How can China prepare for a possible “weaponization” of the US dollar?

Editor’s note: This article has been translated and edited from an analysis published on May 21 by Yu Yongding. Yu is a fellow of the Chinese Academy of Social Sciences and a former member of the Monetary Policy Committee of the People’s Bank of China. The article reflects the opinions of the author and not necessarily the views of CGTN.

After the outbreak of the Russian-Ukrainian war in February, the United States and its allies froze the Russian central bank’s foreign exchange reserves by $300 billion. Whatever the justifications, the freeze seriously damages the international credibility of the United States and undermines the foundations of the rules-based international financial system.

China has $3.3 trillion in foreign exchange reserves, including more than $1 trillion in US Treasury bonds. The “weaponization” of foreign exchange reserves is forcing China to re-examine the safety of its foreign exchange reserves and overseas assets, not only from an economic but also geopolitical perspective.

China’s holdings of foreign exchange reserves are by far the largest in the world and almost three times larger than those of Japan, which ranks second in the world for holdings of foreign reserves. China’s foreign exchange reserves have far exceeded internationally recognized reserve adequacy requirements.

Adjustment of the international investment position and the balance of payments to reduce foreign reserve holdings

China started to adjust its balance of payments and its international investment position (IEP) many years ago. The main objectives were twofold.

The first was to improve the structure of external assets and liabilities. With $2 trillion in net assets made up of about $9 trillion in assets and $7 trillion in liabilities, China has been consistently running an investment income deficit for decades. This vast cross-border misallocation of resources is largely attributable to the inordinate share of US Treasuries held by the Chinese government as reserves, but earning negligible returns.

The second was to minimize possible losses in the value of China’s foreign exchange reserves. In the post-Bretton Woods system, the dominant reserve currency, the US dollar, was provided by a national state – the United States – through current account deficits. As a result, the United States has a net foreign debt of $18 trillion. No one knows if and when the US dollar will collapse, and US inflation is spiraling out of control. Therefore, China should reduce its stock of foreign exchange reserves to at least the internationally recognized reserve adequacy level. From now on, following the freezing of foreign exchange reserves by the Russian central bank, China must take this new dimension into account in the overhaul of its policy for safeguarding its foreign assets in general and its enormous foreign exchange reserves in particular.

For the existing stock of foreign exchange reserves, measures that could be considered include:

-Reduce US Treasury holdings by diversifying into other forms of foreign assets. This approach may not be as useful as previously thought, but it is still worth a try.

-Increase equity investments in countries producing strategic resources, such as equity investments in oil companies in Central Asia and Arab countries.

-Consider providing financing facilities for Chinese investors to purchase high-quality Chinese concept stocks when they have fallen due to geopolitical reasons.

-Strengthening the investment protection of foreign investors in China. The legal repatriation of investment income of foreign investors should be guaranteed.

-Provide necessary support for Chinese enterprises’ overseas financing activities.

-Accelerate the construction of financial infrastructure, such as the construction of settlement, clearing and messaging systems unaffected by the United States. Make full use of China’s technical advantages in digital technology to improve cross-border payment system.

-Reduce holdings of US Treasury securities in accordance with market rules without disrupting the market.

-Increased gold holdings.

While there is not much we can do about existing stocks of short-term foreign assets and liabilities, there is much we can do to adjust the structure of the balance of payments of China which led to the constitution of the current position of the international investments of China. To do this, measures to consider include:

-Stimulate domestic demand and boost imports by implementing expansionary fiscal and monetary policies. It is only when the domestic economy is booming that import demand can increase substantially and a more balanced trade account can be achieved.

-Abolish the remaining export stimulus policies as soon as possible, for example the export tax refund policy should not be used to encourage exports.

-To increase imports of strategic raw materials, and to do so, China’s strategic raw material storage capacity must be increased accordingly.

-While stopping the purchase of new US Treasuries, China should do its best to import more US products to meet the China-US trade agreement, unless force majeure clauses apply .

-China should tolerate trade deficits as long as they are the result of an economic boom and are cyclical in nature, so that China can return “IOU” to the United States for real resources.

-Adhere to the floating exchange rate system and refrain from intervening in the foreign exchange market, except in extreme cases.

-Maintain capital controls necessary to curb speculative capital inflows and prevent capital flight.

-Increase overseas equity investment prudently.

-Increase outward FDI to developing countries, in order to take full advantage of China’s advantages in manufacturing and infrastructure construction, but China needs to pay attention to factors such as political instability and poor balance payments in host countries.

Can the internationalization of the RMB play a role in the security of China’s foreign reserves?

Considering this question in the overall context of the global economic system, the answer should be yes. The internationalization of the RMB is a laudable goal to pursue. But in the short term and in terms of immediate effects, the role of RMB internationalization in safeguarding China’s foreign exchange reserves will be limited.

The safety of China’s foreign exchange reserves will not change significantly, even if they are entirely denominated in RMB, because it is simply a debt of the United States to China. If China is not sure that the United States can fulfill its promise to repay its debt, then China will have no choice but to gradually reduce its holdings of US Treasuries.

Faced with geopolitical as well as economic challenges, the only way for China to get rid of concerns about the security of its foreign exchange reserves once and for all is to implement the “dual circulation” strategy, continuing to maintain open economy but relying more on the domestic market or internal circulation to drive its growth. China hopes for the best, but unfortunately has to prepare for the worst.

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