Cross-border RMB Trade Settlement
The mainland Chinese government’s preliminary announcement in late 2008 that it would be permitting the limited use of renminbi (RMB) as a trade currency between China and Hong Kong/Macau was not entirely unexpected. A limited range of retail RMB transactions has been possible for some time in Hong Kong and these have now been extended as part of the pilot. In addition to the existing seven designated merchants engaged in personal tourism or consumer services, all companies in Hong Kong that are engaged in imports/exports with designated mainland enterprises can open RMB accounts for the purpose of settling cross-border RMB trade.
A further announcement in April 2009 revealed that the pilot project would operate between five designated mainland cities (Shanghai, and four cities in Guangdong province – Guangzhou, Shenzhen, Zhuhai and Dongguan) and Hong Kong/Macau. The final detailed announcement of the pilot scheme by the People’s Bank of China (PBOC) in early July extended the pilot’s coverage in that it allowed these Chinese cities to settle trade with countries of the Association of Southeast Asian Nations (ASEAN) in RMB. (It was originally anticipated that this would not happen until a later phase of the pilot.)
There was a swift reaction by the market to the final detailed announcement of the pilot, which was closely followed by the first ever cross-border RMB trade transaction by an international bank. This was conducted by HSBC in cooperation with its strategic partner Bank of Communications (BoCom).
The recommendation of corporate candidates for the pilot scheme is handled by various agency offices in the appropriate province, and is subject to joint review by the People’s Bank of China (PBOC) , the Ministry of Finance, the Ministry of Commerce, the General Administration of Customs, the State Administration of Taxation, and the China Banking Regulatory Commission. The head office of the PBOC has indicated its intention is to further expand the number of participating companies in the future, but in the pilot stage it appears that the number will be limited to around four hundred.
Although the initial scheme is fairly modest, it is nevertheless a significant and very welcome step. While both Hong Kong and Macau are special administrative regions of China, both have their own currencies, which are also both pegged to the US dollar – albeit indirectly in the case of the Macau pataca. These linkages will afford all participants an indication of the likely response if the scheme is expanded to include ‘direct’ US dollar trade between mainland companies and trading partners in countries outside the initial pilot.
As with any scheme that potentially internationalises the RMB, the PBOC will be keen to ensure the process is orderly. In the initial pilot, settlement of trade transactions in China will take place either through Bank of China (Hong Kong) or mainland correspondent banks via a nostro account.
The pilot scheme to allow the RMB to be used as a trade settlement currency is part of a broader context of currency/trade deals that China has been agreeing with major trading partners since December 2008. By the end of the first quarter of 2009, China had agreed currency swap deals in various formats with Malaysia, South Korea, Hong Kong, Belarus, Indonesia and Argentina, worth some US$100bn.
The motivation behind these agreements varies. Occasionally the aim is simply to promote trade by reducing frictional costs and risks for trade participants. In others, the objective is for the RMB to provide support for the currency of an important trading partner.
A more recent discussion in May 2009 between Brazilian and Chinese leaders Luiz Inacio da Silva and Hu Jintao intimates an alternative approach. Rather than an outright swap for an agreed rate and size, the notion is simply for Brazil to pay for Chinese goods with Brazilian real and China to pay for Brazilian goods with RMB.
These currency swap initiatives and the pilot for Hong Kong/Macau have one key feature in common – they will allow the further internationalisation of the RMB, but in an orderly manner. With most of the former, any currency exchanges are defined in advance and typically involve another sovereign government as the counterparty. With the Hong Kong/Macau pilot scheme, the PBOC will closely monitor the activity of participating banks on the Mainland, while the Hong Kong Monetary Authority will fulfil the same role for banks in Hong Kong and the Monetary Authority of Macau for those in Macau.
In the short-term, this conservative approach may result in a fairly modest effect on trade flows. The mainland Chinese government is facilitating the pilot programme and has emphasised that the currency enterprises use to settle trade is “a voluntary act by both sides of the trading”. However, companies that have the need and can see the potential benefits will be willing to settle trade in RMB.
These benefits could drive a significant, albeit small-scale, currency switch as importers and exporters come to appreciate the potential advantages for their businesses. Nevertheless some mainland companies may have to take a fairly cautious approach, as some of their customers may insist on continuing to be billed in US dollars or euros. While their suppliers may accept being paid in RMB, this will have little effect on its wider adoption if they prefer not to hold RMB and always hedge or translate back into their domestic currency. Importers’/exporters’ adoption of RMB for trade settlement will obviously also depend on factors such as whether they need to purchase or borrow in RMB or if they are interested in investing in RMB-denominated bonds.
Even where trading partners do adopt the RMB for settling their transactions, this is unlikely to drive a significant expansion in total trade with China in the early stages. In most cases, it will be a case of RMB being substituted for transactions currently being executed in US dollars or (to a lesser extent, euros). In the case of trade with Hong Kong/Macau there is an obvious logic to this. Both are close to China in terms of geography and business ties, so using RMB as their trade currency when transacting trade with China is entirely reasonable.
