Initiative for U.S.-China Dialogue on Global Issues

Eleanor M. Albert: Today our guest is Eyck Freymann. Eyck is a Hoover Fellow at Stanford University. Trained as a historian and China specialist, he works on strategic deterrence in the Taiwan Strait, the geopolitics of climate change, industrial policy for emerging defense technology, U.S. and PRC economic statecraft, crisis contingency planning, and other national security topics. He is also a non-resident research fellow with the China Maritime Studies Institute at the U.S. Naval War College. Outside of academia, he is a senior advisor to Greenmantle, a consultancy.

Eyck, welcome to the show. It's a real treat to have you today.

Eyck Freymann: Thank you for having me.

Eleanor M. Albert: We're going to be talking about the internationalization of the Chinese renminbi, but before we do that, I like to ask my guests to explain a little bit about how they came to studying China and their research area. So how did China come into your life? How did you choose to study its history and its place in the world?

Eyck Freymann: I actually came into my undergrad expecting to study classics, and I took a freshman seminar with two classicists called Rome and China, Emma Dench, an expert on Ancient Rome, and Michael Puett, an expert on Ancient China, including philosophy and religion. I was struck by how little I knew about China going in and how much cooler they were than the Romans in many ways. I realized that while I had some access to the Romance languages and Western culture and civilization just by growing up in the United States, this whole Eastern world would've been inaccessible to me unless I learned something of the language and more of the history, and one thing led to another, and here I am.

Eleanor M. Albert: That totally makes sense. I love the happenstance of it all.

But we have you on today because you're a co-author of a recent article in The China Quarterly that's about the logic that's underpinning this partial internationalization of China's currency, the renminbi, or the RMB. Before we unpack some of the findings, could you give us just a quick breakdown on what it means to internationalize the People's Republic of China's currency?

Eyck Freymann: There are many ways in which currencies can be used overseas, and they're often bucketed together under the term internationalization in a way that's sort of unhelpful. One way is that you can do invoicing in a currency, so I sell you some goods and we write the contract so when the goods are delivered, you pay in that specified currency. Another way is whether central banks hold that foreign currency in their foreign exchange reserves. Central banks usually accumulate reserves, and then they will invest them or hold them across a range of currencies.

Eleanor M. Albert: On that note though, if China is doing a partial internationalization, what are the components of that if it's not a wholesale internationalization?

Eyck Freymann: Usually for a currency to be freely used beyond a country's borders, capital should be able to move freely across the border. That's what we would refer to as a liberalized capital account. China, for various historical and political reasons, does not have a liberalized capital account. Money in China cannot freely leave the country, and there is a nexus of institutions, rules, and norms that restricts investors' ability to pull money out of the country.

We can talk a little bit about why China believes this is important for its national security, but suffice it to say that as long as China is the “Hotel California” for your money, that you can check in anytime you want, but you can never leave, it's a bit of a problematic place to park your assets.

Furthermore, there's a question that if China's currency circulating beyond its borders won't be able to move into China to buy the stuff that China makes, well then, if you had the option, why would you hold your money in China's currency rather than in some other currency like dollars or even in gold?

Eleanor M. Albert: Your piece tracks a shift in China's financial regulatory and currency internationalization strategy all the way back to 2018 as a turning point. I'm curious why this date is important, and what indicators did you investigate to pinpoint this as a turning point?

Eyck Freymann: 2018 is a significant date because that's when Donald Trump launches his trade war against China. But the story really begins before then, and a seminal moment is in 1997. China's process of financial opening up actually starts in the 1980s and it continues into the 1990s as part of the broader gǎigé kāifàng—Reform and Opening Up program—that includes building a domestic banking system in a controlled way, letting foreign banks, including Chase Manhattan Bank and others, set up shop in China. It includes sending a generation of young, talented people to study economics in the West and learn the procedures for how you actually run a financial system and regulate it.

Then, the Asian financial crisis of 1997 comes as a shock. It begins in Thailand with the collapse of the Thai baht when the peg breaks, but the financial contagion spreads across the region and it leads to devastation in Japan, and South Korea, in Hong Kong.

