A recent series of policy agreements and announcements by Asian countries has drawn the attention of market observers to efforts to secure financial stability in the region and, at the same time, to pursue more far-reaching ambitions to increase the global influence of Asian currencies. The most spectacular move in this respect was an official deal between China and Japan in December 2011. Headlines conjured visions of the yuan as an international reserve currency announcing the nearing of a new monetary order and the end of the dollar reign. What at first glance seems rather far-fetched appears quite conceivable on closer inspection. True, it takes more than policy will for a currency to gain international status. But as I will explain, in principle, the yuan has all it needs.
Stabilizing markets in Asia
Asian financial markets and policies are in a process of transition. Strategies to promote economic growth by reforming banking systems and developing and opening capital markets are overshadowed by fears of contagion and of being drawn into financial turmoil in Europe and the US. The wish to decouple the region from outside influences and to establish a line of defense is a strong driving force behind recent approaches to closer monetary and financial cooperation. Efforts focus on two aspects: a) to increase the ammunition beyond national stocks of foreign exchange reserves to shelter Asian financial markets and b) to establish a regional anchor to stabilize currencies.
Despite recent setbacks, the process of European monetary integration serves as a model in many respects. One lesson is that it takes time to build trust and that policy cooperation can only succeed in small steps. A Chinese proposal to set up an ASEAN bank, which caught the headlines in October 2011, is a reminder that recent Asian initiatives must be seen in a broader context: Step by step, Asian countries have begun to build a common roof for the developing and opening of national financial markets, and even if those efforts will not result in a “new global monetary order” tomorrow the longer-term consequences may be far-reaching.
The Chinese agreement with Japan rests on three pillars: a) Chinese and Japanese trading companies will start to directly trade their currencies without using the US dollar as intermediary; b) Japan’s government-affiliated Japan Bank for International Cooperation (formerly Export-Import Bank of Japan) will issue yuan-denominated bonds in mainland China and c) Japan will buy up to $10 billion worth of Chinese government bonds in an effort to diversify (an admittedly tiny part of) its foreign exchange reserves.
The agreement is by far not the only Chinese initiative:
- In December 2011, the People’s Bank of China (PBoC) signed a bilateral swap agreement with the State Bank of Pakistan amounting to yuan 10 billion plus Rs 140 billion ($3.124bn).
- China also announced a 70 billion yuan ($11 billion) currency swap agreement with Thailand as part of a plan outlined in October to promote the use of the yuan in the Association of Southeast Asian Nations.
- In October, too, China and Korea doubled an existing bilateral currency swap to 64 trillion won ($56.65bn) and
- central banks from Thailand to Nigeria announced plans to start buying yuan assets.
All in all Beijing has signed a dozen swap agreements with other economies in order to promote the use of the yuan since 2008 – the biggest one with Hong Kong of 400 billion yuan in November 2011.
Recent activities of other Asian countries include
- a $15bn currency swap agreement of Japan and India which, too, was signed end of December 2011 replacing an older $3bn swap deal.
- A swap agreement of Pakistan and Turkey signed the same month amounting to $1bn in equivalent local currencies, and
- an agreement signed by Japan and Korea in October 2011 to extend an existing currency swap from $13bn to $70bn.
Beside, Japan has also bilateral swap deals with other countries such as Indonesia and the Philippines.
Financial markets feel the winds of change as the following examples demonstrate:
- In July 2011, the CME announced to revamp its renminbi-based futures contracts denominated in US dollar terms, in reaction to the fact that the renminbi is now being used for business transactions in multiple off-shore locations which include Hong Kong, Singapore, Korea, Australia and other areas around the world.
- In April 2011, the first renminbi-denominated initial public offering outside mainland China took place in Hong Kong.
- In October 2011, Hong Kong’s Gold & Silver Exchange Society started officially trading gold denominated in renminbi.
- Largely unnoticed by a wider public, the Dubai Gold and Commodities Exchange offers an Indian rupee/dollar future with investors so far mostly drawn from the UAE’s large population of Indian expatriates.
