 3). The third facility for RMB liquidity is the RMB liquidity pool at the Bank for International Settlements (BIS), which was established between the PBOC and five foreign central banks. Offshore clearing banks provide real-time settlement services for cross-border transactions, while onshore transactions are executed through the Cross-border Interbank Payments System (CIPS), which was established in 2015. China also uses the SWIFT interbank payment system. Central bank swap lines, CMIM, the liquidity pool at BIS and CIPS make up the basic infrastructure for increasing role of the RMB as reserve currency. The main focus is on transferability and liquidity within the framework of limited capital account convertibility of the RMB. Capital controls between offshore and onshore markets are highly important for the monetary and exchange rate policies of the central bank.

The majority of cross-border transactions with China continue to be denominated in dollars. Consequently, it was necessary to provide a financial infrastructure for the conversion of RMB holdings into dollars on demand at a market rate that is transparently determined by the FX market. One such mechanism is the offshore RMB market. The largest offshore RMB trading center is Hong Kong, although offshore markets have been set up in 24 other cities in China, while London and Frankfurt are also important offshore markets. Holders of RMB deposits are able to convert these holdings into dollar holdings on demand at FX market rates, but there is limited liquidity provided for offshore market transactions. There are capital controls between offshore and onshore markets, but this is beyond the scope of our paper. It is important to say that limited liquidity of offshore markets enables the PBOC to control markets and the exchange rate of the RMB in onshore markets. The main issue is to what extent the PBOC should provide liquidity for offshore markets to ensure the smooth conversion of RMB holdings into convertible currencies when needed and under the precondition that volume of RMB transactions abroad will increase as the RMB becomes more and more accepted in international capital transactions as a de facto convertible currency.

In such a framework, the dollar backing the RMB is very important (see more in Eichengreen et al., 2022). China’s trade patterns also reflect its composition of foreign exchange reserves. China's trade surplus with US has resulted in an accumulation of dollar reserves in the PBOC, which can be used in the onshore FX market to intervene and manage the volatility of the RMB exchange rate within narrow bands and thus preserve its relative stability. This is a de facto-managed floating FX regime with narrow bands for fluctuations to preserve the central parity of the RMB. A managed floating RMB exchange rate is fully consistent with capital account management or limited capital account convertibility of the RMB. Dollar reserves at the central bank (PBOC) are the most important collateral against limited convertibility of RMB, which gives credibility to RMB holders. In the same time, it is important to emphasize that the “Hong Kong offshore RMB market is a safety valve for RMB holders, it is a barometer of confidence in RMB” (Eichengreen et al., 2022). The PBOC should aim to preserve the stability of the RMB exchange rate against the dollar and enable the convertibility of RMB holdings into dollars when needed in offshore markets. It is crucial in the process of RMB internationalization to develop an efficient interaction mechanism between offshore and onshore markets to strengthen the RMB's financial transaction capabilities. This has been emphasized by a research team from the Renmin University of China, which issued an RMB internationalization report (see more in Renmin University of China, 2021).

China should continue with its own unconventional RMB internationalization strategy, promoting an increased role for the RMB as a de facto convertible currency. Further capital account liberalization is not an issue in China in 2023 and 2024, because of the existing uncertainty in global economy and de-globalization and geopolitical crises. Trade will continue to be the most important channel for accumulating RMB holdings in emerging economies (especially in the BRICs economies) and with major energy suppliers of China. The first China-Gulf Arab States Cooperation summit reached a strategic consensus to develop settlement in yuan for oil and gas trade (Petro-yuan), as with the first LNG trade in yuan. The Shanghai Petroleum and Natural Gas Exchange announced in March 2023 that it had completed its first yuan-settled trade for liquid natural gas between China’s National Offshore Oil Corporation and France's Total Energies. This latest trade deal comes as China is trying to establish the RMB as an international currency. The Belt and Road Initiative (BRI) is also another channel for RMB holdings, which can be accumulated by invoicing Chinese exports and by granting loans denominated in RMB. BRI investments and other Chinese direct investments abroad are a third channel for accumulating RMB holdings.