Mainland China's financial system doesn't suffer the same shock. China has challenges that result from '97, but they don't have the financial distress that many of the Southeast Asians do. The lessons that are drawn from this experience by the [Chinese] Communist Party (CCP) leaders are that actually there is some value in maintaining political control over the movement of capital and allowing free movement of capital actually exposes you to a national security risk that's created by the market.

Now, fast-forward to 2018 at this point, the process of what we would call renminbi internationalization is several years underway. China started to talk about this in the early 2010s. After the global financial crisis, this is part of China becoming more confident, recognizing that as a rising power on the world stage that they might be able to claim some of the prerogatives and advantages of the United States. It's a status thing, but it's also partly functional. China's aware that the United States uses its power through the dollar to sanction other countries and so forth. China thinks that it's good for prestige, it's good for national power, it will eventually be good for financial stability for the margins of Chinese businesses conducting international trade. All these advantages of China's currency [being] widely used around the world and more reformist type officials talk about the benefits of doing this through the 2010s.

Until 2018, and actually a little bit after that, but throughout the 2010s, the consensus among Western analysts looking at China, people like Eswar Prasad or even Barry Eichengreen, very thoughtful people who know the history and know the economics, they believe, “Well, it's only a matter of time until China capitulates to reality.” China has stated that internationalizing the currency is a priority. To internationalize your currency, you need free movement of capital; ergo, it's just a matter of time until the CCP decides to relinquish control.

What happens in 2018 is a paradigm shift in the discourse within Beijing where elites conclude, “Actually, this is a bridge too far in terms of national security. Given what the U[nited] S[tates] is doing to us in trade, given the risk that it could escalate to the financial domain, we cannot open us ourselves up to the risk that the United States could deliberately or accidentally trigger a financial crisis in China, so we have to rethink the entire strategy.”

Eleanor M. Albert: That's really interesting. What surprises me is that in this narrative, the global financial crisis doesn't seem to have brought necessarily new lessons learned, perhaps China doubled down on realizing that its insulation from full market capital provided some ability for it to withstand the crisis in a way that the others had not.

Eyck Freymann: In the narrative that I just shared, I was trying to give the warp speed version of events, all of recorded history prior to 2018. But there are important dates before 2018 that are worth discussing. The financial crisis is one, the announcement of Belt and Road Initiative is another, and 2015 is a third.

Let's touch on them quickly. The financial crisis comes as a surprise to Beijing because it reveals in many ways the fragility of American hegemony. There's some famous stories of Hank Paulson in Beijing begging the Chinese to help with fiscal stimulus. This is a pretty fundamental moment of reflection and reconsideration. Rush Doshi has documented this wonderfully in his book, The Long Game, where Beijing realizes, “Actually, we have an opportunity to stand up now. We're still hiding our brightness and biding our time to a degree, but we don't have to do it quite as much as before because the Americans are really distracted, it will take them many years to recover and rebuild. And in fact, the world economy will rely on Chinese capital to revive itself.”

China at this point is already an export powerhouse. Exports are a big part of China's growth model, so this isn't entirely motivated by generosity and good spirit. There's a recognition that if there's no external demand to buy China's products, China can't keep growing. This is one of the strains of thought that goes into the announcement of the Belt and Road initiative in 2013.

But Xi Jinping is primed for power and then rises to power in this milieu, in this 2012, 2013 moment where the belief is that the United States has now been pushed back to a degree, that a new era of great power relations might be possible with China. That cooperation could be the name of the game, that China can begin to militarize facilities in the South China Sea with impunity, that sort of thing. And it's in that spirit that the conversation about RMB internationalization really starts taking off. This seems possible because of that geopolitical context.

Then in 2015, all of a sudden the bottom falls out of the equity market. It seems like this might be a Lehman moment for China. It's a very disturbing period. No one knows whether this is the beginning of the collapse of the property bubble, something bigger that could actually flatten the Chinese growth story. Under Xi Jinping's leadership, it's really orchestrated by Wang Qishan; as I understand
it, the financial authorities sort of swoop in, they organize a national team. They say essentially, "No, you cannot take your money out of the country. No, foreigners actually in some cases can't even liquidate their assets. And we're going to rush in with tens of billions of dollars of purchases of assets to stabilize the market, to tell people, 'Don't worry, don't pull your money from the banks.’"

