Internationalization of Chinese Yuan – Is it too early to say it's the “Redback v. Greenback War”?

   The challenge posed by the Chinese Yuan (Renminbi) to the US dollar doesn’t necessarily entail a full-fledged war between the Redback and the Greenback. A currency that is yet to be internationalized is simply an unarmored warrior. Even with unbeatable bravery, sacrifice is still unavoidable.

Since the post-financial crisis era, politicians, commentators and scholars around the world all look forward to a rising Chinese Yuan, not only in terms of its exchange value, but also its role to adjust the long-term imbalance of the global currency system, which has long been driven by the world’s largest banknotes printing machine, United States.

Rather than complaining about the unwelcomed quantitative easing pills the U.S forced the world to swallow, the world has moved on to find a solution: a currency that is capable of taking over the dollars’ dominant role. Unfortunately, Euro got bogged down by serious sovereign default and insolvency situations; the Japanese Yen, which has not yet fully recovered from its bubble economy, has been worsened by the devastating earthquake, tsunami, and nuclear crisis and is thus incapable of bearing such grievous mission. Now, everybody turns to China and its heavily undervalued Renminbi.

But the problem is, the Chinese Yuan is not yet a convert-free currency, not to mention how far it is away from the goal of functioning as a global currency. To position itself as a global reserve currency, it still has to go through three major phases to reach real internationalization: from becoming a global trade settlement currency, to a global investment currency, and a global reserve currency. I am not an economist or a financial expert in this regard. By trying to introduce and articulate the basic rationales behind these three processes in a simplified version, I hope to help those who have been so much confused by the plentiful news, comments, and even paradoxes just to get a clear picture of this sexy issue.

According to China’s Twelfth Five Year Plan that was proposed in March this year and the estimations of several important Chinese scholars who specialize in Economics and Finance, Chinese government will try to reach the goal of promoting Yuan as both a global trade settlement and investment currency before 2015. Let’s talk about the three stages separately. Becoming a trade settlement currency essentially means that Yuan could be freely used for payment in both import and export activities across the Chinese borders. There are four main features (or we can call them the Chinese government’s missions) at this stage: focusing on trade related in-and-out flow of Yuan, promoting Offshore Renminbi Market, extending onshore Renminbi Market and widely adopting currency swap with other countries to promote Renminbi as a settlement currency.  To fulfill these missions, Chinese government has authorized Hong Kong and Macau to be China’s Cross-Border trade settlement Renminbi Offshore Markets and designated five major China cities as its Renminbi Onshore Markets since July, 2009. To further promote the use of Renminbi, Offshore Markets have been extended to all countries. Twenty China provinces have also been designated as Onshore Markets since June, 2010. Foreign enterprises can trade with local Chinese company using Renminbi as the settlement currency in the Offshore Market, and designated local Chinese enterprises can trade with the foreign companies in Renminbi in Onshore markets as well. There is no doubt Chinese government will allow all local enterprises to use Renminbi directly in all international trade transactions in the end. Furthermore, in order to make sure those foreign trading partners have enough Yuan in hand for payment, the Chinese government has signed bilateral currency swap agreements with South Korea, Hong Kong, Malaysia, Belarus, Indonesia, Argentina, Singapore, and Iceland. Through the exchange between Yuan and these countries’ currencies, China can meet the goal of increasing outflow of Yuan without jeopardizing its export competitiveness.

Simply making Yuan a trade settlement currency is not enough. Only when a currency could be used for investment purpose can that currency provide incentives for foreign investors to preserve or circulate it. Accordingly, here comes the three important missions in this the phase of promoting Yuan as a global investment currency: promoting the use of Yuan for investment purposes, focusing more on the out-flow of Yuan, and encouraging foreign enterprises’ willingness to increase their Yuan position (through Renminbi Deposits, Renminbi denominated bond, IPO and derivatives). To meet these objectives, the Chinese government started launching the “Dim Sum Market”, where foreign companies are allowed to issue Yuan denominated bonds in Hong Kong from August, 2010 onwards. (Although the first Renminbi denominated bond was issued in 2007, only Chinese enterprises were allowed to be issuers at that time) On January, 2011, the Chinese government promulgated the rules to unfold piloting Chinese non-financial institutions' overseas Renminbi-denominated direct investment. The basic logic is to increase the out-flow of Renminbi in a more moderate way compared with increasing imports from outside market by allowing local institutions to use Renminbi to invest abroad. The same logic is also used in Hong Kong’s Renminbi IPO Initiatives. Increasing foreign natural person’s or enterprises’ holding position in Renminbi is the most important foreseeable task for Chinese governments in the near future.

Even if China can reach the above strategic goals in the near future and have Yuan recognized as a global reserve currency, Yuan still has a long way to go, not to mention replacing US dollar as another worldwide dominant currency. To prepare itself for the wars with the Greenback, in my opinion, Redback Yuan needs to fulfill at least 3 preconditions. First, the “capital account convertibility” has to be enabled in China’s fiscal system. Such Convertibility centers on the ability to conduct transactions of local financial assets at a market determined exchange rate. Then, a well developed, transparent, and global standard financial market should be created. It is only when the capital market matures and become prosperous that the acceptability and rate of circulation of the Yuan can rise. A highly liquidated currency is required to stimulate cross-border uses of the currency. Third but not last, China can increase currency swap agreements with other countries and enhance overseas investment of local entities. These ways are alternatives to enlarge the out-flow of Chinese Yuan, while preventing foreign imports from escalating and the value of Yuan appreciating too dramatically.

A more balanced trade environment and sophisticated industrial structure are required for the Yuan to assume dominance, (it also usually requires the country who issues the currency to be a deficit driven country).  It is also vital for the country to master solid and substantial economic power (which usually means a great inner demand market with a sophisticated, well regulated and anti-speculation financial market). For those who are so anxious and impatient to push the Chinese Yuan to the battlefield without realizing that it would only result in “sacrifice” for now, I would say, they are either too optimistic or just too ignorant.