- India just announced to allow individual foreign investors direct access to its stock market from January 15, 2012. Previously, those were limited to investing indirectly through mutual funds or institutional vehicles.
International foreign exchange statistics show a steadily rising share of emerging market currencies with the yuan accounting for 0.3% and the Indian rupee even for 0.9%, and there are official ambitions to include both currencies in the calculation of Special Drawing Rights (SDR).
Reserve currencies such as the US dollar and the euro fulfill international functions beyond bilateral relations and are widely used beyond national borders. Many observers see the Chinese yuan moving slowly but steadily in the same direction. This raises the question what it takes to become an international currency.
As general prerequisites experts stress the importance of political stability of the issuing country, a comparably stable purchasing power, the existence of broad and deep financial markets in the respective currency and the absence of capital and exchange controls.
A more systematic list of criteria traditionally follows the line of argument of Kenen 1983. Accordingly, a currency fulfills three basic functions: as unit of account, means of payment and store of value. In an international context, for each of these it is useful to distinguish between private and public use as the following table does. This gives six cases and the question is how the Chinese yuan is performing in each of them.
What makes an international currency?
|Function||Private use||Official use|
|Unit of account||Currency used in invoicing bilateral, multilateral and third-country im- and exports||Currency used in exchange-rate arrangements, defining parities and targets in bilateral, multilateral and third-country official relations|
|Means of payments||Vehicle currency in international foreign exchange markets||Intervention currency in international foreign exchange markets|
|Store of value||Currency with broad (wide range of products ) and deep (primary and secondary) open credit and capital markets; currency in which deposits, loans and bonds are denominated …
||Currency in which official reserves are held|
The extent to which a currency serves as a unit of account for the private sector can be seen in its use as an invoice currency in international trade. With respect to this measure, the first impression is rather modest.
In 2010, China’s exports amounted to an estimated $1.581 trillion, with its main partners being the US (18%), Hong Kong (still considered foreign trade, 13.8%), Japan (7.6%), South Korea (4.4%) and Germany (4.3%) (see for all statistics here). Imports were about $1.327 trillion with the main partners Japan (12.6%), South Korea (9.9%), US (7.3%), Germany (5.3%) and Australia (4.3%).
Currency convertibility for trade purposes is limited. In April 2009, China began experimenting with yuan trade settlement for few selected firms in Shanghai and four cities in the Guangdong province which was restricted to trade with partners in Hong Kong and selected countries. In mid-2010, permission was widened to 365 firms in 20 provinces and (above all coastal) towns. End of 2010, the number of exporters that can use the yuan to settle international transactions increased to nearly 70,000. Since August 2011, yuan trade settlement is allowed throughout China. Furthermore, since July 2010 the buying and selling of yuan is no longer confined to mainland China but open to trading in Hong Kong with the result that daily trading volumes soared from zero to $400bn.
China has a sort of crawling-peg currency regime. Its currency is pegged to the US dollar within a preset range that may vary daily. After keeping it tightly linked to the dollar for years, in July 2005 China revalued the yuan by 2.1% against the dollar and announced to move to a basket of currencies as reference. From mid-2005 to late 2008 there was a cumulative appreciation of the Chinese currency against the dollar by more than 20%, but after that the exchange rate remained virtually pegged to the dollar from the onset of the global financial crisis until June 2010, when Beijing allowed for another gradual appreciation.
The yuan does not necessarily trade at the same rate onshore and offshore. Currently, the offshore market acts as a parallel market without influence on the official rate set in Beijing. However, big Chinese companies with subsidiaries in Hong Kong, which are often backed by the state, as well as foreign financial institutions with desks to trade yuan in Hong Kong, usually guarantee for functioning arbitrage which hinders the offshore rate to deviate much from its onshore equivalent. Hong Kong’s market seems for China to serve as a sort of laboratory where the government is able to control the terms separate from mainland conditions.
In 2011, about 9% of China’s total trade has been settled in yuan. In the first half of 2011, 84% of this was carried out by Hong Kong banks. The tendency is rising and only limited by currency convertibility: Trade settlement is strictly regulated. The Bank of China Hong Kong (BoCHK) is the yuan designated trade settlement clearing bank and as far as yuan trade settlement goes it is the only settlement agent between banks in Hong Kong and the People’s Bank of China (PBoC), China’s central bank.
