The Role of the Chinese Yuan in the New Global Financial Order

One of the most popular frameworks for international monetary policy since the 1960s to the present is the impossible trinity or monetary policy trilemma. This approach was popularised by International Monetary Fund (IMF) economist Robert Mundell (1960) and Marcus Fleming (1963). It is popularly known as the Mundell-Fleming model.

The impossible trinity states that a country cannot simultaneously achieve three objectives: maintaining exchange rate stability (fixed exchange rate), ensuring free capital mobility, and securing independent monetary policy.

A country must choose to achieve two out of the three objectives above: first, maintaining exchange rate stability and implementing free capital mobility but sacrificing monetary policy independence. The steps involve joining a common currency, such as the euro, or pegging the currency’s exchange rate to the US dollar.

Second, maintaining free capital mobility and independence of monetary policy from external influences but sacrificing exchange rate stability. The option is to implement a flexible exchange rate regime (floating exchange rate regime).

Third, maintaining exchange rate stability (fixed exchange rate regime) and ensuring independent monetary policy to guarantee tight control over a country’s national economy. This option sacrifices capital freedom (capital controls).

In line with the three options above, China’s central bank, the People’s Bank of China (PBOC), prefers the third option, namely maintaining exchange rate stability and eliminating China’s economy from external factors. At the same time, the PBOC restricts cross-border capital flows.

The third policy option is highly relevant since the 1997-1998 Asian financial crisis, marked by extreme depreciation of currency values and declines in stock price indices in several Asian countries. This was triggered by hot money flows, namely short-term fund flows for speculative purposes (speculative attack).

The PBOC imposes restrictions on Chinese banks borrowing abroad and limits the value of shares that foreign investors can purchase on the Chinese stock market. This policy effectively limits hot money flows and reduces stock price fluctuations.

This policy continues to the present day, hindering foreign investors from doing business with Chinese companies and limiting the international circulation of the Chinese yuan. The Chinese yuan is not yet fully and freely convertible to other currencies.

In line with Eichengreen and Kawai, 2015, the PBOC differentiates money market interest rates in the domestic market, CNY (mainland), and the offshore money market, CNH. This separation ensures the availability of the Chinese yuan for importers, but at the same time, the PBOC controls foreign exchange traffic between countries.

The Chinese yuan is traded freely in the domestic money market but with restrictions on transactions in the Chinese yuan money market abroad. The two Chinese yuan money markets also differ in terms of interest rates. The difference can reach 10 percent. This directly increases transaction costs.

Fundamentally, as stated by economist Prasad, 2017, the PBOC has opened clearing centres to facilitate interbank transactions abroad and money markets outside China, but to date, the Chinese yuan is not sufficiently available in major world money markets, such as financial centres in London and Geneva.

As a result, the role of the Chinese yuan in international trade and financial transactions is limited. This is reflected in the index of Chinese yuan usage in international transactions, which is only 2.5. Meanwhile, the US dollar’s international usage index reaches 66 in 2023.

The index of Chinese yuan usage in international transactions does not align with the size of China’s contribution to the global economy, which is 17 percent. This is larger than the European Union’s 15 percent, with the euro’s usage index at 23.

Similarly, the US economy’s contribution to the global economy reaches 25 percent, measured by real Gross Domestic Product (GDP). In contrast, the US dollar’s usage index is around 67.

In terms of international trade, China’s trade value has already surpassed the US, reaching approximately 6.2 trillion US dollars in 2024. Meanwhile, the US international trade value is only 5.3 trillion US dollars in 2024.

If observed in the early 2000s, China’s international trade value was only 447 billion US dollars. At the same time, the US international trade value reached 2.0 trillion US dollars. China’s international trade value surpassed the US since 2012.

The Chinese yuan’s international usage index of only 2.5 is due to the low use of the Chinese yuan in payments for Chinese goods and services trade. The use of the Chinese yuan in Chinese goods trade is only 27 percent and 30 percent in services trade.

The solution, to increase the influence of the Chinese yuan in international transactions, it is advisable to refer back to the Mundell-Fleming economist; the best option for China’s central bank, the PBOC, is to ensure free cross-border capital flows while maintaining independent monetary policy by switching to a flexible exchange rate regime.

In line with Eichengreen, 2023, the PBOC slightly sacrifices exchange rate stability without sacrificing capital freedom by eliminating restrictions on Chinese yuan transactions with other currencies in the offshore market.

Finally, for the national economy, in the short term, it will still face challenges from US dollar hegemony. However, in the medium term, the share of the Chinese yuan will increase significantly, which will require