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China's attempts to supplant dollar face historic difficulties

Section: Daily Dispatches

By Mike Bird
The Wall Street Journal
Monday, March 26, 2018

The world's first yuan-denominated oil contracts launched today, as part of China's drive to turn its currency into a global force in markets.

The history of international currency markets suggests that may be a difficult task, though not impossible if Beijing eases the capital controls that make it hard for foreigners to buy up domestic assets, economists say.

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Those capital controls and investors' concerns over the opaqueness of Chinese government and central bank policy mean that the yuan remains a minnow in international finance, despite China being the world's largest exporter.

The dollar and euro are global currencies because central banks hold them in their reserves and they are used to buy services and goods both in and outside their home markets.

In launching new yuan-denominated crude-oil futures, Beijing hopes to create an oil benchmark to rival those in New York and London and challenge the dollar's role as the dominant commodity-pricing currency by making it possible for crude exporters to sell oil in another currency.

Professor Barry Eichengreen of the University of California, Berkeley, who writes about the history of currencies in the international financial system, believes the dollar's grip on oil pricing isn't guaranteed.

"As financial markets continue to develop -- as there are liquid markets in more currencies, and currency trading becomes cheaper—- traditional arguments for why one currency should monopolize this function become even weaker," Mr. Eichengreen said.

Still, "I don't think the renminbi will displace the dollar from the global oil market any time soon. Lack of liquidity and accessibility continue to limit its usage," he added.

China's currency has some way to go. The yuan's share of global foreign exchange reserves is just 1.1 percent of the global total, behind currencies like the Australian and Canadian dollars. The U.S. dollar's share is 63.5 percent.

The yuan makes up only 1.1 percent share of international payments, placing it behind seven others, according to payments firm SWIFT. That share has dipped in recent years, from as high as 2.8 percent in August 2015. Currently almost all oil and most commodities are bought and sold in dollars.

However, even in modern history, it hasn't always been this way. Economists point to the demise of the British pound's dominance in world trade as showing that the tide can turn quickly against one currency in favor of another, especially during a crisis.

The London Metal Exchange benchmark copper contract was denominated in sterling until 1993. Even today cocoa trading is priced in sterling.

Though crude has a longer history of being denominated in dollars, due to the U.S.'s status as a major producer, as late as the 1970s oil-producing countries received around a fifth of their royalty payments in sterling, according to economic historian Professor Catherine Schenk.

Before the outbreak of the World War I, dollar-denominated international trade credit was almost nonexistent and British banks dominated the sector. By the mid-1920s the dollar and sterling-denominated trade credit occupied similar market shares.

The economic impact of the First and World War II left London's influence in international finance and trade dramatically weakened, leaving the dollar firmly in the driving seat by the second half of the 20th century.

Sheer economic heft isn't enough to guarantee a currency international primacy. The U.S. economy supplanted the U.K.'s as the world's largest in the 1870s, around half a century before the dollar began to replace sterling as the world's dominant currency.

That is a lesson to China, as its economy catches up with the U.S. and by some measures has already taken over.

One factor currently limiting the adoption of the yuan as a global currency is Beijing's capital controls, which place limits on investment in China. Beijing keeps a tight grip of money coming in and out of the country to maintain control of the country's economy and prevent sudden outflows of capital.

Currently, selling a yuan-denominated future means investors must either exchange the currency back into dollars -- partly defeating the purpose of the contract -- or find assets denominated in the Chinese currency to invest in.

There is no shortage of Chinese assets. The IHS Markit iBoxx Asia China index, a broad index of Chinese bonds, has more than doubled in size in the last 4 1/2 years, to over $11 trillion.

Some of the government controls have already been loosened. In 201, China launched a "bond-connect program" to allow global investors with trading accounts in Hong Kong to access China's interbank bond market.

Just because more foreigners can now buy Chinese bonds, it doesn't mean they will. Some investors say Beijing will have to open up its economy more for that to happen.

"Firstly, China will have to remove, or substantially reduce, capital controls for [renminbi] priced oil trading to take off," said Hayden Briscoe, head of fixed income Asia Pacific at UBS Asset Management.

Mr. Briscoe added that the inclusion of Chinese bonds in major indexes would boost outside investment in the country's debt, given investors and passive funds track such benchmarks.

"When that happens, we're expecting a major reallocation of capital into China's onshore bond markets," Mr. Briscoe said.

Bloomberg LP said Friday it would add Chinese bonds to its Bloomberg Barclays Global Aggregate Index in 2019.

However, the country's controls on capital flows aren't the only concerns. The Chinese government's propensity to intervene in domestic commodity markets and the lack of transparency about the country's monetary policy are also unlikely to find favor among investors.

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