For the growing role of the RMB as an international reserve currency, it is important to closely monitor and control the offshore RMB market in Hong Kong and achieve relative stability in the RMB exchange rate in offshore markets. The main policy instrument of the PBOC to make the RMB a credible de facto convertible reserve currency is to unconditionally support necessary liquidity in offshore markets by using its official dollar reserves in the Chinese central bank (USD 3277 billion as of 2022, according to IMF, 2023b). The PBOC could always create a new collateralized liquidity window for other central banks, if and when needed. For instance, in June 2022, the PBOC created a new RMB Liquidity Arrangement allowing other five central banks (Indonesia, Malaysia, Hong Kong, Singapore and Chile) to obtain pooled reserves at BIS should they require liquidity. Then, on July 4, 2022, the PBOC and the Hong Kong Monetary Authority (HKMA) signed a standing swap agreement, allowing the two sides to upgrade the currency swap arrangement established in 2009 to a standing one with no need for renewal while also expanding the swap scale from RMB 500 billion/HKD 590 billion to RMB 800 billion/HKD 940 billion.

The PBOC emphasizes that it will “promote the use of the RMB in foreign trade and investment, steadily promote the two-way opening-up of financial markets and improve the liquidity of RMB financial assets. It will continue to promote cooperation with other central banks on bilateral currency swap and local currency settlement, and support sound and orderly development of offshore RMB markets.” (PBOC, 2022). The most important policy measure of the PBOC is that “it will provide more stable and longer-term liquidity support for the Hong Kong market, better support for the development of the Hong Kong SAR as an international financial center and foster development of the offshore RMB market in Hong Kong” (see more on specific measures implemented by the central bank since 2009 in part six of the annual report on RMB internationalization—“Highlights of RMB Internationalization”: PBOC, 2022). In May 2017, the Chinese central bank announced a “countercyclical adjustment factor” (CCF) as a discretionary policy instrument to control the exchange rate, if necessary. This central bank instrument was abandoned in 2020, but reintroduced again in September 2022 and is actually very similar to the “Transmission Protection Instrument” (TPI) of the European Central Bank created in July 2022 and “The Bank Term Funding Program” (BTFR) introduced by the Federal Reserve in March 2023.

We can conclude that there is an interdependence between two currencies—the dollar and the RMB—within the framework of the de facto capital account convertibility of the RMB, with its limited capital account openness and managed exchange rate policy, which is backed by official central bank dollar reserves. The two currencies are complementary, and while there is a process of accelerated de-dollarization underway as new geopolitical conditions emerge and RMB internationalization is China’s long-term strategy, the dollar will still remain dominant in the near future.

Commodity-Based RMB and RMB Internationalization

The Chinese approach to capital account liberalization is unorthodox, because it does not follow the classical strategy of de jure capital account liberalization based on IMF policy advice. Many argue that China has to retain capital controls and protect its domestic economy from external shocks and negative spillover effects from abroad, specifically the US “dollar trap” and, to lesser extent, from the EU. China's plan is to build an alternative RMB-based system that will coexist with the present US dollar system. This alternate system should be based on China's national interest, for her economic benefit and for the diversification of risk, particularly geopolitical risk. Of course, it seems that China also wants to participate in the existing international monetary system (IMS), which was created under the Breton Woods system of “fixed but adjustable exchange rates” and based in the International Monetary Fund, which was established as an institution that promotes balanced development of international trade and stability of the international monetary system as a “lender-of-last-resort” (LOLR). But, there are arguments for change in the current IMS, and some experts see the creation of a multipolar currency world that anchors alternative currencies to commodities. This is important. It is about creating a foundation for RMB internationalization. As Zoltan Pozsar correctly said, “we are witnessing the birth of Bretton Woods III—a new world (monetary) order centred around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West” (see more in Pozsar, 2022). In the presently unfolding crisis, especially the “crisis of commodities,” commodities are collateral for alternative currencies and they serve as basis for enhancing the credibility of alternative currencies that are not backed by the US dollar or gold reserves.

