Tragedies in Eastern Europe and the associated sanctions shocked the global financial system. In the subsequent years, emerging economies will all have to reflect upon to what extent their cross-border banking networks and international reserve centered around the US dollar and Euros are reliable. Countries that might be at odds with the superpowers aside, allies of superpowers may also have second thoughts due to rising populism.
The seeds of doubts upon the financial system they created and dominated are the real pain for the US and the European superpowers, even if the measures are withdrawn in the future. In this sense, the power of financial sanctions reaches the highest at the first punch, and each blow afterward will be weaker.
However, the international financial is a derivative of the global political order. As long as the latter is still under a question mark, a stable solution for the former, let it be supernational currencies or blockchains, will be hard to find.
Fining some temporary solutions answering to near-sight problems will be more practical. Many are betting that the Renminbi may serve as an alternative system. While it did serve as a partial safe asset recently (RMB is one of the few currencies of Emerging Economies that appreciated in the past weeks), third-party participation (exporters/importers reside outside China) remains challenging due to lack of trade finance, guarantees, and other financial services.
Cooperation among policy banks and intergovernmental agencies may help alleviate the problem. An intergovernmental agency with access to the RMB bond market may raise RMB funds in mainland China and loan it national Export-Import Banks, which extends RMB trade finance to domestic importers. When receiving RMB settlements, exporters invest directly or indirectly in the RMB bond market, completing the cycle.
Three Necessary Elements of a Temporary Alternative Mechanism
Settling international trade is more than currencies. Over the past 70 years, the US dollar (and Euros in the past two decades) has been providing a complete set of financial services, involving at least three necessary elements.
First, they provide a global network of banks with cross-border branches, connecting to a centralized clearing platform. Global banking makes it possible for funds to go across borders. Since most transactions today do not involve the actual relocation of banknotes anymore, international financial flows are reflected by certified changes in book-keeping records between financial institutions. These certified changes are ultimately made through centralized clearing systems, such as CHIPS for the US dollar and TARGET2 for Euros. International financial transactions rely on the network of global banking because it connects other countries to CHIPS or TARGET2 through branches or correspondent banks in the US and Europe.
**Second, they provide good investment instruments for net exports to store value. **In reality, it is hard to find an economy that holds zero trade balance with any of its trading partners. This leads to excess holding of settlement currencies (i.e., savings) for net exporters, demanding debt or equity instruments for investment. Some will prefer liquid and safe assets (as reserves), while others may choose riskier assets with higher returns. Therefore, for a currency to be widely used for investment, there need to be ample supplies of investable securities with various risk and return profiles.
Third, sufficient provision of trade finance, guarantees, and other related financial services at low costs. **International trade is nearly impossible to work in a “cash for goods” paradigm.** Exporters need to verify their counterpart’s ability to pay, while imports need to confirm their counterpart’s ability to deliver. This naturally leads to payables/receivables, export/import credits, their party guarantees. For instance, an importer may apply for a loan in the settlement currency to make payments. For another example, an importer may approach a domestic bank to issue a Letter of Credit, which gets delivered to the exporter via a correspondent bank in the exporter’s country. These financial services serve as lubricants for international trade and should be widely available at reasonably low costs.
The current sanctions touched upon all three elements. Banks losing access to SWIFT cannot make time and secure communications with correspondent banks connecting to centralized clearing platforms. Frozen foreign exchange reserves destroy the value stored via savings. Financial institutions are restricted from providing trade finance or guarantees to trade deals due to moral and compliance concerns, although trade-related transactions are exempted from sanctions. Their impacts on trade are comprehensive.
Renminbi as a Temporary Solution for Bilateral Trade involving China
Despite moral and compliance pressure, it would be difficult to completely cut the targeted country out of the world economy. As an industrial powerhouse, it produces many industrial supplies other than oil and gas, such as 37% of the world’s palladium production, 20% of potash production, 28% of sunflower oil exports. Current shocks have already caused considerable discounts for commodities it produces compared with international benchmark prices. Given time, basic economic principles will incentivize demand, calling for alternative trade settlement mechanisms.
Sanctions made it challenging to use recognized international currencies besides the US dollar and Euro, such as the British Pound, the Japanese Yen, and the Swiss Franc. Even the Singapore dollar, a leading Emerging Market currency, is taken out of the list.
For trade with Chinese exporters/importers, Renminbi is a practical substitute. Among their USD 106 billion bilateral trade in goods, China has a deficit of USD 5.6 billion. This means the other counterpart will hold Renminbi assets in net terms after settlement. Therefore, as long as Chinese financial institutions are willing to extend import finance or guarantees to domestic importers, Renminbi will be able to flow across borders through branch banking of Chinese banks to foreign exporters, who can deposit these payments at banks or invest in RMB securities, completing the cycle.
What about trade not involving China?
There are other Emerging economies that may want to continue trading with the targeted country. For instance, a South Asian country had a bilateral trade of USD 8.1 billion in 2020, of which it had a deficit of USD 3.1 billion. Although this was only 1.5% of its total trade in goods and 2.6% of total deficits, 80% of its imports are industrial supplies (According to the Broad Economic Category classification, 37% are under “Category 3, Fuels and lubricants” while 44% were under “Category 2, Industrial supplies not elsewhere specified”.) Meanwhile, this bilateral trade relationship provided 29.3% of the total imports under “Category 7, Goods not elsewhere specified” (a residual category covering arms and other goods).