The implications for Hong Kong as a trade centre are also interesting. Companies both within and beyond Asia (especially in those Latin American countries with which China has signed swap agreements) may be encouraged by the pilot scheme to establish entities in Hong Kong to execute trade business in RMB. Ultimately they may use Hong Kong as a hub from which to conduct back-to-back trade beyond the special administrative region.
While the short-term effects of the RMB trade pilot scheme seem likely to be relatively low key, the medium- to long-term picture is a different matter. If there is further extension of the pilot, it is likely that domestically focused Chinese companies will be inclined to rethink their business strategy. They may previously have been deterred from international trade by the prospect of having to manage US dollar or euro currency risk, but will be more inclined to expand into this area if they can settle and/or hedge easily in their domestic currency.
While by no means a perfect parallel, the effect of the introduction of the euro on trade1 gives some indication of what may happen to trade flows in the mid to long term if the RMB becomes more widely adopted as a trade currency. The comparison is imperfect, as the new entrants to cross-border trade in Europe were in many cases attracted by the lower frictional costs of trading with partners within the eurozone. Nevertheless, there is empirical evidence to suggest that the availability of the euro as a trade currency has also had a significant influence in boosting trade flows between eurozone and non-eurozone countries.2
While the US dollar has a long pedigree as the currency of trade, the sheer volume of non-US-related China trade now flowing makes the RMB an attractive alternative. At present, the European Union is still comfortably China’s largest bilateral trading partner, with the US second. However, China’s trade with other nations – particularly the other BRIC countries (Brazil, Russia and India) – has grown phenomenally in recent years. (For example, in April 2009, China’s trade with Brazil topped US$3bn; the mainland has now overtaken the US as Brazil’s primary trading partner, upsetting a status quo that had prevailed since the 1930s.) Therefore, from the perspective of trade between Chinese companies and their customers/suppliers outside the US, trading directly in RMB (as opposed to using the US dollar as an intermediary currency) makes increasing sense.
If the RMB continues to become more accessible as a trade currency, further positive considerations kick in. Given the robust state of China’s economy when compared with the current condition of other major trade nations (such as the US), it seems reasonable to assume that the RMB would be similarly robust as a currency. If that assumption proves valid, then a growing number of China’s trading partners would be content to hold RMB as an appreciating/strong currency, rather than always hedging out.
At present, the huge liquidity of US dollar spot and derivative markets make hedging reasonably cost-efficient, but there is still some frictional cost to using it as an intermediary currency. Assuming the availability of liquid RMB hedging and trade finance instruments, some non-US suppliers to Chinese companies may see further potential in adopting it for trade. Switching from billing their Chinese customers in US dollars to billing them in RMB may offer the opportunity to expand margins, while also reducing risks and hedging costs.
While many of the fundamentals for greater trade adoption of RMB are positive, a critical factor will be the pricing and availability of suitable bank products. This in turn will be heavily dependent on the efficiency of the methods available to banks to hedge and raise funds in RMB. On this point there has been some talk of allowing China-based subsidiaries of Hong Kong banks to raise RMB funds in Hong Kong. (HSBC has just completed such a fundraising exercise in Hong Kong and it is expected that other banks will shortly follow suit.) While there is a non-deliverable forwards market in RMB, growth and usage of other RMB derivatives has been limited.
If there is insufficient liquidity available in the interbank derivatives market for offsetting RMB risk, then pricing and availability to importers/exporters will be impacted and demand for RMB-denominated trade reduced. The key is how this can be facilitated and extended without giving rise to unwanted speculative activity.
There are certainly signs that the Chinese authorities are already putting the appropriate derivatives infrastructure in place. For example, the PBOC made an announcement in March 2009 approving the consolidation of various derivatives master agreements into one uniform master agreement.
It is clear that greater levels of RMB-denominated trade could in the mid- to long-term prove highly positive for global trade volumes. While it may be premature to predict a significant decline in US dollar-denominated trade, it is certainly safe to assume that many trade participants will see the recent moves by the Chinese government and the PBOC as highly positive.
The key will be at what point new participants expand their domestic focus to a global one and/or existing trade participants ramp up their activity in response to the RMB opportunity. Predicting this tipping point with any degree of accuracy is impossible, but it is obvious that the range, availability and pricing of RMB trade finance and hedging provided by banks will have a huge influence on its timing.
1 For more information, see ‘The Competitiveness of European Firms and the Euro’ by Filippo di Mauro, Gianmarco I.P. Ottaviano and Daria Taglioni, published in the Centre for Economic Policy Research portal.
2See ‘The Euro’s Progress – Inquiry into Some Issues Related to the Eurozone – Response to a Call for Evidence’, a presentation for the Select Committee on the European Union by Philippe Maystadt, European Investment Bank.