China understands well the benefit of anchoring the RMB to real commodities, because of the search for resources needed for accelerated development and persistent inflationary pressures due to the changes in various commodity markets, particularly oil and gas, lithium, and other natural resources. For instance, Leung (2022) believes that the RMB will eventually anchor to commodities/physical goods and for diversification purposes will focus on three areas: (1) the Petro-RMB system with Russia/Saudi Arabia and OPEC countries; (2) the Renewable energy-RMB system with Latin America; and (3) the RCEP-RMB system in Asia (RCEP, Regional Comprehensive Economic Partnership). All three schemes of the RMB anchoring strategy will create additional demand for RMB over time due to mutual investment projects that will inevitably facilitate RMB internationalization. However, this is a long-term process and it will take time as anchoring to real commodities is a complex strategy.

In the gradual implementation of such an RMB internationalization strategy, geoeconomic considerations and geopolitical risks are of the utmost importance and 2023 is an important turning point for RMB internationalization. There are two main factors in accelerating the process of RMB internationalization: (1) Financial instruments being weaponized in the form of sanctions, forcing emerging markets to resort to local currency settlement (LCS) and (2) monetary policy tightening (QT) and interest rate hikes by the Federal Reserve that have forced countries to reduce their dependence on the US dollar. This has driven greater acceptance of local currencies by trading partners in emerging markets, especially in BRICs economies, and will also have a positive effect on the further developments of offshore markets.

Concluding Remarks

After decades of intense globalization, the world economy is facing risks of fragmentation. Policy-driven reversals of globalization are defined by IMF experts as “geoeconomic fragmentation” (GEF) and are multidimensional process of reversals in world economic integration. GEF could naturally be seen as an obstacle, but it is also an opportunity for RMB internationalization. To avert fragmentation, the rules-based multilateral system must adapt to changing circumstances. Some are talking about Bretton Woods 2.0, while others are suggesting even deeper changes in the multilateral rules-based international monetary system that is being called Bretton Woods 3.0 (Pozsar, 2022), mainly due to changes in US dollar-based international monetary system. The role of the US dollar as the main reserve currency has gradually weakened in recent decades, but it is still the world’s main reserve currency. It is followed by the Euro, but the structural crisis in European Monetary Union is challenging the stability of Euro as a reserve currency. This could also have an impact on the progress of RMB internationalization.

Prospects for China's re-opening and economic development are good in 2023 (Yu, 2023; IMF, 2023a). However, China has to manage a “polycrisis” by implementing complex policy responses and the internationalization of the RMB will accelerate in 2023 in spite of geopolitical risks. The basic approach of economic reforms in China is gradual, based on incremental reforms and prudent progress in external/internal liberalization and preserving the stability of the domestic financial and economic system. Capital account management by the PBOC has been selective and targeted, while also being flexible and consistent with overall macroeconomic policy objectives. It seems plausible that its RMB internationalization strategy has been internally consistent, and that the sequencing and speed of external reforms were in line with the gradual strategy of the PBOC, which has been very successful in boom and bust cycles management. Re-regulation of the financial industry is needed within the context of new geopolitical/geoeconomic risks and the latest developments in international capital markets.

In this paper, we have tried to present additional arguments in favor of the view that an unconventional strategy for the internationalization of the RMB is the best policy option for China. China’s approach to capital account liberalization has been unconventional from the beginning, while its unorthodox strategy of external liberalization has been detrimental to the conventional strategy of the removal of capital controls in order to achieve full capital account liberalization in accordance with the IMF rules. However, our main conclusion is that this is actually a strategy of de facto capital account convertibility for the RMB, with controlled capital account liberalization. Our paper does not suggest significant changes in the strategy of the PBOC as the unconventional approach of the central bank is optimal from an academic perspective, while the results of the internationalization of the RMB are convincing from a policy maker’s point of view. China should continue with its own RMB internationalization strategy, promoting an increased role of the RMB as a de facto convertible currency (especially as a trade settlement currency). Additionally, the PBOC could also further promote RMB internationalization in a few other areas, but crucial policy measures should focus on “fine-tuning” of “recycle mechanisms” and liquidity instruments in offshore markets.