Can China’s yuan replace the U.S. dollar as the world’s reserve currency?

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Let's start with the conclusions in terms of-- for people watching, impatient investors. We want to know what it all means. Tell me what the conclusions of your report is. And then we'll get into the reasons why.

Well, I think the big picture is that we're moving from a unipolar world that's dominated by the US, the US dollar, and its financial system. And we're moving to something which is more bipolar. And we're being a world in which the renminbi has a bigger role. And that's reflecting the bigger economic heft that China has in global trade, global economics, and so forth.

Yeah. So the big-- the de-dollarization means that, again, it's this bipolar world. Another currency gaining acceptance, gaining strength. You also mentioned, though, that another byproduct of this we could be seeing-- and again, you know, predictions. We have to kind of wait and see how the world unfolds. We could see stronger gold, and we could see a weaker US dollar.

Yes. Certainly, the US has this exorbitant privilege, which means a lot of money goes in the US dollar assets. That makes the dollar strong and also keeps interest rates lower. In this new world we envision where it is going to be more difficult for the US to fund their big deficits, interest rates could be higher, say, by 25 to 150 basis points. The US dollar, we think, over the long term will be about 20% cheaper.

And then gold, at least during the transition period, will be viewed as an alternative type of reserve currency. And we certainly have seen over the last 10 years a real bid from a number of countries for gold for these reasons, until the renminbi is ready and all the different aspects of plumbing to be in a position to challenge the US dollar as the predominant global currency.

And just to be clear, we're not talking about this happening tomorrow. This is going to take some time.

It takes a very long time. So for example, the US became the largest economy in the world in 1870, just after the Civil War. But it didn't become the global reserve currency until immediately after World War I. So that was a period of 40 to 50 years. So these things move very slowly.

I want to-- again, we're going to dig into the reasons because you've put together a very detailed report, I think, explaining it. But one thing that is notable to me is that I think a lot of people have been hearing this for a while. And I think there's a lot of skeptics that this could actually happen. So maybe you could just start by telling us what has been the US history of getting dollar dominance and why the skeptics maybe are not seeing what could be happening.

I think, for a lot of the skeptics, they're looking and they're saying, well, what is a global currency? And certainly, for everyone who's alive today, they only really know one global currency. And that's the US dollar. And they say, well, to be a global currency, you need to have a big current account deficit. So there's lots of money coming in. You have to have enormous capital markets, the treasury market, equity markets, venture capital private equity, all these things. You need to have an open capital account. So money can go in and out freely.

So all different aspects of the US dollar financial system. But that's based on a set of one. So, one example. And people are extrapolating from that, where we think this new global currency is going to be one with Chinese characteristics. And it's going to look quite different from what the US dollar has been over the last 50 years or before the US dollar when Sterling was the global currency.

It's interesting, too, because you mentioned-- and it's funny, I've never heard it talked about in this context about the network effect that happens with the US dollar, which is part of the reason that it has the strength that it does right now. Maybe-- and I've heard about it with internet and with viral things on that front. But how do you see it? And how does it help?

Well, I think-- if you don't mind my going on a little bit of a tangent for network effects because they're quite common in digital economies. So for example, I use Twitter a lot. And Twitter is a place where there's a lot of content. And there's content providers and content consumers. And you have this sort of two sided network effect.

And now some people are moving towards Threads. And Threads doesn't have some of the features that Twitter has, but it also doesn't have an owner who wants to tax or penalize both the consumers and producers of content. So people are moving to this different platform. And I think it is similar. The US dollar has all these network effects.

So once you become dominant, you have all these features. People are issuing US dollar assets. People are buying US dollar assets. And then, there's all the different parts of the plumbing that go associated with that, the regulatory parts with the Fed and the Treasury, the interbank payment system, the messaging system, all the different types of markets, offshore markets, onshore markets. It's very complex. And you need both sides coming to it.

And that takes a long time to build up. And it's only been, I'd say, the last 15 years that Beijing has realized the importance of building up all this infrastructure, all this plumbing, to ensure that they do have the two sided network effects that are necessary to attract both providers and consumers, in this case, not of content but of capital.