A Latin American country serves as another example. It had a bilateral trade of USD 4.4 billion in 2020, of which it had a deficit of USD 1.4 billion. More than 80% of the imports are under “Category 4, Industrial supplies not elsewhere specified”.
Three options are left for settling these trade deals not involving China: gold, the currency of the net exporter or the net importer, or Renminbi.
**Gold seems to be a trustworthy instrument against mounting uncertainties but is associated with two apparent caveats. **On the one hand, increasing gold price adds a burden to importers since they need to purchase gold with domestic currencies before making payments. On the other hand, since cross-border shipment costs for gold would be substantial and time-consuming, transactions cannot occur in a real-time gross settlement method, which again calls for certified book-keeping among gold accounts. This, in turn, asks strong presence of cross-border branches of financial institutions between the exporter’s economy and the importer’s economy, which may not always be there currently.
**Currencies of the exporter or the importer are also not ideal. **A net exporter’s currency has depreciated significantly since late February and is still subject to large volatilities. In addition, the 20% policy rate makes it almost impossible for importing firms to obtain trade finance. Currencies of net exporters suffer less from those caveats. However, compared with RMB, they are associated with smaller supplies of liquid and safe investment securities and may be less favorable for exporters.
Renminbi can be a solution, but Renminbi trade finance and guarantees are less accessible for non-Chinese exporters and importers
Although much less international than the US dollar, Euro, Yen, and Pound, Renminbi is part of the SDR basket. Meanwhile, China has the world’s second-largest bond market (accessible to foreign investors, particularly central banks). China sovereign debt is rated at A+ by S&P and offers a yield of 2.85% (10-year treasury bonds), not too low for investors and not too high for borrowers. For comparison, the yield for 10-year Indian government bonds is 6.8%, while Brazil’s is 12%. Meanwhile, the offshore market in Hong Kong, which has about USD 150 billion worth of RMB deposits currently, offers a market free of capital control.
How would a non-Chinese importer get enough Renminbi trade finance, then?
It could apply for loans from a Chinese bank branch, but this requires a strong presence of Chinese banking business locally.** The local branch has the ability to verify and monitor local borrowers, and the headquarter located in China is willing to increase foreign exposure given the uncertain business environment.**
It is also possible for a local bank to issue Renminbi bonds in China and then extend RMB-denominated trade finance to importers. However, this requires local financial institutions to be familiar with the Chinese bond market and be able to issue bonds at a low credit premium. This is also something hard to achieve in the short term.
Bilateral governmental cooperation may be helpful. For instance, the central bank of the importing country may initiate a currency swap with the People’s Bank of China and then pass the Renminbi they received to domestic institutions. However, two caveats are associated with this bilateral approach. On the one hand, not all economies have signed currency swap agreements with China (India, for instance, does not have one, while the BRICS Contingency Reserve Arrangement allows participants to borrow USD, not Renminbi, against domestic currencies).
On the other hand, since the People’s Bank of China has a less direct business incentive in these swaps, the deal may be perceived as a political decision challenging the dominance of the US dollar rather than a practical move to facilitate international trade.
Multilateral Inter-Governmental Cooperation as a Temporary Solution
I propose a multilateral approach to temporarily provide Renminbi trade finance to non-Chinese exporters and importers. This approach relies on an existing multilateral mechanism covering Ministry of Finance, central banks, and Export-Import Banks. This multilateral mechanism should also have an existing development financing institution with easy access to the Chinese bond market.
The solution works as a three-step cycle. First, this Multilateral Development Financing Institution (MDFI) issues RMB bonds in China. Second, it extends an RMB loan to the Export-Import Bank (Eximbank) of the importer’s country, which then extends RMB trade finance to domestic importers (or asks domestic financial institutions to do that on its behalf). Third, when receiving the RMB payments from importers, exporters directly or indirectly invest in RMB securities (bonds of the MDFI in particular), completing the cycle.
The RMB bonds and the loans extended to Eximbanks may be rolled over when reaching tenors. Therefore, only interest payments need to be settled (in this case, Eximbanks can even collect trade finance in local currencies). Assuming the MDFI can issue RMB bonds very close to Chinese government bonds’ yield, the loan interest rate (funding cost + operating cost + premium) it extends to Eximbanks will be lower than Eximbanks’ domestic funding costs. As long as bilateral foreign exchange rates against RMB are not too volatile, interest payments will not be a substantial burden.
This approach is associated with four advantages. First, as is endorsed by all parties within a multilateral mechanism, it provides non-Chinese users of RMB a louder voice, alleviating the doubts on abusing monopoly power. Second, it utilizes MDFI’s familiarity in the Chinese bond market to obtain RMB at a lower cost. Third, it utilizes domestic financial institutions’ capacity in verifying and monitoring local firms, minimizing idiosyncratic risks. Fourth, all transactions are done with MDFI, which is collectively owned by participants of the multinational mechanism, rather than the government of another country, reducing political sensitivity and the risk exposures between sovereign institutions.
