CHINA’S dominance of global trade provides a path to increase its currency’s share in global central bank reserves, but the country will need to maintain large U.S. dollar reserves for that to happen, according to a new research.

While the yuan isn’t on course to displace the dollar as the world’s dominant currency, it could play a larger role in a more “multipolar” financial world, economists, including Barry Eichengreen of the University of California Berkeley and Camille Macaire of France’s central bank, argue in a new paper hosted by the Center for Economic Policy and Research.

The analysis found a significant correlation between countries’ trade with China and the size of their central bank yuan reserves, which have grown in recent years.

“The share of the yuan in reserves can increase if Chinese trade and yuan invoicing continue to increase,” the authors argue.

Even if countries have a trade deficit with China, they can accumulate yuan reserves if China pays for imports in yuan but accepts dollar payments for its exports, and China’s overseas direct investment and lending are another way countries can acquire China’s currency, they wrote.

In this situation, central banks are holding more yuan to provide domestic companies with emergency liquidity, the authors wrote.

To encourage other countries to hold more of their reserves in the yuan in a dollar-dominated world, China has to promise that these reserves can be converted to dollars at a stable rate, and the key to this is the offshore yuan market and China’s dollar reserves, which allow it to intervene in that market if necessary, the paper argues.

There are signs that the yuan is gradually becoming more important as a currency in international trade. Australian mining conglomerate BHP Group Ltd. saw its first shipment of yuan-settled spot traded iron ore dock at a port in eastern China in June, and the yuan’s share of global trade financing was nearly 3% in June 2022, up from about 2% two years earlier, according to cross-border payment operator SWIFT. That compares with about 87% for the dollar.

China’s central bank said in June it will create a yuan reserve pool with the Bank for International Settlements and Indonesia, Malaysia, Singapore and Chile to provide liquidity to participating economies in periods of market volatility.

“The situation of the yuan today is not unlike that of the dollar in the 1950s and 1960s,” the report’s authors argue. “Both the London gold market in the 1960s and the offshore yuan market today are products of a similar problem, namely the imperfect convertibility of an international currency [the dollar then, the yuan now] into the ultimate reserve currency [gold then, the dollar now].”

While holding large dollar reserves increases China’s dependence on the United States, “this peculiar relationship between the world’s two largest economies is the only way for China to make the yuan a significant reserve currency without embarking on full capital account liberalization,” they authors write. However, “the yuan can nonetheless undergo an internationalization process with Chinese characteristics.”

Research published by the International Monetary Fund earlier this year showed global central banks have reduced the share of dollars in their foreign exchange reserves over the last two decades, with one quarter of the reduction heading into the yuan.

The rest was into currencies of smaller countries that have traditionally played a limited role as reserve assets. (SD-Agencies)