Illustration: Luo Xuan/GT

Through various investment instruments under the Belt and Road Initiative (BRI) framework, China is upgrading the yuan's internationalization and controlling more diversified, non-foreign-reserve assets despite declining foreign exchange reserves. These non-foreign-reserve assets provide more ammo if the US tries to wage a financial war that will hurt both sides.

China's enormous foreign exchange reserves have provided flexibility and credibility for the country's financial dealings. But its foreign exchange reserves have been in decline over recent years, down from $3.82 trillion in 2013 to $3.07 trillion in 2018. Moreover, foreign debt which will be paid off with foreign exchange reserves has been expanding quickly, from $863 billion in 2013 to $1.97 trillion in 2018. Most of China's foreign debt is short and medium-term. Deducting foreign debt and assets held by foreign companies, the net foreign reserves have become thinner. 

Some may claim that China's shrinking foreign reserves could make the country more vulnerable to the financial market and economic fluctuations. However, those opinions may have underestimated China's resilience. It will be more prepared than expected for any exogenous shocks, especially if the US moves to upgrade the trade war to a financial war.

CNBC, citing ANZ Research, reported on Sunday that China is building up its "shadow reserves," meaning its offshore investment which amounts to $1.86 trillion, to counter its reliance on the US dollar. The report seems to be making sense, to some extent. But it is the US' protectionism that has triggered the global de-dollarizing trend. The development of the BRI allows more countries to explore the possibility of bypassing the US dollar. The large investment demand generated by the China-proposed BRI has created unprecedented opportunities for the yuan's internationalization. And the large quantities of trade settlements can promote financial connectivity among the countries along the BRI route.  

Transactions made through the yuan are becoming more prevalent. China has established yuan settlement arrangements and local currency-swap agreements with many countries including Zimbabwe, Morocco and Japan under the BRI. 

As of the end of first quarter of 2019, the value of overseas-yuan-denominated funds has reached 300 billion yuan ($43 billion). The funds have supported the BRI project through multiple financial instruments. 

Aside from expanding the usage of the yuan, China is diverting increased amounts of foreign exchange assets from the US Treasury to the issuance of loans through state-owned banks and development banks for countries on the Belt and Road route. China has been holding less US Treasury in the last few months.

In recent years, China has also been increasing its stakes in alternative investments through its state-owned companies and banks, as well as through funds co-managed alongside other countries, according to CNBC's report. The Bank of China and China Construction Bank have issued offshore-yuan-denominated bonds and foreign currency bonds to help finance for the BRI.

Anticipating a global economic downturn, countries like China and Russia have been gradually stockpiling gold as a reserve asset. According to the State Administration of Foreign Exchange, China held 62.64 million ounces of gold by the end of September, compared to 59.94 million ounces in January. 

China's foreign exchange reserves are still its largest official reserve asset, and large shares of China's foreign reserves are still being invested in US dollar-denominated assets, particularly the US Treasury. Despite this, de-dollarizing and working toward fewer US Treasury holdings could be a direction for China to take against the backdrop of a protracted China-US trade war and gloomy global economy.

With its dominant advantages, the US may escalate the trade war to the financial sector by laying sanctions on Chinese companies, blocking China from the global financial settlement mechanism, or even short-selling Chinese currency. This would be the worst-case scenario for the global financial system. But the US will not take an easy win, just as China will not be easily defeated. The yuan's internationalization has shaken the financial system centered on the US dollar. More diversified investment of reserve assets will provide China with more ammunition to fight back if the US instigates a financial siege.

The author is a reporter with the Global Times. bizopinion@globaltimes.com.cn