The decline of the dollar and the rise of the renminbi could be the “story of the next cycle” thanks to a confluence of political, economic and structural shifts, a large asset manager is predicting.
The widening ambit of US sanctions, epitomised by a renewed push to cut Iran’s oil exports “to zero”, but also encompassing measures against the likes of Russia, Venezuela, North Korea and to a lesser extent China and the EU, will be one driver of “de-dollarisation”, as countries seek to cut their exposure to the greenback, according to Investec Asset management, a $134bn fund house.
Investec also pointed to structural shifts in China, such as the decline in the working-age population, which will cut the domestic savings rate, leading to persistent current account deficits, which Beijing would prefer to fund by borrowing in its own currency, rather than that of the US.
It cites the fact that China has overtaken the US as the world’s largest oil importer, as illustrated in the first chart, as a third driver.
“One reason for the dollar’s historic dominance is the US-Saudi settlement in the 1970s to invoice oil in petrodollars, which underpinned a dollar-based network of trade and finance,” said Philip Saunders, co-head of multi-asset growth at Investec.
“[But] China would prefer to settle its trade bill in renminbi if possible. Oil companies in Russia, Iran and Venezuela have already begun accepting renminbi as payments for Chinese imports, and were Saudi Arabia to follow, that would have a substantial impact,” added Mr Saunders, who also pointed to last year’s unveiling of renminbi-denominated oil futures on the Shanghai International Energy Exchange.
Others also foresee this trend.
“Every central bank I met last year asked how do I get out of dollars,” said Hayden Briscoe, head of Asia-Pacific fixed income at UBS Asset Management. “More renminbi is now traded in London than sterling.”
The comments come as research from Morgan Stanley suggests the “renminbi bloc” is the second-largest currency bloc in the world, having taken share from the dollar.
Based on the IMF’s method of using regression analysis of the co-movements of currencies to determine reserve currency blocs, the US bank found the renminbi-bloc now accounts for 28 per cent of global gross domestic product, just 8 points behind the dollar, as the second chart shows.
The flurry of interest around the rise of the renminbi comes as Beijing’s push to internationalise its currency has gone backwards since the country’s stock market crash in 2015, which triggered a sharp sell-off in the renminbi and the imposition of tighter capital controls in an attempt to attempt to stem outflows.
The currency’s share of cross-border payments, as measured by the SWIFT payment network, peaked at 2.8 per cent in August 2015 before nearly halving in the subsequent two years. It has since picked up a little to 2.1 per cent, but that is a country mile behind the 42 per cent and 37 per cent share of the dollar and euro, respectively.
The proportion of China’s trade that is settled in renminbi has also plunged since its 2015 high point, falling back to the 20-25 per cent level of 2013-14.
The renminbi’s share of global foreign exchange reserves (stripping out China’s own reserves) rose to a record high of 2.5 per cent last year, from about 1.5 per cent 12 months earlier, according to calculations by Morgan Stanley (again, well below the 62 per cent of the dollar and 20.5 per cent of the euro).
On one hand, this may not be the unequivocal vote of confidence it might seem, with last year’s buying dominated by the Central Bank of Russia, which now has 15 per cent of its reserves in the renminbi. Strip out Russia, and the Chinese currency’s share of global FX reserves barely rose in 2018.
However, Moscow’s diversification from the dollar to the renminbi in the wake of US sanctions fits neatly into the multipolar world increasingly being envisaged by Investec and UBS.
“After 2008, China lost control of their fuel and energy sector because everything was settled in dollars. They said from that point on they were not going to settle everything in dollars,” Mr Briscoe said. “They went and bought up Africa, bought the largest live hog exporter in the US [Smithfield Foods] and they listed commodities on their own exchanges.”
He argued that the Shanghai Cooperation Organisation, encompassing China, Russia, India, Pakistan and four of the central Asian “Stans,” with Iran as an observer state, was “the most important organisation in the world today”.
“It’s like Nato and the World Bank rolled into one. It has 45 per cent of the world’s population,” Mr Briscoe said. “The SCO will announce a payment system outside of the dollar at some point, then no one can push you around because you have access to a financial market, you can control commodity markets.
“Traditionally it has taken 70 years to set up a financial hub but with Hong Kong it’s there, it’s plug and play.”
Data from Investec illustrate how far away the renminbi is from being a serious contender to the dollar as a reserve currency, but also how dramatic the shift might be if it was to achieve this status.
It is essentially absent from the international debt and loan markets and invoicing of world trade, and accounts for just 2 per cent of foreign exchange turnover.
When it comes to what Investec describes as “exorbitant privilege”, the renminbi’s share of global reserves divided by China’s share of global output was a negligible 0.07 in 2017.
