Australian-based financial institutions have almost doubled their use of Chinese funding over the past three years to $46.7 billion, with Chinese investors liking the returns on offer despite the deep-freeze in bilateral trade and diplomatic relations.

At the same time, the institutions have cut their lending to China by about 20% to $47.6 billion, likely reflecting a reduced tempo of Australian business expansion in China.

The sums involved are significant, but they’re small compared with Australian institutions’ financial exposure to the United States and the United Kingdom, where data from the Reserve Bank of Australia shows that they obtain funding of a combined $600 billion and extend loans of $300 billion.

Australia’s financial engagement with China slips beneath the radar. The RBA quietly renewed a currency swap agreement with the People’s Bank of China last year that allows for the exchange of local currencies between the two central banks of up to $41 billion or 300 billion renminbi (RMB).

The deal, first signed in 2012 for three years and renewed in 2015 and 2018, has now been extended for five years.

The RBA has similar currency swap agreements with the US Federal Reserve and the central banks of Japan and South Korea. They are designed to ensure currency is available to settle international transactions during times of global financial instability, such as the global financial crisis of 2008–09 and the Asian financial crisis in the late 1990s.

While Australian ministers and senior officials have been unable to secure appointments with their Chinese counterparts, central banks have their own schedule of meetings that generally ignore underlying political tensions.

The commercial Bank of China, which established operations in Australia during World War II, is licensed by the RBA to act as an official clearing institution for RMB in Australia to make it easier for businesses to settle bilateral trade in RMB and to foster the development of an Australian pool of RMB deposits. Australian-based financial institutions had $8.3 billion in RMB deposits in December last year and had extended RMB loans equivalent to $9 billion.

The RBA has about 5% of its $51 billion in foreign exchange reserves in RMB assets, predominantly in Chinese government bonds.

China has long had a goal of promoting the international use of the RMB. This effort is likely to intensify in the wake of the shock of the US-led freezing of the Russian central bank’s foreign exchange reserves and expelling Russian banks from the global payments cooperative SWIFT.

The Financial Times ^[1] reported this week that China’s central bank and ministry of finance held a meeting with domestic and foreign bank executives recently to explore the risks to China’s international assets, particularly its US$3.2 trillion in foreign exchange reserves.

‘No one on site could think of a good solution to the problem,’ the newspaper reported from one unnamed attendee. ‘China’s banking system isn’t prepared for a freeze of its dollar assets or exclusion from the Swift messaging system as the US has done to Russia.’

The International Monetary Fund sees a potential fragmentation of the global economy into two rival blocks as one of the biggest threats on the horizon.

The fund’s latest review of the global economic outlook ^[2] says the war in the Ukraine has ‘increased the risk of a more permanent fragmentation of the world economy into geopolitical blocks [sic] with distinct technology standards, cross-border payment systems, and reserve currencies’.

‘In the longer term, the war in Ukraine risks destabilising the rules-based frameworks that have governed international relations in the post–World War II period.’

The fund says fragmentation would limit technological exchange while production networks and technology standards would coalesce into distinct blocks. The international monetary system would face a reorganisation, with a segmentation of global reserve assets and the emergence of alternative cross-border payment systems.

‘[F]racturing international relationships could also undermine the trust and cooperation vital to addressing long-term structural challenges, including climate change, debt resolution, and trade barriers. If this risk materializes, the global economy will likely suffer through an unpredictable transition to a new political reality, with financial volatility, commodity price fluctuations, and dislocation of production and trade along the way.’

China already conducts about 40% of its international transactions in RMB, according to RBA analysis ^[3]; however, broader use of the currency is negligible.

No pair of countries that didn’t include China would settle transactions in RMB. By contrast, the most efficient way for a Mexican importer to settle a transaction with a Canadian exporter would be to convert pesos into US dollars and then US dollars into Canadian dollars.

The dominant role of the US dollar in international transactions is a source of resentment in China, Russia and other countries that may feel the force of US economic sanctions.

Although the US share of the global economy has contracted from 30.1% to 24.5% over the past 20 years, the US dollar is still used on one side of 88.3% of all international transactions, according to the Bank for International Settlements.

It’s hard to see how the IMF’s vision of a bifurcated world with separate payments systems would work. While Russia and China can invoice their exports in roubles or renminbi and may even be able to insist on payment for at least some of their imports in their own currency, there’s no obvious path for China to persuade the nations of ASEAN, for example, to switch from the US dollar to RMB in their own transactions. Even if Australia’s trade with China were conducted exclusively in RMB, it would still be dealing in US dollars with everyone else. Nor is it easy to imagine how Chinese financial institutions would persuade global banking institutions to deal in RMB when channelling investments and other capital flows.

The preponderant role of the US dollar in global business is often mistakenly ascribed to its role as a ‘reserve currency’. The US dollar is by far the largest component of the world’s central bank foreign exchange reserves, although IMF research ^[4] shows its share has come down from 71% in 2000 to 59% in 2021, with ‘non-traditional’ currencies, including RMB, the Australian dollar and the Canadian dollar, being the main beneficiaries.

However, this doesn’t explain the US currency’s role in global transactions, which is primarily due to the massive liquidity of US dollar markets. As a US Studies Centre report ^[5] by economist Stephen Kirchner explains, ‘The United States is the premier producer of safe assets that act as stores of value for the world’s savers.’

‘The real source of the dollar’s global role is the unrivalled size, depth and liquidity of US capital markets, backed by high quality political and economic institutions that few countries can match either currently or prospectively.’

While China rivals the US in economic size, China’s authoritarian political and economic institutions don’t allow it to match the strength and openness of US capital markets.