China's push to reduce its reliance on the U.S. dollar by internationalizing the yuan will only make limited progress, leaving the country vulnerable to U.S. financial sanctions and economic policies for the foreseeable future. For more than a decade, Beijing has sought to turn the yuan into a fully-fledged international currency in the hopes of reducing China's sensitivity to U.S. financial and economic volatility as well as potential U.S. sanctions. This has included setting up bilateral swap lines and multilateral swap agreements with more than 30 countries. Other measures China has taken to internationalize its currency include the provision of official bilateral yuan financing in the context of Beijing's Belt Road Initiative, the creation of a small offshore yuan market, a yuan-based payments system, (limited) capital account liberalization, the creation of a yuan-based payments system, and the introduction of a central bank digital currency called the "e-yuan." China also made diplomatic efforts to have the yuan included in the International Monetary Fund's special drawing rights currency basket.

In practical terms, the process of currency internationalization involves measures to increase the use of a country's currency for international current (trade) and capital account (financial) transactions.

China has established more than 30 bilateral yuan swap lines, and it has facilitated access to its domestic financial markets for foreign official investors. (The U.S. Federal Reserve, by comparison, maintains swap lines with the systemically important countries in the Group of 10, which include Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, and the United Kingdom).

China also continues to pursue policies to promote the use of the yuan through the multilateral Renminbi Liquidity Arrangement, as well as an upgrade to the Chiang Mai initiative of the late 1990s (which now allows for local currency as opposed to dollar swaps among participating central banks).

By expanding the yuan's use as an international currency, China is hoping to reduce its dependence on the dollar as well as its vulnerability to financial sanctions and U.S. economic policies. The global economic and financial system is centered on the dollar, and China (along with virtually every other country in the world) significantly relies on the U.S. currency to engage in international trade and capital transactions. This enables Washington to impose significant economic costs on companies and even countries by restricting their ability to use the dollar. U.S. economic (and especially monetary) policy also has an outsized impact on global financial conditions due to the dollar's importance as an international currency. Dependence on the dollar thus makes China not only vulnerable to U.S. financial sanctions, but sensitive to American macroeconomic policies, such as rapid monetary tightening and precipitous dollar appreciation. The global financial fallout from Washington's Ukraine-related sanctions on Russia over the past year has only highlighted this risk, which will drive Beijing to intensify its efforts to internationalize the yuan, with the aim of mitigating the threat of secondary sanctions by sidestepping the use of the dollar in global trade transactions.

The U.S. dollar is involved in 90% of all global foreign-exchange transactions and also accounts for 60% of all (allocated) foreign-exchange reserves. The Chinese yuan, by contrast, is involved in less than 5% of global foreign-exchange transactions and accounts for only 3% of foreign exchange reserves.

Using currencies in international foreign-exchange transactions that are not the traditional “hard currencies” (e.g. the dollar, the euro or the Japanese yen), if possible at all, is less efficient and more costly. This suggests that China's push to reduce its dollar dependence will be increasingly driven by a desire to reduce its vulnerability to U.S. financial sanctions.

Following the onset of the Ukraine war in February, the United States (and its allies) demonstrated their readiness to use financial sanctions to punish Russia through asset freezes and dollar sanctions.

But despite Beijing's efforts, the yuan will ultimately fail to rival the dollar or the euro in international transactions (with the possible exception of intra-Asian trade) for several more decades. China meets many of the conditions necessary for the yuan to become a prominent international currency, including economic size, extensive foreign trade, large yuan-denominated financial assets and military might. But the yuan is not freely convertible, China's domestic capital markets are underdeveloped, and the currency's exchange rate is tightly managed by the Chinese government. Crucially, many foreign investors are wary of the rule of law and the risk of government intervention. Even if China makes progress with respect to domestic capital markets reform and exchange rate flexibility, Beijing will remain loath to offer foreigners unfettered access to domestic capital markets for fear of losing control over its economy and destabilizing its financial system. The yuan may come to play a greater role in regional trade in East and Southeast Asia; the share of yuan assets held by foreign central banks may also increase. But this is not going to transform the Chinese currency into a full-fledged reserve currency capable of rivaling the dollar or the euro in the short (or even medium) term, which would require the extensive use of the yuan for capital account transactions.

The United States accounts for 20-25% of global GDP and China for 18%.

The U.S. capital account is open, while China's currency convertibility remains very limited.

Around 30% of U.S. treasuries are held by non-residents. Foreign holdings of Chinese government bonds account for less than 10% of the total.

The dollar accounts for almost 100% of export invoicing in the Americas, 70% in Europe, 25% in Asia-Pacific and 80% in the rest of the world. (Non-dollar, non-euro currencies currently account for about 20% of Asia-Pacific trade, but these figures include the Japanese yen.)

Beijing has remained reluctant to liberalize broader currency convertibility following the market instability China experienced in 2015-16.

China will thus continue to find it difficult to insulate itself from dollar-related financial volatility and U.S. sanctions, as the self-reinforcing dynamics of geopolitical and economic alliances — along with the prevalence of network effects and incumbency advantages — limit the yuan's international role and maintain the dollar's global dominance. The U.S. dollar will remain the world's dominant international currency, barring tail events such as a U.S. debt default or the breakup of the euro area. This — combined with the only limited progress Beijing will make in terms of internationalizing the yuan — will enable the United States to keep imposing or threatening to impose significant economic costs on other parties, including Chinese companies. In response, Chinese authorities will continue to push for the yuan to play a greater role in regional trade by promoting greater local currency settlement between the yuan and other regional currencies. But the yuan's limited convertibility will continue to hamper the more extensive use of the Chinese currency. Yuan foreign-exchange transactions will also remain characterized by higher costs, lower liquidity and funding stability, as well as more limited hedging opportunities, compared with dollar transactions. The e-yuan may eventually make yuan transactions cheaper, assuming Chinese authorities approve the digital currency for large-scale cross-border transactions. But the e-yuan won't be a game-changer for China in terms of overcoming network effects and the incumbency advantages of the dollar, as cheaper yuan transactions would do little to ease concerns about the rule of law, geopolitical competition, and limited currency convertibility. Finally, Washington is also closely monitoring the e-yuan and, in the unlikely event that its internationalization begins to weaken the role of the U.S. dollar, will accelerate efforts to issue a digital dollar, which will preserve dollar dominance.

The U.S. treasury market remains the largest and most liquid pool of safe assets, which form the bedrock of the international financial system, and the dollar is freely convertible. The size of China's domestic government debt market is expanding rapidly, which could theoretically accelerate the yuan's international use, but liquidity remains low and capital account restrictions remain significant. This will hamper the availability of yuan necessary for Chinese trade partners to finance bilateral trade deficits with China, thus further impeding the yuan's greater role in international trade.