Europe's Central Banks Beginning To Replace The U.S. Dollar Reserves With The Chinese Yuan

Europe's central banks are starting to replace US dollar reserves with the Chinese yuan

Late last year, China’s Xi Jinping said it was time for the nation to “take center stage in the world.” There are many ways for China to do this, including promoting globalization, boosting foreign aid, and developing advanced technologies. Another critical step in taking “center stage” is to be at the center of the global economy. To achieve this, China is, among other things, trying to internationalize its currency.

For the past 70 years, the US dollar has been the world’s dominant currency. Two-thirds of the world’s $6.9 trillion allocated foreign exchange reserves are held in US dollars. The yuan took a major step towards broader international adoption in 2016 when the IMF decided to include it in the basket of currencies that make up the Special Drawing Right, an alternative reserve asset to the dollar.

Still, as of the third quarter of 2017, just over 1% of foreign exchange reserves were held in yuan, according to the latest data from the IMF. Now, there are signs that this is about to increase.

The Chinese yuan hit a two-year high against the US dollar this week, after the German Bundesbank said that it would include the yuan in its reserves for the first time. “The notable development from the European point of view over the past few years has been the growing international role of the renminbi in global financial markets,” Andreas Dombret, a member of the central bank’s executive board, reportedly said at a conference in Hong Kong (paywall). The decision was made last year and no investments have been made yet, as preparations are still in process. The French central bank then revealed that it already held some reserves in yuan.

As most central banks’ reserves are held in dollars, any shift into other currencies, such as the yuan, will come at the expense of the greenback. In June, the European Central Bank announced that it had exchanged €500 million ($611 million) worth of US dollar reserves into yuan securities. This was a small shift—the ECB has €44 billion in foreign exchange reserves—but nonetheless it reflects China’s growing prominence in the global financial system.

As Trump’s “America First” policies push the US out of the international limelight, more people expect China to fill the gap, including in world finance. Barry Eichengreen, an economics professor at the University of California, Berkeley and expert in global currency systems, predicts that the US dollar will eventually lose its dominance and multiple currencies will coexist on a more equal footing in international markets. In the future, the dollar will be forced to share prominence with the yuan and the euro in particular, he says.

China still faces several hurdles in having a truly international currency. Capital controls and a lack of regulatory transparency make financial institutions reluctant to invest in Chinese assets. However, last week China showed signs that it was relaxing some of its rules used to control the currency. As the yuan gains more international clout, and value, Beijing might be emboldened to open up further.