Late last month, the central banks of China and Germany agreed to settle payments using the Chinese Yuan as one way of boosting bilateral trade. Earlier, the Bank of England had also agreed to a deal with China to make London a hub for Chinese currency dealing.

China, the world’s second largest economy, is pushing for a bigger role for the Yuan in international trade by signing currency swaps with major economies around the world. 

Prior to the German and British deals, China had signed 23 bilateral currency swap agreements with several central banks worth over 2.2 trillion Yuan ($358 billion).

Experts now predict that, the end of the dollar’s reign as the global reserve currency may be fast approaching.

Figures from the German statistics agency, Destatis, show that China is Germany’s third largest trading partner, with total imports and exports amounting to $193.2 billion in 2013.  According to Wall Street analysts, the currency swaps will make it easier to trade the Yuan offshore and ease investors’ concerns over the ability to dispose of large sums of the currency on short notice for trade settlement needs.

A swap allows currency exchange between two foreign parties in repayment of loans or trade transactions, thereby circumventing foreign exchange controls and costs.

In order to appreciate the significance of China’s currency pacts in global trade, one has to consider the role of the US dollar as a reserve (anchor) currency in International trade.

The dollar has been the world’s primary reserve currency since it replaced the British Pound sterling in 1945 following the Bretton Woods agreement, signed in 1944, that sought to make currencies convertible in order to facilitate trade. 

A reserve currency or anchor currency is money that is held in significant quantities by governments and institutions as part of their foreign exchange reserves mainly for use in international transactions.

This means apart from the USA, that owns the dollar, all other countries seeking to engage in international trade have to buy dollars at market rates that are determined by forces of demand and supply.

That means that if a Rwandan importer seeks to buy goods from China, he must buy dollars using Francs. When an importer buys dollars expensively, it has an impact on the price at which the final consumer will buy the goods. This could contribute to a type of inflation that originates from outside the country—known as imported inflation.

Yet an American is at an advantage because they don’t have to buy foreign currency to import. This saves Americans in excess of $100 billion per year, according to Rogoff, Kenneth (October 2013).

Now, experts predict that China’s currency pacts with major economies will ultimately lead to the day when the Yuan will substitute the dollar in all of China’s trade with other countries; and could gradually end the reign of the dollar as a global reserve currency.

There is indeed a strong evidence to believe this assertion:

In June 2013, Britain became the first member of the G7 to establish a currency swap line with China after a three-year swap deal worth 200 billion Yuan (20billion pounds) was sealed with Bank of England.

Then in October 2013, China and the European Central Bank (ECB) signed a 350bn yuan ($57bn or £36bn) currency swap treaty that was tipped to, "expand Yuan-based settlement and reduce the reliance on the US dollar,” according to Guo Tianyong, a financial studies professor with China’s Central University of Finance and Economics.

In June 2012, China agreed on a currency swap deal worth $30 billion with Brazil with intention of boosting reserves and bilateral trade with the southern American economy now estimated to be worth $100 billion.

Earlier that year in March, China had signed another currency deal with Australia worth $31billion for three years aimed at supporting bilateral trade between the two countries which already exceeded $100 billion per annum as well as reduce transaction costs.

January 2012 also saw China sign another three-year currency swap with United Arab Emirates worth 35 billion Yuan ($5.54 billion) and with Turkey worth $1.6 billion in February the same year.

Financial observers note that China began the process of internationalising its currency in November 2010 when then Russian Prime Minister Vladimir Putin and Chinese Premier Wen Jiabao announced that Russia and China had decided to use their own national currencies for bilateral trade, instead of the dollar. Trade between China and Russia is above $70billion per year.

Indeed, the Yuan started trading against the Russian Ruble in Shanghai immediately, and in December 2010, it began trading on the Moscow Interbank Currency Exchange. 

How is the dollar affected?

At this point, it’s obvious that the rise of the Yuan in international trade would reduce the demand and value of the dollar as more and more countries settle payments using the Yuan.

The first advantage is that low demand will reduce the cost of the dollar, which would lead to less expensive commodities. However, investors holding large amounts of dollars could also lose money given the subsequent decline in value.

What further weakens the future prospects of the dollar is the fact that in 2013, China became the world’s largest trading nation overtaking the US when it recorded annual trade transactions of over $4 trillion.

In 2013, China’s imports rose by 7.3 percent to $1.95tn; that makes China a leading buyer of dollars to pay for its huge import bill. With swap deals allowing China to use the Yuan, it means there would be less or no need for the dollar.

Also, as a leading exporting nation whose exports earned $2.21tn last year; it means if China allowed buyers to pay using the Yuan, again the dollar will be unwanted.

In its 2010 report, the Hong Kong Banking Service (HSBC) predicted that by 2015, half of China’s trade transactions with emerging markets could be settled using the Yuan; adding that nearly $2 trillion worth of trade flows could be settled using the Yuan, making it one of the top three global trading currencies.

According to the Bank of International Settlements (BIS) triennial report published in September last year, trading in the Chinese currency more than tripled between 2010 and 2013 and now boasts over $120 billion transactions per day.

East African economies

From a trade perspective, this is a very significant development for East African economies given their strong trade ties with China. The trend might require EAC central banks to consider diversifying their foreign currency reserves to back up dollar stock-piles and allow importers an option for the Yuan when shopping from China.

This could be done through a currency pact between EAC and China or for EAC members to reach bilateral agreements that suit their situations. 

Take Rwanda as an example; with Rwf1000, an importer can buy almost 10 Yuan, but only less than $2 for the same amount. In 2013, trade value between Rwanda and China hit $240million which’s a strong impetus for a currency pact between China and BNR.

Skeptics question the capacity of China running a stable currency but the 2008 crisis showed the world that the US too can no longer guarantee economic stability after its monetary policy went awfully wrong. 

In fact, as a result, China and Russia have previously proposed a move towards a super-sovereign reserve currency to safeguard the global economy and against situations like that of 2008 financial crisis.