China's Yuan Faces Tumultuous Decline Amid Rising U.S. Sanctions and Dollar Dominance

 

The Chinese yuan has experienced a significant decline, exacerbated by U.S. sanctions and central banks' growing preference for the U.S. dollar, highlighting vulnerabilities in China's economic strategies.

The Chinese yuan has been experiencing significant depreciation, a trend that can be attributed to the escalating risk of U.S. sanctions and central banks' increasing preference for the U.S. dollar. The decline of the yuan, particularly in the context of its valuation against other currencies such as the Russian ruble, highlights broader economic and geopolitical dynamics affecting China's financial stability.

The yuan’s depreciation is evident in its performance against the Russian ruble, where it has fallen to approximately 11.51 rubles, its lowest in a year. This decline is not isolated but is part of a larger trend where central banks globally are reducing their yuan holdings. A survey by the Official Monetary and Financial Institutions Forum (OMFIF) revealed that 12% of central bank reserve managers plan to decrease their yuan holdings in the next one to two years, while 20% intend to increase their dollar reserves during the same period. This shift is a reversal from previous years when a significant proportion of central banks were more optimistic about the yuan.

The imposition of secondary sanctions by the U.S. on entities engaging with Russia’s economy has significantly impacted China due to its deepening economic ties with Russia. Since Russia's invasion of Ukraine in 2022, China and Russia have strengthened their economic partnership, achieving a record trade volume of $240 billion in 2023. This "no limits" partnership has seen a substantial shift away from the U.S. dollar in their bilateral trade, further entrenching the yuan’s role in Russian economic transactions.

However, the geopolitical climate has added layers of uncertainty. Reports suggest that U.S. lawmakers are drafting potential sanctions targeting Chinese banks, which, if implemented, could exclude these banks from the global financial system, severely disrupting their international operations and trade. In response, Chinese state-run banks have already begun restricting their lending to Russian clients to mitigate the risk of falling under U.S. sanctions.

Central banks’ cautious approach towards the yuan is also influenced by China’s internal economic policies and market dynamics. For instance, the yields on Chinese government bonds are significantly lower compared to those of U.S. Treasury bonds. The yield on China’s 10-year bonds is around 2.3%, whereas U.S. 10-year Treasury notes offer yields of approximately 4.5%. This substantial difference makes U.S. bonds more attractive to reserve managers seeking higher returns.

Moreover, China’s economic policies have introduced additional layers of risk and uncertainty. The Chinese government's strict capital controls and interventionist policies have made foreign investors wary. While China has made efforts to internationalize the yuan, including initiatives like the Hong Kong-Shanghai stock connect and the launch of yuan-denominated gold and oil contracts, these measures have had limited success in significantly boosting the yuan’s global acceptance.

The yuan’s share in global foreign exchange reserves has grown modestly but remains relatively small. According to the People’s Bank of China, the yuan accounted for 2.88% of global reserves in the first quarter of 2024, up from 1.2% in 2017. Despite this increase, the U.S. dollar still dominates, comprising 59.2% of global reserves. This disparity underscores the challenges faced by the yuan in gaining broader acceptance as a reserve currency.

China's strategy to promote the yuan as an alternative to the dollar includes deepening its economic ties with countries facing similar sanctions and geopolitical pressures, such as Russia and Iran. For example, China has been facilitating trade with these countries in yuan to circumvent U.S. sanctions. However, this strategy has its limitations and cannot fully offset the broader market's preference for the stability and returns offered by dollar-denominated assets.

In plain terms, the tumbling of China's yuan amid U.S. sanctions and central banks’ bolstering of dollar holdings reflects a complex interplay of geopolitical tensions, economic policies, and market dynamics. While China continues to push for greater international use of the yuan, the currency faces significant headwinds, including lower returns compared to the dollar, market transparency issues, and geopolitical risks. As the global economic landscape evolves, the future of the yuan will likely depend on China's ability to navigate these challenges and implement policies that enhance the currency’s attractiveness and stability.