China’s Neighbors Are Eyeing Up Yuan as Banking Worries Spread

Recent U.S. banking turmoil is casting doubt on America’s ability to maintain its leadership of the global monetary system. Washington needs to take decisive steps to shore up confidence, including extending dollar credit lines to a clutch of Asian countries.

The collapse of Silicon Valley Bank after a sharp rise in interest rates over the past year slashed the value of the bank’s bond holdings and put the spotlight on other weak banks: Witness the rapid demise of Credit Suisse after anxious depositors deserted Switzerland’s second-largest lender, prompting the Swiss authorities to arrange a shotgun takeover by the bank’s bigger rival, UBS (formerly Union Bank of Switzerland).

The direct fallout in Asian banking markets has been limited. But the longer-term ramifications are likely to be significant. For it is in Asia that the United States’ global financial hegemony is being most keenly contested—by China.

For several years now, starting in response to the 2008-09 global financial crisis, Beijing has been pursuing a coherent, long-term strategy to decouple from the dollar and coax its Asian neighbors to join a regional monetary order that would have the yuan, China’s currency, at its core.

China wants to be able to purchase what it needs from other countries using its own currency and its own payment systems. It wants to reduce its dependence on the dollar and achieve greater financial self-reliance.

Beijing laid the foundations of its campaign from 2009 to mid-2015, making it possible to transact in yuan overseas and creating opportunities for foreigners to use the currency. Initial progress was encouraging, thanks to the yuan’s appreciation against the dollar, but cross-border use declined in tandem with a reversal in the yuan’s exchange rate.

After taking stock, Beijing has focused since around mid-2017 on giving foreigners reasons to use the yuan despite the higher cost of transacting in it, based on its merits as a medium of exchange, store of value, and unit of account—the characteristics of a global reserve currency.

At its most basic, Beijing is trying to create a permanent and sustainable cycle of yuan flowing out of China into the global economy, then flowing back again. Beijing is trying to ramp up outflows by concentrating its efforts on trade. Meanwhile, the main channel for inflows is investment into China’s financial markets.

The failure of U.S. regulators to spot the trouble that was looming at Silicon Valley Bank can only burnish the appeal to some Asian policymakers of an alternative to the United States-led financial order. Disillusionment with Washington’s economic stewardship has been increasing in a region dependent on global inflows of dollars and thus exposed to abrupt swings in U.S. monetary policy.

The shock of the global financial crisis; the perception by some economists of poor monetary management during the COVID-19 epidemic; and, more recently, the U.S. Federal Reserve’s belated rush to jack up interest rates after it misjudged the severity of inflation have all damaged the United States’ economic reputation in Asia.

The situation is far from irreversible, but Washington needs to halt the corrosion of trust by forging closer ties with countries that are willing to respect the United States-led rules-based financial system.

The Biden administration’s Indo-Pacific Strategy, published in February 2022, provided a fair idea of which Asian countries the United States wants to keep in its own orbit and out of China’s.

As part of the strategy, the United States said it was deepening its five regional treaty alliances—with Australia, Japan, the Philippines, South Korea, and Thailand—and strengthening relationships with a group of “leading regional partners,” including India, Indonesia, Malaysia, New Zealand, Singapore, Taiwan, and Vietnam.

All these countries are wary of being drawn too tightly into China’s embrace, and they do not want to become mere pawns in a Sino-U.S. struggle for supremacy. However, some could easily drift toward Beijing if, for example, lurches in Washington’s monetary policy start destabilizing their economies and China can offer what seems like a steadier alternative.

A lot is at stake. These Asian countries generate a large chunk of the world’s saving flows. If China can lure them into its financial clutches, it will have more heft to push back against the United States-led financial order. Beijing would like its neighbors to use the yuan rather than the dollar for imports and exports; hold more of their central bank reserves in Chinese assets; and, in the future, use China’s digital yuan for cross-border payments.

To fend off China’s challenge and retain its geopolitical role in the Indo-Pacific, backed by economic might, the United States needs to pursue a twin-track policy. First, it should beef up its military presence in the region—something it is already doing via the AUKUS trilateral security pact (whereby the United States and U.K. will provide Australia with nuclear-powered submarines) and a deal giving U.S. forces access to four more military bases in the Philippines.

Second, the Federal Reserve should add the central banks of its Indo-Pacific leading partners to the list of foreign central banks with which it has standing dollar swap lines, via which the banks can exchange their national currencies for dollars (and vice versa). Currently, the only participating bank in Asia is the Bank of Japan.

These swap lines were set up during the global financial crisis to make sure that countries had enough dollars to pay for imports and that their banks could keep extending dollar credit to businesses. They were turned from temporary to standing arrangements in 2013.

Responding to the latest banking tremors, the Federal Reserve and the five central banks it has standing swap arrangements with—the European Central Bank, Bank of Japan, Bank of England, Bank of Canada, and Swiss National Bank—announced on March 19 that they would offer dollar swaps daily instead of weekly.

No doubt the United States fears that by granting permanent swap lines to developing nations, it would potentially be enabling them to pursue reckless economic policies. However, the financial stability of those countries is threatened by sudden outflows or inflows of capital and by exchange rate fluctuations caused by changes in the Federal Reserve’s monetary policy.

Swap lines could help lessen the impact of such changes and ensure that the dollar remains more attractive than the yuan for countries that matter to the United States. Moreover, widening the web of swaps would be a symbol of goodwill from Washington and would signal to Beijing that the beneficiaries are permanent members of the dollar zone.

One of the consequences of Russia’s invasion of Ukraine is that Moscow is conducting more and more trade in yuan instead of dollars because of the sanctions the West imposed on its banks. China’s currency thus has the wind in its sails.

Without better access to dollars, Asian countries that the United States has identified as leading partners might one day have no choice but to turn to China for emergency funds. Given the competitive threat it says is posed by Beijing, does Washington really want to take that chance? Expanding the Federal Reserve’s swap lines would be a simple and effective way to avert the risk.