Can the yuan dethrone the US dollar as the world’s reserve currency?

The US dollar index (DXY) continued its downward trend this week after Federal Reserve minutes pointed to a recession later this year. And with inflation falling, there is a possibility that the Fed will start pivoting soon. The DXY index was trading at $100.49, ~15% below the highest point in 2022.

The Chinese yuan, on the other hand, has been in a strong bullish trend. According to TradingView, the USD/CNY pair was trading at 6.831 on Friday, down by 6.70% from its 2022 high. This performance happened as the Chinese economy reboots after last year’s Covid-zero strategy.

So, as the US dollar and the Chinese yuan diverge, there are some concerns about whether the US dollar will maintain its reserve currency status.

Global discomfort about the US dollar status

The reality is that there is a global discomfort about the role of the US dollar a the world’s reserve currency. These concerns are both happening among America-friendly countries and foes like Russia and China. Among European allies, there has always been a concern about why the euro is not as popular as the greenback.

The situation, I believe, has gotten worse during the Covid-19 pandemic and Russia’s invasion of Ukraine. In the past few months, the Federal Reserve has hiked interest rates by more than 400 basis points in its bid to fight inflation.

The aftermath of this is that most countries that have dollar bonds have seen the cost of servicing them surge. As I wrote here, many emerging and frontier markets are going through their worst liquidity crisis on record as the dollar shortage escalates. Countries like Ghana, Kenya, Pakistan, and Sri Lanka are all on the verge of collapsing. 

Meanwhile, the decision by the American government to sanction Russia’s central bank and block its foreign reserves sent shockwaves among many countries. The concern is that the US now has the power to sanction any central bank they seem fit.

Is the Chinese yuan the solution?

Worries of the US dollar dominance explain why central banks bought a record amount of gold in 2022. Most of these purchases happened in countries that are critical of the US like Turkey, China, India, and those in the Middle East.

Now, there is a lingering debate about whether the Chinese yuan can dethrone the US dollar. As we wrote here, one of the biggest forex news of the year was that Russia has turned to the Chinese yuan recently. And as China’s influence grows in the developing and frontier markets, we could start seeing more yuan demand. As seen in this report, many African countries have embraced the yuan.

To dethrone the US dollar, countries need to trust Beijing and its actions. For now, most countries, including allies, have a lot of distrust against Beijing. For example, many countries funded by China lament that the country’s practices are predatory. As a result, protests against Chinese citizens in many developing countries have risen 

Most importantly, there are signs that China’s economic growth peaked. For decades, most of China’s economic growth was driven by the real estate sector, an industry that is on life support. Further, the export market that powered the economy seems like it is slowing as countries find for alternatives.

At the same time, the judicial and political systems are not compatible with that of most countries. For people to trust a currency, these are fundamental issues. Therefore, the US dollar will maintain its reserve currency status because of the democratic process in the US, strong judicial system, and the independence of the Federal Reserve.