Towards an International Chinese Currency: Developments and Implications

Since the end of 2008, the Chinese government has taken a series of steps towards internationalising the renminbi, or Chinese yuan. Together, these actions demonstrate the government’s intent to have the renminbi play a more significant role on the world stage, including becoming an international trade settlement currency.

A Series of Concerted Steps

Recent actions reflect China’s concerns over their large US dollar reserves and their intention to find ways to manage their foreign exchange (FX) exposures. Noteworthy developments include:

• The People’s Bank of China (PBOC) Chairman Zhou Xiaochuan commented that Special Drawing Rights (SDRs) should replace US dollars as the world’s reserve currency¹.
• On 25 March 2009, the State Council of China stated its intention for Shanghai to become an international financial centre by the year 2020.
• The State Council authorised the use of renminbi as a settlement currency for international trade and formally launched a trial phase for renminbi international settlement, providing implementation details on 2 July 2009 after announcing the trial phase on 8 April 2009.
• PBOC established bilateral currency swap agreements – worth a total value of RMB650bn – with six central banks, including: Hong Kong, South Korea, Indonesia, Malaysia, Argentina and Belarus. The swaps may enable the central banks to inject renminbi liquidity into their financial systems, thereby facilitating trade denominated in renminbi.

The Impetus for Internationalising the Renminbi

There are a number of key drivers for these developments, with local, regional, and global impact.

Local Objectives

• Reduce the exposure assumed by companies in China that conduct trade in US dollars and bear the associated risk and hedging costs. Chinese exporters and importers conducting cross-border transactions in US dollars are vulnerable to FX volatility. Adoption of the renminbi as a cross-border trade currency reduces FX risk for China-based companies by enabling them to conduct business in renminbi – i.e. for exporters to receive renminbi payments, and importers to make renminbi payments – for eligible commercial trade transactions. This shifts the risk of exchange rate volatility from China-based companies to their overseas counterparts.
• Increase the pricing power of Chinese corporations. At this stage, the use of renminbi for trade settlement depends in large part on which counterparty has more leverage in a buyer-seller relationship. Chinese corporations may ask trading partners outside of China to replace US dollars with renminbi as the functional currency for eligible trade transactions. However, currently overseas buyers and sellers have limited options for hedging renminbi FX risk, since the currency is not fully convertible and has limited utility outside of China. Non-deliverable forwards (NDFs) remain the only alternative available for hedging offshore.

Regional Objectives

• Position the renminbi as a primary regional settlement currency. Renminbi international settlement is a significant move in promoting the renminbi as a settlement currency in Asia and aims to strengthen trade relations with neighboring countries. Conceivably, the renminbi could emerge as a regional trading currency standard within Asia similar to the euro’s status within the European Union (EU). Most Asian currencies are pegged to some extent with the US dollar. Given the market expectation for the US dollar to continue to depreciate against the renminbi, these countries have an incentive to adopt the renminbi as a primary settlement currency and hold assets in renminbi.

Global Objectives

• Insulate China from exposure to US dollar currency risks. Given that more than half of its nearly US$2 trillion-worth of FX reserves comprise US Treasuries and other US dollar-denominated bonds², China’s desire to diversify its reserve holdings and manage US dollar depreciation risk is not surprising. The internationalisation of the renminbi is one response to China’s concern that the financial crisis and US response could lead to increased US debt, US dollar depreciation, and the erosion of the dollar’s purchasing power.
• Position the renminbi as a global trade currency. The introduction of the renminbi as a trade settlement currency in Asia could be a first step towards advancing the renminbi as an alternative trade currency to US dollars globally. The emergence of the renminbi as a global trade settlement currency also would help position China as a more competitive financial centre on the world stage.

Trial Phase of Renminbi International Settlement

As a first step, China implemented a pilot programme, or trial phase, with participation by select companies in China in limited geographic areas for specified transactions.

Scope of pilot

• The trial phase is focusing on cross-border trade settlement within Asia. The geographic scope covers payments to or from Hong Kong, Macau, and the ASEAN nations³, and five pilot Chinese cities: Shanghai, Guangzhou, Shenzhen, Zhuhai, and Dongguan.
• Eligible payment methods initially include: letters of credit (LCs), documentary collections – including payment against acceptance (DA) and payment against receipt of documents (DP) – and open account transactions on a payments-against-goods-arrival basis.

