Yuan small step for China

Bit by bit China is internationalising its currency. Next week Wayne Swan will be trying to hurry them along but full liberalisation of this key tool in Beijing's command-and-control structure is still years away.

Wayne Swan’s trip to Hong Kong and Beijing next week is another indication of China’s slow acceleration of its efforts to internationalise its currency.

Swan will co-host a conference in Hong Kong on yuan internationalisation before holding talks with Chinese officials in Beijing. Australia’s interest in supporting the process of internationalisation follows the creation of a bilateral currency swap arrangement between the Reserve Bank and the Bank of China earlier this year.

While there is no doubt that the ability to directly convert Australian dollars into yuan and vice versa would be beneficial for Australian and Chinese businesses and trade between the two economies – it would reduce transaction and hedging costs between two major trading partners – China is moving very cautiously towards liberalisation of the yuan.

While the pace of that process has picked up over the past year it could be decades, assuming China maintains the policy, before the yuan is a fully internationalised and freely traded currency.

Until the middle of the last decade the yuan was very tightly controlled, with limited exchangeability, and was a currency that was tightly "managed" by Beijing in order to enhance the competitiveness in export markets that was the core of China’s economic growth strategies.

It wasn’t until then – about the time it became apparent that the mercantilist phase of development was waning and domestic consumption would need to be a bigger driver of growth – that China started to realise that internationalisation of the yen could bring both economic and political benefits, a realisation that would have been emphasised by the development of the global financial crisis and the damage it has done to the US and Europe, which issue the two most significant reserve currencies.

This year we’ve seen more currency swap agreements with foreign central banks, an agreement with Japan that allows direct conversion between the yen and the yuan, a widening of the band in which the yuan is allowed to trade against the US dollar and some modest liberalisation of domestic interest rates and lending.

In Hong Kong, presently the only place outside mainland China where yuan transactions can be cleared and settled, the Chinese have encouraged the development of yuan-denominated bond markets and financial products, using Hong Kong as a kind of laboratory for experimentation. It has also slightly liberalised the strict controls of foreign investment in local stocks and bonds.

It is, however, moving very carefully and incrementally because while there are major potential benefits in internationalising its currency it would also mean profound changes for other aspects of China’s economic and, potentially, political settings.

The economic benefits China is pursuing so cautiously relate to the lowering of transaction costs – China’s businesses would be able to do business offshore in their home currency – the greater economic flexibility associated with floating exchange rates and seigniorage and the ability to swap something intrinsically worthless (paper and ink) for real goods and services.

If the yuan could develop into a reserve currency alongside the US dollar and, perhaps, the euro, there is also the potential benefit of lower borrowing costs for the government and private borrowers without having to do what China does today (as Japan did before it) and effectively tax domestic savings to create cheap funding.

From a political perspective, internationalising the yuan and establishing it as one of the world’s key currencies would also reflect and facilitate China’s ambition of being seen and treated as a world power. Given that it is already the world’s second-largest economy, that’s a not unreasonable ambition.

China is, however, hastening slowly in pursuing the liberalisation of the yuan.

If the yuan is to develop into a reserve currency it would also need to liberalise and renovate its rigidly controlled banking system (where there have been some tentative positive steps recently), it would have to completely open up its capital account (where, again, there has been some movement at the margin) and radically overhaul its legal structures and processes. It would need to develop deep, liquid and sophisticated financial markets.

It would have to turn its back on the command-and-control approach the state has taken to managing its economy and financial system and embrace markets and transparency. A pegged currency and rigid controls over bank lending and capital flows have been central to its economic development and relative political stability.

With about 60 per cent of China’s official reserves held in US dollar-denominated assets, a rapid move towards internationalisation and a diversification of its reserve holdings would also mean big losses in the value of those reserves.

China has talked about a goal of having about 30 per cent of its foreign trade settled in yuan by 2015. Since its first small step toward liberalising the yuan when it moved away from the dollar peg and was aligned with a basket of currencies in 2005 about 10 per cent of its trade is now settled in yuan.

The goal of full convertibility, however, will almost inevitably be a distant one as China pursues gradualist policies rather than risk the disruption and destabilisation – economic and political – that might occur if it tried to accelerate the process too quickly.

That’s why China’s officials talk about the yuan becoming a meaningful reserve currency by 2020 but don’t see full internationalisation until 2025 and beyond.

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