News Update

The arithmetic of money is incorruptible: when it comes to international settlement systems, the pricing of commodities and energy, and access to the credit system, the U.S. dollar still reigns unchallenged. Eighty-nine percent of all foreign exchange transactions are conducted in greenbacks — central banks, commercial banks, and other capital pools hold roughly 57 percent of global currency reserves in U.S. dollars.

Global banking cannot function without the dollar standard and its settlement systems — everything is calibrated to the dollar, from banks’ settlement systems to the benchmark yield of the ten-year U.S. Treasury note to the petrodollar, the pricing mechanism for the world’s most vital commodity: oil. On top of that, the still-dominant SWIFT system forces large swaths of the business world, of states, and of central banks into the dollar network. Exclusion from this network amounts, in many cases, to economic death — the ultimate sanctions hammer in the hand of any American president.

Russia recently felt the full weight of this dollar power. Cut off from SWIFT, it took a maximum political effort to stay afloat in international trade through alternative payment mechanisms. Yet Russia is an exception: it sits atop natural resources worth 75 trillion U.S. dollars — a resource giant that hardly anyone in the world can do without, except perhaps the EU, which seriously believes it can wean itself off Russian gas.

With this experience of geopolitical fragility in mind, China’s political leadership decided, over a decade ago, to establish a parallel payment and store-of-value system. Beijing had time to study the elements that made up the dollar’s network effect. Aside from the omnipresence of the U.S. military around the world, one might cynically add, it was the standard that grew out of the Bretton Woods system after World War II that fulfilled the following core functions: direct clearing of transactions in a single currency, the U.S. dollar; store of value in the interbank sphere and as collateral in the form of dollar-denominated government bonds; and settlement systems operating on the same standard. (RELATED: Can Kevin Warsh Save the Dollar?)

A further success factor of the dollar system was its high liquidity and the deep capital market concealed behind the currency’s surface — the prerequisites for a functioning banking system with steadily growing credit volume. Government bonds, corporate bonds, and equities can be issued and circulated in a matter of seconds. That makes the dollar space a near-unlimited investment universe for central banks, commercial banks, funds, and private investors. The foundation of the dollar’s success surely also rested on the strong property protections the United States offered. Commodity invoicing ensured that the lifeblood of the global economy — energy — was priced in dollars. No one could escape it.

China, for its part, is attempting to build a similar system. The Chinese strategy rests on three pillars.

The first pillar of China’s transaction system, the Cross-Border Interbank Payment System (CIPS), was launched in 2015 as a cross-border payment system for renminbi transactions. At its core, it functions much like the well-known SWIFT system: an infrastructure through which banks worldwide can settle yuan payments directly, without necessarily having to route them through Western correspondent banks. In doing so, Beijing reduces the dependence of Chinese and international trading partners on the dollar network, while still cooperating in part with SWIFT-compatible messaging standards — a pragmatic first step, not a radical break with the existing dollar standard.

Serving as the second pillar alongside CIPS is the Shanghai Clearing House, a kind of central counterparty for securing risk in the markets. Its clearing operations cover bonds, derivatives, and commodity trades, all settled against the Chinese yuan. In mid-September, there was fresh news to report: the addition of the Singapore dollar, the New Zealand dollar, and the Thai baht to the pool, with 12 banks taking part — in their first session, they processed transactions worth nearly one billion yuan.

What looks unspectacular at first glance should not be underestimated in its significance: step by step, the yuan is being built up — first within the Asian financial sphere — into a hub for regional capital flows and interbank clearing.

Yet a problem shimmers through in the background: there is a lack of trust in the political integrity of the dictatorship in Beijing. The state is attempting to heal this problem by backing its currency system, step by step, with gold. This approach was already tested with Russia in the case of energy imports — and yet the yuan still accounts for only around 8.5 to 9 percent of global foreign exchange trading, and is held as a reserve currency by other central banks at a rate of only around 2 percent.

One element that reaches far beyond mere clearing procedures in the interbank market is China’s mBridge. Conceived as a distributed ledger technology — a method for steering financial flows via central bank digital currency (CBDC) — mBridge was initially envisioned as the great pathbreaker of the BRICS financial architecture.

Here, though, it stalls: the integration process is hampered by that same trust problem in the digital yuan. Who wants to hold a currency — or yuan-denominated securities — that could be eliminated at the push of a button by the financial administration of the Communist Party? We know this problem from Euroclear and the Russian central bank’s assets parked there: frozen at the push of a button. Political damage and lasting loss of trust are the result.

For mBridge, the following holds true: while CIPS merely internationalizes the existing yuan, the new ledger technology creates a technological revolution — direct exchange between central banks, without third parties and without detours through Western correspondent banks.

Taken together, these three pillars make the direction of Chinese policy clear: the latest technological standard, right up to crypto technology, is on offer. Immediate clearing and an interbank market are being provided that, down to the repo level, replicate the existing architecture of the dollar system.

Yet two problems already discussed loom over all of it: the powerful network effect of the U.S. dollar, and America’s absolute commitment to private property. Even the fact that U.S. political leadership has recently wielded SWIFT — and with it the dollar — as a geopolitical sledgehammer within its sanctions policy has, so far, done nothing to change that effect. (RELATED: Why the Trump Administration Intervened to Support Japan’s Yen)

Then there is the problem of Chinese politics itself: at bottom, the Communist Party is a dictatorial system with total domestic power — property rights are assigned in a neo-feudal manner and can just as easily be withdrawn. How China intends to resolve this problem in financial markets over the long run remains to be seen.

Whether the massive gold accumulation by the Chinese central bank can close the trust gap trading partners have in the yuan is, however, not unlikely — provided China succeeds in establishing a transparent custody and exchange system with an independent oversight mechanism.

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