Somehow this works. And I'm simplifying the history greatly, but between summer of 2015 and when the last ripples disappear in early 2016, there is this moment of great uncertainty and China comes out on the other side without having suffered a meaningful hit to growth, let alone a financial collapse. So this is, I think, important in shaping Xi Jinping's experience and thinking in a couple of
ways.

First of all, it reveals financial crises can come on fast and unpredictably, but secondarily, the state has to be ready to rush in and stabilize things to isolate the problem before it becomes a systemic threat. The successful experience of 2016, I think, is something that leaves Xi Jinping feeling basically pretty optimistic that this is a playbook that could work. But 2018 and the souring of U.S.-China relations, it happens very quickly. It starts in 2017, but the tariffs really kick in 2018. What's happened alongside this is the Trump administration's dialing up of economic pressure on Iran, what they're calling “maximum pressure.” And the thinking is, "Well, if they could do this to Iran, why couldn't they do this to us?"

Eleanor M. Albert: Obviously post-2018 and with the conflict in Ukraine, the pressures on Russia have made China all the more aware that the U[nited] S[tates] and other Western powers could easily choose, if they wanted, to impose certain amounts of sanctions. This isn't necessarily an attempt to sanction-proof, but there's definitely got to be some thinking there as well.

Part of your analysis really emphasizes this idea of financial and economic security as being a core component of China's national security, and I'm curious if this change in policy that you've tracked suggests a perceived threat or vulnerability to economic security for China? What are the types of financial repercussions that China is trying to perhaps insulate itself from? Or is it seeking a diversification of the types of economic relationships it has through this internationalization strategy for its currency?

Eyck Freymann: You raise a couple of interesting questions there. If the Americans are turning hostile and there's a risk that trade war could become financial war at any time, and that this might involve the use of the dollar weapon… If there's a risk that the U[nited] S[tates] could start leveraging the dollar's central role in the system to constrain China's ability to trade, then actually, all the more reason why you need to get your currency used abroad, because that's your lifeline if you get sanctioned.

But there's a catch-22, because you can't internationalize your currency, the conventional economic analysis says, without having a liberal capital account. But if you liberalize your capital account, you make yourself vulnerable to precisely that risk in the interim, in the period after you've liberalized capital flows, but before you've achieved a fully internationalized currency. So this is why I think the thinking lands with a compromise strategy.

The compromise strategy is, “We need to have two currencies rather than one, and we'll pretend like they're basically the same currency, but they won't be. One will be the onshore RMB, what we call the CNY.” Normally when you talk about China's currency, that's what you mean—the onshore. “The other is the offshore RMB or the CNH. And we will do what we can to encourage foreigners to hold CNH, we will do what we can to deepen the capital market for CNH and create investable instruments like so-called panda bonds that we will pay returns that are denominated in CNH, and we'll try to make this a thing offshore, mainly in Hong Kong, but with some help from the British. And we will also expand swap lines so that our trading partners, countries like the Southeast Asians, can
access CNY, the offshore version, under controlled conditions, and that will enable them to do certain transactions and denominate them and settle them in CNY/CNH.”

Eleanor M. Albert: Without having to think about the dollar at all…

Eyck Freymann: This process uses a system called CIPs (Cross-Border Interbank Payment System). To understand what CIPs is, we need to take a bit of a detour to talk about how the international payment ecosystem works. If I want to send you a payment across the border, there's two things that have to happen. The first is we're going to be using a correspondent bank to facilitate the interaction, and my bank has to talk to your bank and they have to figure out who am I, who are you, how can we validate this to know that I'm not a terrorist and you're not a terrorist or an international criminal, how much is being paid, and so forth. Then there's the actual process of sending the money; that's called clearing. So there's messaging and clearing.

In the current makeup, the system that is used for messaging is called SWIFT (Society for Worldwide Interbank Financial Telecommunication), which is based out of Belgium. The system that is used for clearing is called CHIPS—not semiconductor chips, it's an acronym (Clearing House Interbank Payments System). It's connected to something called Fedwire. It's essentially run out of New York City; it's a Federal Reserve system. Because of the network effect where most banks in the world want to be able to exchange payments with all of the other banks in the world, there's a very powerful incentive to be part of the system and a very powerful disincentive to be expelled from the team. This is essentially mechanically how U.S. dollar sanctions work,  the threat is to the banks that are financially intermediating the transaction. If you facilitate a transaction with a sanctioned entity, goodbye from the club. The U[nited] S[tates] also has acquired over the years visibility into SWIFT payments. So the Treasury has an all-seeing eye essentially through payments that are messaged through SWIFT.

