The true value of Australia's renminbi conversion

The direct currency conversion deal between Australia and China will not be material in the short-term, but in time heavy two-way trade will mean the savings on transaction and hedging costs will be significant.

The agreement to allow direct conversion of Australian dollars into China’s renminbi and vice versa is a major and positive development in the economic and trade relationships of the two countries as well as the latest example of China’s accelerating internationalisation of its currency.

The announcement of the deal, which coincides with Julia Gillard’s visit to China, follows last year’s agreement between the Reserve Bank and China’s central bank for a $30 billion currency swap agreement. It is part of a determined effort by the Chinese authorities to develop the renminbi into a regional reserve currency.

While initially the impact of the agreement is likely to be modest because it will take time for liquidity in the market for direct trading to develop (although the central banks’ currency swap deal could help) the two-way trade flows between Australia and China mean that the potential over time is considerable.

The major benefit from direct convertibility of the currencies is the reduction in transaction and hedging costs it would facilitate by removing the necessity of involving a third currency, generally the US dollar, in foreign exchange transactions.

Given the scale of Australia’s exports to China any reduction in ‘’friction’’ costs could produce considerable savings, as well as helping to progress Australia’s ambitions to be a regional financial centre. The other major economy in the region to have struck a similar deal is Japan.

The latest deal is part of a relatively recent effort by the Chinese authorities to internationalise the renminbi, which traditionally had been very tightly controlled. Indeed it wasn’t until after the financial crisis that China started to liberalise the role of the renminbi in cross-border trade.

There are now more than 10,000 financial institutions doing business in the currency, the pool of offshore renminbi is swelling rapidly and cross-border capital flows are surging.

While China appears to be conscious of controlling the rate at which it opens up trading in the renminbi – it would recognise that real liberalisation of the currency would have profound implications for its domestic market and institutions and would require deregulation of its capital accounts – it has established offshore renminbi centres, entered currency swap arrangements with central banks and given its domestic financial institutions a greater degree of flexibility in pricing credit.

There is obviously prestige available from greater acceptance of the renminbi in global trade – and potentially more political clout within Asia, where acceptance of the renminbi has, as one would expect, been greatest – but the more practical benefits relate to the impact on foreign exchange risks and costs for Chinese businesses and potentially access to global capital to finance China’s continuing development.

In an economy where there are some concerns about the way capital is allocated it could, with further deregulation of China’s financial system, also help introduce more discipline to the allocation of capital within China.

The deal with Australia is another small but meaningful step towards a more open Chinese financial system, even if it is unlikely that China’s authorities will countenance anything more than cautious, controlled and limited liberalisation within the foreseeable future.

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