Although the use of yuan for foreign trade is globally allowed now, the Chinese government imposes quotas which determine how much foreign trade in yuan is settled by the clearing bank. Currently, the official quota is 8 billion yuan annually. Once this is reached BoCHK informs participating Authorized Institutions (AIs) at short notice that further trade settlement services cannot be provided (example).
Coming to the second criterion, the public function of a currency as a unit of account, one indicator is the role a currency plays in defining parities, for example as part of an exchange rate arrangement including a currency basket. China’s claim to include the yuan in the SDR must be seen in this context. The IMF is due to conduct its next review of SDR composition only in 2015, but China observers are optimistic about an earlier adjustment.
Largely as the result of limited convertibility, so far the yuan plays no noteworthy role as international vehicle in foreign exchange markets or in official foreign exchange interventions. However, the numerous swap agreements listed in the beginning and recent announcements demonstrate a potential of future significance.
Given the size of global financial markets compared to trade flows, these days maybe the last two functions in the table – private store of value and official use as reserve currency – are the most important ones. For those criteria to be met broad and deep markets with a wide range of financial products and maturities, and sufficient liquidity to allow for both IPOs and secondary trading, must exist.
So far, China has been reluctant to allow capital to move freely across borders. Restrictions on residents to take capital out of the country have been eased in recent years, for example, increasingly allowing Chinese companies to buy foreign firms with yuan (with government approval). But foreigners still face strong barriers to investing yuan in China. Investment in onshore bond markets is restricted to overseas renminbi clearing banks and foreign central banks under narrowly defined conditions and subject to an undisclosed quota. Some “qualified” foreign investors are allowed to buy mainland securities, but for these, too, quotas exist:
Investment quotas are granted under the Qualified Foreign Institutional Investor (QFII) program. Launched in 2002 the program allows licensed foreign inverstors to buy and sell yuan-denominated shares (A-Shares traded in Shanghai and Shenzhen, in contrast to B-Shares, issued and traded in foreign currencies in mainland China – in Shanghai in US dollars and in Shenzhen in Hong Kong dollars). The current list of 88 QFIIs includes international banks and investment companies, insurance and asset management companies, but also the Bill & Melinda Gates Foundation and universities such as Harvard and Yale.
Decisions about the size of quotas are influenced by the yuan/dollar exchange rate in the offshore market. When the yuan faces pressure to appreciate, the Chinese government tends to slow or suspend quota approvals. In times of capital outflows and weaker yuan, approvals are easier to get. In 2011, combined quotas granted under the scheme totaled $1.92 billion, nearly $1 billion alone since October. From 2002 to December 2011 a total of $21.6 billion have been granted under the program.
A similar system exists for approval of fund outflows: The Qualified Domestic Institutional Investor (QDII) program has grown more rapidly than the QFII scheme, amounting to $74.95 billion in December 2011. Furthermore, there is a Renminbi Qualified Foreign Institutional Investor (RQFII) program which was established to encourage Hong Kong subsidiaries of Chinese brokerages and fund houses to raise offshore yuan to invest in mainland China. For RQFIIs a quota of 20 billion yuan was announced in August 2011.
Aware of the “missing markets” problem of the yuan on its way to become an international currency, China hesitantly started to promote the development of a yuan offshore bond market. In 2007, the first “dim sum” bond, denominated in the currency of mainland China, but sold in Hong Kong, was issued by the China Development Bank. More than 80 issuers followed, including the World Bank, McDonald’s and Volkswagen. But usually size is small and maturities range from two to three years. Furthermore, non-financial foreign companies shun the market (although this is changing as European firms face increasing difficulties to raise funds economically at home due to the euro crisis) because they still face difficulties getting the necessary permission to bring the cash raised into China. As a consequence the sale of 20 billion yuan ($3.1 billion) by China’s Ministry of Finance in August 2011 attracted considerable attention. In an effort to further boost market development it came with the announcement that non-financial Chinese firms would be allowed to raise yuan offshore, a privilege previously reserved for mainland banks.