So China has created an alternative. The alternative is called CIPs—it's a China interbank payment system. And CIPs in various ways is very robust and high-tech; it's faster and better in certain ways and it can do both messaging and clearing. Now, in practice, it often is not used for both, but it can be. In principle, there's no reason why a sanctioned entity in Iran or Russia or someplace else couldn't do a transaction to buy some stuff from China and do all the messaging and payment on this China-controlled platform. Not only is it beyond the reach of the United States to sanction, it might be beyond the reach of the United States to even detect. So that's a, and potentially in the long term, very significant threat to the power of the dollar weapon. The problem that China faces is that in order to do this, especially if you want to be paid in your own currency, is that the people paying you have to acquire your currency somehow.

Eleanor M. Albert: You were talking about this difference between a trade war versus a financial war, and in your article you talk a lot about this potential for thinking about what financial war might mean. Trade is technically an exchange of goods—it's a purchase. When you write about financial war and cautioning around it, what are you explicitly thinking that that would look like?

Eyck Freymann: Crudely, trade war means tariffs, financial war means sanctions. Trade war means we will buy your stuff, but the importer has to pay 10%, 20%, 100%, name the number on the goods coming in. You can also use quotas. Trump likes the word tariff rather than the word quota, but they're both on the trade side. The foundational concept here is that every country has a balance of trade and it's a ledger. There's two sides of this balance. You have a trade account and then you have a capital account. So if I'm importing $500 billion more than I export on net, then I'm running a $500 billion trade deficit, what you'd call a current account deficit. But at the same time, the equal and opposite reaction is I am exporting $500 billion more than I'm importing, so I'm running a  capital account surplus. These things definitionally have to be balanced. The trade war concept focuses mainly on the trade side, on the movement of goods.

The financial war concept in a sense affects trade indirectly via the capital account. It's not actually putting pressure on the delivery of goods at the port, it's putting pressure on the ability of one party to pay another. But the way that they manifest is also different because while trade wars like tariffs that the Trump administration is now putting on Canada, they can have a big macroeconomic effect on Canada. They can slow Canada's growth, leading to job losses and other negative things. They're unlikely to trigger a financial crisis in Canada.

Sanctions are potentially threatening to a country's financial stability because the way that banks operate is they lend out more money than they have—fractional reserve banking—and there's regulations and capital ratios and so forth. But at any given time, if there's a panic and everyone tries to withdraw their funds, there's not enough to cash everyone out.

So the imposition of sanctions can threaten a country's financial stability, and this depends, in part, on how fast the tariffs come on and how sweeping they are. But what we're talking about when we talk about financial war here is China's fear that a set of U.S. sanctions on various Chinese entities would cause a market reaction in which people try to pull their money from China's banks and/or try to pull their money from China into other countries and that might cause a rapid movement in the exchange rate, it might cause a collapse of one bank, which could lead to collapse to another bank, and so forth. It's the fragility or resilience of that network that Beijing is concerned about.

Eleanor M. Albert: Talking about the article, how did you determine the presence of fear among Chinese elites and decision-makers about this potential for financial retaliation or financial fragility? How did you source this? How did you go about unpacking some of this information?

Eyck Freymann: My methodology is to work with open sources. This is not a perfect methodology because materials that are available in the open source are usually in the open source for a reason, and that means you are getting only a partial view of the picture, and you might actually be getting information that is curated to give you a misleading view. But I have a methodology that I use in much of my work, which involves going on Chinese language academic databases, and looking at papers, policy reports and academic journals written by serious Chinese government academics and policymakers and think tankers.

What I do is I put these in chronological order and I read through them like a historian would read through them. I try to understand: what does the debate look like? Who is on team A? Who is on team B? How are they constrained by the limits of what you're allowed to say? As we all know, the boundaries of acceptable conversation are always moving in China. What are they responding to? Who are they trying to influence or inform? And what are tells that they might actually know what they're talking about based on their credentials, their professional networks, who they studied with, who funded them, other hints or giveaways?