OK, you set up for us. There's basically two sides or two parts to this argument, strength of China and basically the politicization of the US dollar. Let's stick with China right now. We talked about this network effect. And in your report, you talk about the path to strength of helping create that is actually having a currency that helps-- becomes common with invoicing, and settlement, and those types of things. So maybe we just kind of talk about that environment that has to be present to allow that to happen.

Yeah, there's a natural or sort of logical sequence on how a currency starts to get used beyond its borders. And this is really the sequence that the United States followed, say, just over 100 years ago. And the UK did, say, 220 years ago or

But initially, you start with invoicing. So if you're exporting from China electronics or what are they exporting, instead of having it invoiced and settled in dollars, you'd have it settled in renminbi. And we've seen that share that settled in renminbi go up from roughly 0% a decade ago to about 30% now. So that is something they are doing.

And China is having a lot of discussions with countries, not just Russia. Russia clearly is being forced to do this. But also India, Iran, Argentina, Brazil, South Africa. Well, the BRIC countries plus a few others. Turkey would be in that group. So more and more countries for more and more goods are interested in invoicing what they import from China and then settling in renminbi rather than Euros or US dollars.

And people might look at 30% and think that's not quite the number one. But it is the second most used currency, is it not?

Yeah, for invoicing for trade, it's now number two to the US dollar and above the Euro. And certainly, the slope is increasing.

What about emerging markets? Because this is an interesting piece you highlight as well, too, where I've done my fair share of traveling, too. And you notice sometimes when there are no strings attached when it comes for financing or helping emerging markets. What-- tell us what's happening.

So, certainly, China, when they're looking for their allies-- and there are a lot of people who are sympathetic to China and also are suspicious of the US dollar. So whether it's Belt and Road lending, or it can be central bank swaps that China set up. And they've now set up about 39 central bank swap lines. And they've actually used about 17 of those.

They're becoming more involved as a lender of last resort to countries that get in trouble. And these are often countries that receive a lot of Chinese FDI. They do trade. They've been recipients of Belt and Road money and so forth. And that's beginning to be a long list and includes different countries in Asia, Africa, and quite a few countries in South America as well. So, different EMs.

And that is the process in which the renminbi is becoming used more in China's financial infrastructure, monetary infrastructure, is spreading out. And countries want to have an alternative to the US dollar system because-- to some extent because they fear sanctions. But also, they're concerned about the, I think, the oversized role of the US dollar in their economic activities.

And then, when you layer on top of that China recognizing some of the growing strength as any country would do, putting in some new systems in place to help with this. And we've heard a lot more about SWIFT. I think a lot of people weren't familiar with SWIFT before, what happened with Russia. We all became familiar very quickly. And there's something called Chips.

Yes. Yeah, and so when we're talking about the US dollar and de-dollarization, it's not really about the US dollar per se. It's about the US dollar financial system. And part of the US dollar financial system is SWIFT, which is a messaging system. So it'll tell one bank where the money is supposed to go.

Chips is the clearinghouse interbank payment system. So it actually is a hub and spoke system like our airline system is to send money from one bank, typically a US bank, a correspondent bank, to another bank either in the United States or globally. But there's lots of other parts of the US dollar financial system. There's the regulatory structure with the Fed and the Treasury. There's the onshore and offshore markets, bonds, equities, private equity. So it's quite big.

And so China knows that they need to build these. So they have, for example, created Cips. So it's a China interbank payment system. So it's modeled on Chips. And that's getting used increasingly. It still relies on SWIFT for messaging. But more and more countries and more and more banks are using their financial transactions through the Chinese system rather than the US based Chip system.

I thought it was interesting you started your report talking about, not about currency, but more about de-risking and the idea that throughout history, you see these cycles where people decide they have to de-risk, whether energy is power is too concentrated or semiconductor power is too concentrated. This is a parallel to those conversations.

Yeah. So as we move from a unipolar world to a bipolar world, we're realizing that there's lots of risk and vulnerabilities, particularly in global supply chains. So from the position of the US, Canada, Europe, and other sort of Western countries, we realize that there's vulnerabilities in terms of getting your energy from Russia. There's vulnerabilities in terms of semiconductors if we're very reliant on supplies from Asia.