This trails wildly behind the equivalent figure for the US of 4.1, the eurozone’s 2.15, the UK’s 1.96, Japan’s 1.15 and Switzerland’s 0.49, as the third chart shows.
This long-run representation illustrates that changes in the status of reserve currencies can be abrupt, however. The US ratio rose dramatically from 0.21 in 1913 to 5.54 in 1950 as its economy and financial system “just became too large to ignore”, according to Mr Saunders at Investec.
In contrast, the UK’s ratio tumbled from 6.33 in 1966 to 0.38 in 1976 as the pound suffered a torrid decade, and that of Switzerland from 5.35 in 1980 to 0.44 in 1999 as its safe haven status became less prized.
“Currency changes tend to be quite sharp. It’s unrealistic to suggest that it will be slow, gradual change. It’s more likely to be quite rapid,” said Sahil Mahtani, a strategist at the Investec Investment Institute.
Mr Mahtani said the data also undermined “the prevailing view that you need to have an open capital account to have a reserve currency”.
“That has not been the case historically,” he added, noting that the US had capital controls in the 1960s and the sterling area had capital controls throughout its period of dominance, yet even some non-Commonwealth countries such as Sweden and Denmark “had most of their reserves at the time in sterling”. “Currency dominance lags economic dominance,” he added.
James Lord, head of emerging market fixed income strategy at Morgan Stanley, also suggested “it is possible that full convertibility may not be necessary,” for the renminbi to increase its role as a global reserve currency.
Mr Lord said that a commitment by Beijing that capital controls would continue to only be applied to Chinese nationals, not foreign investors or central banks, would help surmount this potential barrier.
Moreover, he argued that since capital controls had been imposed in part to keep the exchange rate stable, reserve managers might view this stability as important enough to trump convertibility.
The other requirements for a reserve currency country, at least according to Bill Dudley, former president of the New York Federal Reserve, are “deep, liquid and transparent capital markets”.
With the largest equity and bond markets outside of the US, and the beginnings of a potential torrent of foreign investment as these markets start to be incorporated into the major global indices, China may soon tick this box as well.
“[Bond market inclusion] is the biggest change in financial markets in our lifetime,” said Mr Briscoe. “China will be 20-25 per cent of the Global Aggregate [bond index] in the next few years. It will be the same size as the US bond market within five years,” added Mr Briscoe, who foresaw a “tectonic shift” with bonds doubling their share of the overall Chinese credit market to 30 per cent, at the expense of loans.
The role of geopolitics cannot be divorced from any debate about future reserve currencies or payment networks, however.
Jean-Claude Juncker, president of the European Commission, has said it is “absurd that Europe pays for 80 per cent of its energy import bill in US dollars when only roughly 2 per cent of our energy imports come from the US . . . [or] that European companies buy European planes in dollars instead of euros.”
Likewise, in the wake of the tightened Iran sanctions (which France, Germany and the UK have attempted to find a way around by setting up a non-dollar payment system, but so far failed), the likes of China, India and Turkey may be wondering why the US has the right to tell them who they can and cannot buy oil from.
“I think there is a long tail of economic consequences from President [Donald] Trump’s election. I think there is a reasonable chance that Europe is going to become less dollar dependent, the way US politics is working,” said Mr Saunders, who also listed US fines imposed on European banks for offences such as sanctions-busting and money laundering as an issue.
However, he believed the involvement of China was necessary to make any viable alternative payments system work.
Nevertheless, he added: “You are making a call on political stability and on whether they really fall out and end up in actual conflict with the US. People underestimate the degree of political stability in China. There is this assumption that the one-party state will ultimately fall apart and that that will be a highly disruptive experience.
“There was this view that China will ultimately evolve into a more liberal political system. There has been surprise in Washington that the bureaucracy in China is held in very high regard.”
Investec’s central forecast is that Beijing does spur the creation of a new monetary system, but only on a regional basis, with the renminbi a reserve currency within an Asian trading bloc that is increasingly China-focused, as the final chart shows.
This scenario, which is in line with existing policy initiatives such as the Belt and Road Initiative and the ongoing expansion of the People’s Bank of China’s swap lines, would mirror the sterling bloc between the 1930s and 1960s, Mr Saunders said.
Mr Briscoe concurred. “We are saying to clients this whole silly demarcation of developed markets and emerging markets needs to end,” he said.
“There will be dollar, sterling, euro and Swiss blocs, the renminbi bloc and maybe the yen, because Asia is going to re-regionalise and move up the value chain. Correlations are going up between Asian currencies and the renminbi.”