With this method, you can essentially discard 99% of the material as junk, but then you have material from a small number of highly credentialed people, at very significant institutions, who are saying stuff which is surprising in one way or another. Maybe it's surprising because it's talking about China's weaknesses in a candid way, or maybe it's surprising because it's disagreeing with the party line in a respectful but firm way. If you trace that debate among the people who actually matter and you trace it through time, like a detective, you can figure out a lot about what they're actually talking about and the problems that they're actually trying to solve on behalf of their bosses who always loom over the conversation even though they never speak up.

The sources that I draw on in this paper include speeches, essays, and the like, by leading financial regulators, chief economists of major state banks, economics professors, heads of major institutes at major party think tanks, professors at the Central Party School, professors at Beida or Tsinghua, people who understand the legal mechanics of sanctions. A general principle of interpreting these sources, I think, is the more technical people are, the more you can learn because the technical people have just been given an instruction and are told, "Tell me how to work this. Tell me how to make it happen." So they're just trying to explain how to achieve the goal. If you want to know what the goal is, just look at what they've been asked to do. If you start reading through, you see there's a very, very sharp break in the terms of this conversation that starts pretty much immediately after the trade war starts, and then it evolves from there. That's the core of what I'm trying to trace in the paper.

Eleanor M. Albert: That's great. You conclude that even with this shift in thinking, the country is still vulnerable to, what you term, “monetary sniping.” Could you unpack this sniping?

Eyck Freymann: Monetary sniping is related to financial war, but it's actually slightly different. You can call it a type of financial war, and China fears both, but sniping is, I believe, seen as more immediate and hard to counter.

So financial war, in Chinese jinrong zhanzheng, it's a broad-spectrum economic attack that uses state-directed financial sanctions or other coercive measures, but basically sanctions like blocking a country's access to SWIFT or freezing assets; maybe it could involve certain trade restrictions or even legal warfare to impose very strict secondary sanctions on third parties and third countries that are doing business with China.

But regardless of the methods, the goal of financial war is basically to cripple a rival's economy by disrupting its access to international capital markets and disrupting its ability to trade and exerting long-term economic pressure. Essentially, what the United States did to Iran and what the United States threatened to do, but didn’t quite do completely, or as completely as it maybe should have, to Russia.

Currency sniping, or huobi juji, is a speculative attack on a country's currency. The idea in the PRC literature is that a currency sniping attack is often orchestrated by private actors, but with state coordination. So the conspiracy theory is, the 1997 Thai baht collapse was actually George Soros and his cabal. There are those within China's financial community, they tend to be those without much formal economic training, but they do exist, who believe that the hand of Soros lies behind many a Color Revolution and that he's actually backed by the CIA and the U.S. government and so forth. And so these things aren't organic, they're not an accident. When the financial markets move roughly, it's because the U.S. government, as a financial imperialist, still can play the markets like a marionette. Obviously, this is not the view of everyone in China.

What I'm doing in this paper is tracing a debate between two different communities, one who are generally formally trained in economics, English speaking, foreign educated, the technocrats. Then on the other side, the more ideological PLA (People’s Liberation Army), national security people. We have this same divide in our own system in the United States. And they see the world in different ways. But I think it's foolish to assume that just because the latter group doesn't have former economics training, that they're not actually influencing the thinking or driving the conversation. In fact, when the two of them get into a room and have to hash things out, as I show in the paper, it's often the terminology and the discourse of the ideologues that gets used.

What's interesting about the currency sniping idea is that it essentially takes the 1997 Thailand example as a case study. And what Soros legendarily did, although if it actually happened is disputed, is he recognized that the Thai central bank was intervening to keep the currency, the exchange rate, stable against the dollar at an artificially strong rate. So he organized a large-scale short trade against the currency betting that it would go down, and eventually the size of the short trade grew so large that the Central Bank of Thailand lacked the foreign exchange reserves, it lacked the foreign currency, to spend to bid up the value of the exchange rate. So it became a self-fulfilling prophecy. As it became clear that the peg would break, more investors piled into the trade because clearly the exchange rate was going down and this was an easy way to make a buck. Then, when the peg broke, the baht exchange rate corrected violently, and it took the Thai financial system down with it.