Bank participation

There are nearly 400 government-approved corporations in China participating in the trial phase, although the list of approved companies will likely expand.

There are two ways that banks can participate during trial phase:

• Clearing banks, formally referred to as domestic agent banks, provide renminbi clearing services for domestic settlement banks and overseas participating banks⁴. Initially, only on-shore banks were approved to be direct clearers.
• Domestic settlement banks are China-based banks that originate and receive payments in renminbi to settle applicable trade transactions for eligible corporations. Overseas participating banks have two options for clearing renminbi cross-border trades. First, they can clear transactions via Bank of China’s Hong Kong or Macau branches, which have existing renminbi clearing models. Alternatively, they can use nostro accounts opened with domestic agent banks in China.

Length of pilot

There has been no official announcement concerning the length of the trial phase. However, based on previous experience with government-launched initiatives, JPMorgan expects the pilot to last between two and three quarters.

Factors in Adoption of Renminbi as Trade Settlement Currency

The adoption rate so far has been low. There are a number of factors that could influence the rate of adoption of renminbi as a trade settlement currency, for example:

Internal – onshore

• The PBOC and tax bureau will offer tax rebates as one incentive for companies to invoice in renminbi. Chinese exporters have been enjoying tax rebates from local tax bureaus for the amount of goods they export that are settled in US dollars. In principle, the same policy will apply if transactions are settled in renminbi. However, detailed administrative rules have not yet been finalised for renminbi transactions; until such time, exporters are hesitant to adopt the renminbi. At the end of August, the National Tax Bureau announced that the administrative rules for tax rebates in renminbi have been finalised, with implementation forthcoming.
• Broaden the pilot to allow more countries, corporations and banks to participate.

External – offshore

• China potentially could influence adoption of the renminbi as a trade currency in countries that are beneficiaries of its financial aid. Likewise, nations with mutual agreements in place with China for direct foreign investment could be candidates for early adoption of renminbi international settlement. Balance in power between a buyer and seller could influence the adoption of renminbi settlement by trading partners. For example, in a scenario where China is a substantial buyer of a commodity that has limited demand, or, conversely, a seller of a commodity that has significant demand, China may have leverage in specifying that trade be settled in renminbi.
• Foreign companies based in China and importing into the country may find it beneficial to generate income in renminbi for use within China.

Implications for Renminbi and China

Are the latest moves precursors to a fully convertible renminbi? Within China there are differences of opinion on how much control China would be ceding by making the renminbi a freely tradable currency. To date, restrictions on renminbi convertibility have given the country a measure of protection from current problems in the global marketplace.

On the other hand, some within China see full convertibility – and the development of China’s capital markets – as necessary to China becoming a full power on the world’s financial stage, and, longer term, the possible adoption of the renminbi as a world reserve currency.

Today, China’s banking regulations strictly restrict capital account activities, and renminbi is not a global currency available outside of China. Trapped cash remains a big challenge for foreign companies doing business in China. Companies are limited in their ability to repatriate earnings and optimise their use as part of a global cash position. They also have limited options for investing internal liquidity within China.

However, over the last few months new policies are starting to make it easier for China-based corporations to use their cash surplus in China. For example, with approval from the State Administration of Exchange (SAFE), corporations in China are allowed to use their surplus in foreign currency or renminbi to purchase foreign currency to advance loans to their affiliated companies outside of China and to make direct capital investments in overseas markets.

Some believe that a fully convertible renminbi would support China’s efforts to establish Shanghai as a global financial centre and encourage companies to place regional treasury centres in China. Further, it would support the full development of the financial industry on par with China’s mature manufacturing sector.

Because of these and other complex factors, the renminbi’s prospect for growth as an international currency – and decline of the US dollar as a reserve currency – is uncertain, at least in the short-to-medium term. To date, initiatives to internationalise the renminbi are focusing on the yuan as a trade currency. A fully and freely convertible yuan could be a game changer in the global balance of economic power.