Why should a country with an annual budget deficit of 1.6% of GDP and a public debt of 16.3% of GDP (2010 estimates) issue government bonds? One reason is that usually in financial markets government bonds serve an important function as benchmarks. Up to the eurozone crisis they were essentially considered as risk free and still are generally regarded as superior to other sorts of debt. Markets are highly efficient and liquid. Large borrowing needs and a long life enable governments to offer a wide range of maturities which, in turn, facilitates the construction of a yield curve. For a currency gaining an international reputation without a well-developed and efficient market for government debt seems inconceivable. As Izabella Kaminska observed: “Most of the time it will be countries with the largest public debt … that will have preferred reserve currency status thrust upon them.”
Can it happen?
An international currency cannot be built from the scratch. Policy will is no substitute for investors’ demand and the existence of broad and deep financial markets. An international currencies is not footloose: As a rule, to be accepted it needs a big economy and a strong “hinterland” which provide for the neccessary credentials. In addition, although being a global phenomenon, international currencies have roots. They are strongly tied to regional financial centres: The US dollar to New York, the European currency to London and the Japanese yen to Tokyo. A greenback is a greenback. Financial centres, their history and culture, as well as the myths surrounding them, create a web of “tales” which become anchored in collective memory supporting the image of the currency in the eyes of the international financial community thereby increasing its significance.
In many respects, China’s financial system is still in its infancy. Should full convertibility be introduced now, the yuan as an international currency in fact would appear built from the scratch. Yuan markets and products exist only briefly, many of them still in a rudimentary state. The same holds for most bilateral official agreements. As an international currency it would seem largely a political construct.
From another perspective, however, the yuan is much more than this, showing a strong potential for rapidly winning international status: China is a big economy (the third largest behind the US and the euro area) and a strong hinterland for the yuan. It is the second largest exporter (behind the euro area). Many current financial market imperfections would – after a period of transition – automatically vanish with convertibility. Demand is there. Observers agree that markets want this currency. Supply will come: In one respect, the yuan differs from other aspirants from emerging market economies: Financial markets and instruments in this currency need not be developed painstakingly starting at zero. On the contrary: Not one but two (!) highly sophisticated international financial centres in the region are competing for the role to become an international hub for trading yuan:
In Singapore banks are already offering yuan deposits and bond funds. Although Hong Kong has a privileged role, many expect this only to last as long as China maintains strict capital controls. Under a fully convertible yuan, electronic brokering would make national borders largely irrelevant and Singapore’s advantage as the world’s fourth largest centre of foreign exchange trading would strengthen its position and add to the yuan’s potential.
In studies refering to China’s underdeveloped domestic financial markets this location aspect is often overlooked. Both Hong Kong and Singapore are highly developed and competitive financial places with a long history and market culture, and there is a web of tales and images surrounding them, of which the Chinese currency has always been part, anchored in the collective memory of the financial community. As a consequence, establishing yuan markets will pose few acceptance problems. In the range of financial products these places offer, despite strong rivalries, both rather complement each other. For instance, while Singapore is a leading foreign exchange centre, Hong Kong is strong in equities. After foreign exchange and capital liberalisation their combined market volumes could easily outnumber those in the traditional leading centres in other world regions, in particular, since large-scale yuan trading could be expected to trigger what Paul Krugman once called “centripetal forces” attracting business in other currencies, too.
It can happen, and sooner or later will happen – and the result might well surpass even the wildest prophecies. Currently, there is a huge global investor demand for exposure to China. Not only from ailing markets in Europe and the US, and from Asian neighbours eagerly awaiting a regional alternative to the dollar and the euro. The worldwide Chinese diaspora which according to rough estimates amounts to over 40 million people can be expected to welcome opening and boost market growth. Furthermore, their demand may become a stabilizing element in markets at the mercy of the ups and downs of western China fantasies and contribute to establish a safe haven in the region for both local and international investors. It is all out there – waiting for the signal.