So the idea is that the United States might potentially pull a similar move with respect to China, essentially exploiting any flexibility or freedoms in the capital account. The lesson is, you need tight capital controls, the tightest possible, and far from being on an incremental gradual path to liberalizing your capital account, you need to lock this down because it's a national security priority. I think that the national security people won the argument because it's now 2025 and China keeps talking about RMB internationalization, but they have done zero to liberalize the capital account. In fact, they're moving backwards.

Eleanor M. Albert: Essentially, we have a currency internationalization “with Chinese characteristics” taking place, so to speak.

I want to conclude with asking you to look forward a little bit. Given what China's economic outlook is looking, like coupled with the U.S.-China geopolitical outlook is also pretty tenuous right now. What do you think the future holds in terms of the debate and the groups that you were talking about? Do you see the national security ideologues having a more prominent influential voice in the regulatory system in thinking about China's financial and economic regulations?

Eyck Freymann: In a word, yes. In more than a word, two points. First on the currency, second on payment infrastructure.

One of the lessons that China seemed to learn from the 2015 experience, but also from the 2018 experience, is if you want the market to have confidence that your financial system is robust, you want to keep the most stable possible exchange rate. Keeping a stable exchange rate is a symbol of state control over the system. This has been well-documented.

China spends an extraordinary amount of resources, which they go to great lengths to cover up, to acquire foreign currency on the sly and spend it holding the exchange rate stable. I think that's a priority for Xi Jinping, and it will remain one. You can look at the last couple of years: the dollar has moved dramatically. You look at the Japanese yen or the Korean won, the Taiwan dollar, or any other regional currency against the dollar, and you see dramatic moves, whereas the CNY is flat. This makes no sense because interest rates have been plummeting in China, whereas U.S. interest rates are very high and likely to remain high.

So what I'd expect is, even as China's economy continues to slow, and I think it will continue to slow regardless of this new growth number they've just promised at the two sessions. The currency is going to stay strong, and that has a political, almost a national security logic behind it.

The second point is just because China's economy is slowing, doesn't mean it can't continue to internationalize its currency. CIPS is a very attractive system for obvious reasons, but China is also developing techniques, one is called MBridge—it's sort of a crypto-based solution between central banks—and some of these technologies are just better. They're faster and more reliable for moving money across borders than SWIFT and CHIPS, which are 1970s technology. It's like using fax machines and Xerox machines.

China's fundamental problem is that as long as it runs a large current account surplus, as long as it's exporting more goods than it imports, then it's importing capital. For that reason, according to the theory, it's very hard for a country that runs a large current account surplus to internationalize its currency because as soon as the currency leaves the borders, it comes right back in to buy more stuff. This is sort of a structural problem, and this is the reason why economists, rightly, are skeptical that the BRICS will ever have a currency.

But I think the argument of the paper is China's goal is not to dethrone the dollar. If that is the metric that you're looking at, that's the wrong metric. What China wants to do is to be robust and resilient to sanctions and to a financial attack. To do that, China only needs robust capital controls, substantial foreign exchange reserves, so the national team can come in and save the day if they have to and enough of these back channels and bridges, which could be CIPs, it could be MBridge, it could be Pakistani banks acting as a secret backdoor to the U.S. dollar system. It just needs a little bit of help from foreign partners using these new technologies to enable it to violate sanctions in that worst-case scenario.

As long as China is moving in this direction, the RMB doesn't have to be a major share of international payments, major central banks don't have to be holding lots of it on their balance sheets, but stealthily under the surface, China has built enough of an alternative plumbing for international payments that if we sanction them, it won't actually be as effective as we think. This is why I think it's a national security threat, it should be on our agenda, and we should take seriously what they say about the perceptions of their own vulnerabilities and strengths.

The views and opinions expressed are those of the speakers and do not necessarily reflect the position of Georgetown University.

Outro

The U.S.-China Nexus is created, produced, and edited by me, Eleanor M. Albert. Our music is from Universal Production Music. Special thanks to Shimeng Tong, Tuoya Wulan, and Amy Vander Vliet. For more initiative programming, videos, and links to events, visit our website at uschinadialogue.georgetown.edu. And don’t forget to subscribe to our podcast on Apple podcasts, Spotify, or your preferred podcast platform.