And so we decided to de-risk those. Similar, China, Russia, Iran, and other countries have realized they have a real vulnerability or risk exposure to the US dollar financial system, and they need to de-risk, reduce their exposure and vulnerability to that. And I think that's ultimately what this is all about.

And then, when you go into that, you start to talk about just all the reasons why, I think, people want to de-risk. And you alluded to this earlier, but this-- you talk about weaponized interdependence right now. And you talk about how the Biden administration, what they've been doing compared to previous administrations. Maybe just take us through how much that has increased, I'd say, the weaponization of the US dollar.

Yeah. So weaponized interdependence is a very good term. And clearly that's what Russia had in mind with supplying natural gas and oil to Europe. And I think that's a good way to think about it. And certainly, with the US dollar, they've decided to weaponize the dependence that Iran, Russia, and other places have to the US dollar. So I think that's a good way to be thinking about this.

And it works until it doesn't, I guess would be probably a good way to think of it, too, right? I mean it works as a weapon until people find alternatives. So but you have a chart here. I think was looking at the number of, I think, states that are actively targeted by US sanctions. I think it's four, if I look at it back in 2000, up to just under 25 currently. So it's becoming more common.

Yeah. So the number of states under sanctions has increased six-fold in the last two decades. And the number of sanctions overall has increased more than 10-fold. So it is something that the US dollar is using. And really, they're forcing other countries to come up with an alternative to the US dollar financial system.

And one complexity in this is there's primary sanctions. So if the US decides to put in place sanctions against Iran, that means any US individual or entity cannot interact financially with entities or individuals in Iran. So that's primary.

What they did with Iran in 2018 is they took it another level up, and they introduced secondary transactions. So they said that the US individuals and companies can also not transact with anyone who is transacting with Iran. And so what that meant, for example, is a European bank who has business in Iran-- and certainly they have a different position on Iran than Americans do-- they had to choose, do I want to be doing business with Iran or with America? And in the vast majority of cases, they chose America.

And it's interesting that before the Russian invasion of Ukraine last February, the region that was most interested in decoupling from the US dollar was Europe because they realized that there was this potential for financial sanctions, US foreign policy being imposed on them. And they were very unhappy about this.

With the sanctions against Russia, America's decided not to have secondary sanctions. So for example, India is not signed on to the sanctions, but America could force them through secondary sanctions but realizes there would be a huge backlash to do that. Really, there's-- countries with 2/3 of the world's population are not on board with the sanctions against Russia. So there are real limits to the ability of America to push both primary and secondary sanctions.

I've only got about three minutes, Kevin. But I do want to mention because it takes up a big piece of this report, too, you talk about the Chinese military industrial complex companies, how they're affected, and Chinese persons who are also affected.

Yes. Yeah, so the US has sanctioned a lot of Chinese entities and Chinese individuals over the last couple of years. And there's for a host of reasons. One are companies that are linked with the Chinese military who are doing activities outside of China, which could be related to different types of forms of surveillance. It could be activities that are viewed as anti-democratic protests or human rights abuses in the Uyghur areas, Hong Kong, and so forth.

So there's a lot of entities. And that certainly has gotten China's attention. So they realize that these sanctions are painful. They can precisely target individuals and entities. And they can be broadened. And certainly, there's every reason from the discussions that are coming out of the White House to believe that these sanctions against Chinese entities and individuals will be broadened over coming years.

We've only got about a minute, Kevin. But again, my favorite part of your report is when you quote Niall Ferguson stressing that the law of unintended consequences is the only real law of history. And the thing is it's hard to say how this could unwind, accelerate, change. But the path of acceleration could be concerning.

Yes, absolutely. And so we have-- even if we become a bipolar world, the two worlds are very interconnected in terms of trade, economics, financial. And so as we move to this equilibrium, this transition, I think we really do have to pay attention to Niall Ferguson's warning about the law of unintended consequences, how this is going to play out. We've been surprised so many times over the last couple of years. And we're continuing to be surprised.

Kevin, it was a real pleasure. Thanks for taking the time to take us through this.

Thank you very much, Kim.

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