Why the yuan is still an international pretender

Any idea that a currency conversion deal between Australia and China heralds the yuan's genuine internationalisation is overblown and will remain so until Beijing drastically liberalises its markets.

It was reported last week that Prime Minister Julia Gillard is set to announce a deal that will allow the Australian dollar to be converted directly into the Chinese yuan. This, and other issues, will be discussed when Gillard visits our largest trading partner for the first time since the successful leadership transition in Beijing. In an era when any agreement with China is seen to be a signal of some shift of historical proportions, any such deal will give rise to a number of breathless commentaries about the emergence of the yuan as a genuine global currency, and in the long term, perhaps even a reserve global currency. Others will see the currency exchange deal as further and incontrovertible evidence that the Australian economy is predominantly tied to China now and even more so into the future.

Sensible commentaries will caution that even if the trends are in the right direction, the yuan has a long way to go. But even many of these columnists will underestimate the obstacles against the true internationalisation of the yuan, its emergence as a reserve currency, and China’s rise as Australia’s and the world’s most important investment market. For that to occur Beijing’s currency policy has to change. But more than that, the Chinese political-economy would have to fundamentally change, meaning that China would be barely recognisable from the country that it is today.  

To be sure, any decision to allow direct convertibility of the Australian dollar into the Chinese renmimbi would be a genuine win-win situation for exporters and importers in both countries. China conducts almost all of its trade in American dollars, and a small percentage in Japanese yen. This means that local currency needs to be converted to the greenback, and then into yuan (and vice versa) when trading with China. The extra cost of intermediary conversions to and from the US dollar in IOUs increases the transaction costs of trade, and precludes businesses from hedging against rises or falls in the American dollar. It also carries the additional risk of a liquidity crunch during trading transactions with China should American dollars be in short supply into the future, even though the prospect of this is minimal for the moment.  

To minimise transaction costs and other settlement risks, the People’s Bank of China has signed almost twenty currency swap memoranda-of-understanding or actual agreements with central banks of major trading partners such as Japan, South Korea, United Kingdom, Indonesia, Singapore and Brazil. Such an agreement was also signed with the Reserve Bank of Australia in March 2012. These deals differ in the maximum amount of currency available for the swap. They also vary as to whether the direct swap agreement applies to the principal or only the interest payment of any IOUs from bilateral trade. But the point of these agreements – besides providing central banks a buffer against possible shortages in American dollars required for trade with China - is to establish a future foundation for importers and exporters to exchange yuan for local currency without having to sign IOUs that are denominated in American dollars.      

Any future currency exchange deal between Australia and China builds on the earlier currency swap agreement. Note that a direct exchange or convertibility deal is qualitatively different to a currency swap agreement. The latter is really an agreement between the respective central banks to exchange local currencies up to an agreed amount in the case of short-term supply problems of American dollars in settling the trading or current account – $A30 billion in the case of the March 2012 agreement between Canberra and Beijing.

But a currency exchange agreement allows direct exchange of the agreed two currencies without the greenback as an intermediary currency. Moreover, such an agreement opens the door for direct conversion for the purposes of the capital or investment account, and not just for the settlement of trade; and the potential of seamless access (when it comes to currency issues) to Chinese capital, asset and equity markets. For the moment, the yuan can only be directly exchanged for American dollars and Japanese yen. It is no wonder that any direct currency exchange agreement between Australia and Canberra will raise expectations that the financial and economic integration of Australia and China will be significantly accelerated, with the broader expectation that the internationalisation of the yuan is only a matter of time.

Such expectations should be shelved for the foreseeable future for several reasons.

First, China still maintains a de facto fixed currency regime, linked to a US dollar dominated ‘basket of currencies’. Until this changes there is little incentive to hold too many IOUs in yuan since the prospect of dramatic appreciation in the value of China’s currency is slight. Bear in mind that Beijing still places significant restrictions on the band within which conversion rates utilizing currency swap arrangements can deviate from official, fixed conversion rates for the yuan into US dollars.

The prospect for changes in China’s fixed currency regime is also poor. China’s two largest export markets in America and the European Union remain stagnant, and the margins of its exporters are increasingly suffering from competitors in rising Asian manufacturing hubs such as Indonesia, Vietnam and Cambodia. To protect an export manufacturing sector that employs approximately 150-200 million people, Beijing will not float the yuan and allow it to significantly appreciate in the foreseeable future.

Second, foreign businesses are reluctant to hold too much yuan denominated cash and IOUs for the simple reason that there isn’t much use for the currency outside China (and Hong Kong). In the event of any direct currency conversion deal, Australian businesses will soon come to the same conclusion.

Remember that Beijing does not allow large quantities of its currency to be freely converted outside China and Hong Kong. Added to this is the fact that China’s capital account is tightly regulated and effectively closed. Even if the capital account was eventually relaxed, it would be meaningless without significant opening of Chinese financial markets and key sectors of the domestic economy which currently remain closed to outsiders and even private domestic firms.

Indeed, there are severe limitations on foreign entities purchasing Chinese government and corporate bonds, while there are significant restrictions on Chinese firms being able to issue their own freely traded bonds. For example, China holds about US$1.3 trillion worth of US Treasury bonds and hundreds of billions more in other agency bonds, as well as over US$230 billion worth of Japanese yen denominated bonds. Yet, it was only after an extended period of negotiations that Tokyo was given the green light in 2012 by political officials in Beijing to purchase a mere US$10 billion worth of Chinese bonds.  

More serious is the fact that every important and lucrative sector in the Chinese economy, excluding export manufacturing, is reserved for Chinese state-owned-enterprises to dominate at the expense of private domestic and foreign firms. Foreign firms are only allowed to participate in a number of strategic ‘joint-ventures’ designed to hasten technology and know-how transfer into the domestic economy.

The point is that until China opens up its markets to outsiders, there is no good reason (beyond speculating on the yuan which remains the primary reason why outside investors hold yuan currency and bonds) to hold large wads of yuan denominated financial assets and instruments beyond having enough to meet trading and settlement requirements. And even then, many exporters will prefer agreements in American dollars which remains the world's reserve currency. Besides, pegging the yuan to the US dollar means that American inflationary policies will continue to drive down the strength of the yuan. If so, one might as well hold assets and IOUs in American dollars than in yuan as the latter’s future global convertibility remains unclear.  

Any Gillard government announcement of a currency exchange deal is welcome news. But it won’t herald a game changer in our economic relations with China or the yuan’s role in global financial markets. There will be lower demand for the yuan than many predict until exchange-rate, capital account and market access reforms are well underway. Until Australia and the world can freely invest in major sectors of the Chinese market, and easily buy and sell Chinese companies, fixed-income assets and corporate bonds, any direct currency exchange agreement is likely to be under-utilised.

Dr John Lee is the Michael Hintze Fellow and adjunct associate professor at the Centre for International Security Studies, Sydney University. He is also a non-resident senior scholar at the Hudson Institute in Washington DC and a director of the Kokoda Foundation in Canberra.