The invasion of Ukraine by the Russian forces has led to the most aggressive financial sanctions by Western countries against another country in modern history.

Two financial sanctions stand out in particular. Firstly, the decision to block the majority of Russian banks from SWIFT, the global messaging system that enables them to transfer money across the world. This measure is backed by the major world economies such as the European Commission, France, Canada, Germany, Italy, Japan, the UK and the US.

Secondly, these countries also agreed to prevent the Russian Central Bank from using its international reserves held by these countries to undermine sanctions.

The aggressive sanction response from Western nations will most definitely influence the Central Bank of Russia’s decisions in the management of its currency reserves. And here the neutral role of China will be pivotal.

A telling factor is that China, the second largest economy globally, did not join in introducing sanctions against Russia. China also abstained during the UN General Assembly vote and followed a toned-down condemnation approach by stating that sanctions are not the solution to the problem.

The US, UK, Japan and countries in the EU and their respective currencies are the dominant players on the world financial markets. The US dollar and the Euro dominate SWIFT payments – in 2021 they made up 77.2% of them.

But earlier this year Bloomberg noted that the Chinese yuan (also known as renminbi) reached fourth position in the international payments market. This is a remarkable improvement. In 2010 the yuan ranked 35th when SWIFT started its tracking of international transactions.

That was the year that the yuan entered the international financial transaction market. Six years later the currency received IMF approval as a reserve currency.

China has great power aspirations on a wide front. A decade ago it indicated that it was aspiring to make the yuan the dominant currency in trade, financial transactions and especially as a global reserve currency

The country has expanded access to more foreign financial institutions through the Belt and Road Initiative and the expansion of offshore yuan transaction centres. This, in turn, has boosted the yuan’s role in trade and financial transaction as well as its role as a reserve currency.

Geo-political considerations in the past such as Brexit and the US/China trade tensions under US President Donald Trump affected reserve management positions. These events contributed to global trade tensions and may have started the gradual shift away from the US dollar and Euro as reserve currencies.

The Russian/Ukraine conflict, which has contributed substantially to renewed geo-political tensions, is expected to have an even more pronounced influence.

But does the Chinese yuan have the potential to crowd-out the dollar as the eminent global reserve currency?

The recent global uncertainty and divisions created by the Ukraine crisis may give further momentum to this process.

On the rise

More than half – 55% – of all central bank currency reserves are still held in US dollars and 19% in Euros. But a clear shift has gradually been taking place. The most notable has been the decline of the US dollar as reserve currency, down from 69% in 2007.

The yuan now holds the fifth position in the Currency Composition of Official Foreign Exchange Reserves after the US dollar, the Euro, the Japanese Yen and Pound Sterling.

The yuan’s share is a mere 2.5% of official foreign exchange reserves. But its share has increased , dramatically so since 2016.

In addition, it’s held as a reserve currency by an estimated 75 countries around the world.

The increase of China’s role in world trade is an important factor determining whether countries are increasing their reserve holdings in yuan. In 2017 the European Central Bank added the yuan as a prominent reserve currency when China became one of Europe’s biggest trading partners.

The same applies for countries in Asia and Africa.

All these factors could influence its standing as a more prominent future reserve currency.

The fallout from Russia’s invasion of Ukraine could provide added impetus to this.

The ripple effect of sanctions

Russia has built up its reserves dramatically. It now holds total reserves of US$ 630 billion. Unconfirmed 2021 estimates indicate that Russia holds the number five spot in the world and is surpassed only by reserve holdings by China, Japan, Switzerland and India.

According to the Central Bank of Russia (June 30, 2021) China is the single largest foreign holder of Russia’s foreign currency reserves. The country holds 13.8% of Russia’s total reserves, of which 13.1% of the total reserve holdings of US$ 630 billion are denominated in yuan. 21.7% of reserves are held in gold reserves.

Russia’s remaining currency reserves of 65% are held by France, Japan, Germany, the US, UK and international institutions. This means that Russia will now only have access to an estimated 35% of its reserves under the financial sanction dispensation.

Russia may consider channelling some of these reserves through China to access much needed goods and services.

But will China embrace the roll?

Russia and China have a close relationship. In 2019 Chinese President Xi Jinping was quoted as saying that he and Russian President Vladimir Putin have met nearly 30 times. And just less than a month before the invasion the two heads of state signed an agreement before the start of the Beijing Winter Olympics. The two leaders agreed to close and extensive cooperation on economic, political and security fronts.

The changes that need to happen

Before the yuan can expand its role as eminent reserve currency China would have to comply with some regulatory requirements. Most importantly, the People’s Bank of China would need to relax its managed peg to the US dollar and other prominent global currencies.

Another key ingredient is the requirement of greater transparency and stability in monetary policies and the regulation of financial markets.

As the world becomes more divided by this war, the Chinese yuan may become the safe haven for Russia and other liked-minded countries. It may be just the stimulus that China hoped for.