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Finance 26 September 2014 A PLUS EXCHANGE of IDEAS China is attempting to internationalize the yuan by signing bilateral deals, encouraging its use in the settlement of trade and broadening the range of financial products available. George W. Russell asks experts about the future of the world’s seventh-most traded currency Illustrations by Harry Harrison A fter more than two decades working in the Mainland, Jimmy Leung knows all the quirks of the renminbi, China’s “people’s currency,” also known as the yuan. He remembers the currency confusion of the 1980s caused by multiple exchange rates: the official rate, the market rate and the black market rate. He also recalls the 1990s, when non-citizens had to change hard currency for used foreign exchange certificates at the Bank of China and use them at designated outlets such as hotels and the infamous state-owned Friendship Store chain. “You did not want renminbi in Hong Kong in those days,” says Leung, now China Banking and Capital Markets Leader with PricewaterhouseCoopers in Shanghai and a Hong Kong Institute of CPAs member. “Nobody wanted it.” But like many observers, Leung believes today that the renminbi is on an unstoppable path to becoming a major world currency. There are many reasons to welcome the ability to invest and trade in yuan, Liu Linan, Greater China Rates and Foreign Exchange Strategist at Deutsche Bank in Hong Kong, wrote in a recent report tracing the currency’s internationalization. “Currency risk can be neutralized by raising capital in the offshore renminbi bond market to fund onshore subsidiaries.” Yuan bonds also offer a relatively September 2014 27 Finance competitive source of financing and the potential to tap a new investor base. “Invoicing goods in yuan for Chinese buyers may provide competitive advantages and the potential for significant cost savings,” Liu noted. The most obvious growth of the yuan is in international trade settlement. At the end of 2013, the yuan was the eighth-most used currency in terms of value, behind the U.S. dollar, the euro, the pound sterling, the Japanese yen, the Australian dollar, the Swiss franc and the Canadian dollar. (It had overtaken the Canadian dollar by June this year.) It is likely to rise higher. Last year, the yuan became the second-most used currency in global trade finance – letters of credit and bills for collection – after the U.S. dollar, according to the Society for Worldwide Interbank Financial Telecommunication. Moreover, many countries are eager to enter the offshore yuan trade: Beijing has signed numerous bilateral currency swap deals in which the central banks can supply each other’s currencies without a delay. These will create more yuan liquidity overseas and reduce transaction costs by eliminating the need for converting into a third currency. Treading carefully Leung at PwC expects China to extend the reach of the yuan in a cautious manner, firstly aiming to encourage more availability outside China before it expects any worldwide role. “In the short term, the objective of the government is clearly to internationalize the currency,” he says, “but it is far from being a global one.” While the yuan assumes more importance as a medium of exchange, it lags far behind as a future reserve currency. “To be a reserve currency, you need a flexible exchange rate, an open capital account and deep financial markets so foreign investors can actually get hold of renminbi-denominated assets 28 September 2014 and can move relatively freely in and out of them,” insists Eswar Prasad, a former head of the China desk at the International Monetary Fund. “In all these dimensions China is not there yet.” “Signing a bilateral swap is a symbolic yet significant gesture from the central banks.” However, the nation is moving in the right direction. Tim Pagett, Financial Services Industry Leader at Deloitte China in Hong Kong, notes that earlier this year, the Central Bank of Nigeria announced it would increase the renminbi’s share of its currency reserves from 2 percent to 7 percent. “We feel that the renminbi will slowly start becoming a strong and viable option as a reserve currency,” he says. According to data compiled by Standard Chartered, at least 30 central banks have already invested in renminbi assets: about 10 central banks hold renminbi as part of their reserve portfolios, and another 20 or so have signed the local currency swap lines with the People’s Bank of China to create renminbi liquidity. Such swap deals also have a wider meaning. “Signing a bilateral swap is a symbolic yet significant gesture from the central banks on their acceptance and support to the renminbi,” says Pagett. “This provides a positive signal to the industry on the renminbi’s acceptability for settlement and financing purposes.” Despite such international attention, Hong Kong is expected to remain the priority offshore yuan market. “It’s a part of China, it has a lot of transactions already, there are lots of Chinese banks in Hong Kong,” says Walkman Lee, a Financial Services Partner with KPMG China in Beijing and an Institute member. Since 2009, Hong Kong has seen a rapid growth in yuan deposits, notes Vijay Chander, Executive Director for Fixed Income at the Asia Securities Industry & Financial Markets Association. He also points to strong demand for so-called dim sum bonds, yuan-denominated bonds issued outside the Mainland. In the first quarter of 2014, 29 new dim sum bonds totalling US$6.5 billion were issued, almost triple the same period last year, according to London-based data provider Dealogic. “Hong Kong will cater to the needs of domestic Chinese issuers wishing to issue dim sum bonds for many years to come,” says Chander. Competing cities However, Hong Kong does face increasing competition. Thomas Gilles, Head of the China Desk at the Baker & McKenzie law firm in Frankfurt, says the currency swap deal between Germany and China “opens up possibilities of new capital market products, such as dim sum bonds issued” directly in Frankfurt. Rival financial centres are playing to their own strengths as they seek to peck away at Hong Kong’s current near-monopoly on the offshore renminbi market. Gilles points out that Germany is China’s largest trading partner and Frankfurt is its financial capital so they have advantages. Other cities have their niches, large and small. “London is a major world financial centre with a lot of bond issues and also, by a large margin, the largest centre for the settlement of foreign exchange transactions,” says Andrew Carmichael, a Partner with the Linklaters international law firm in London. “Luxembourg is the largest asset manager for funds and mutual funds in Europe, and Singapore is the private wealth centre in Asia, while Hong Kong is more China ori- A PLUS entated,” he adds. “If the renminbi is to be a global currency, London, Luxembourg, Singapore and Hong Kong want to play their parts in that.” The increasingly cross-border nature of the yuan trade, adds Leung at PwC, is a reflection of the Chinese economy’s opening up. “After 2000, there were a lot of changes,” he says. “China’s accession to the World Trade Organization in 2002 meant there were a lot of commitments in terms of opening up to other parts of the world, including the currency.” The Chinese government has also become more open about its regulation, Leung adds. “Fifteen years ago you heard nothing from PBoC, you heard nothing from the Ministry of Finance, about their thoughts or their participation in the global economy. You heard absolutely nothing about currency policy. It was very opaque.” This increased transparency makes the renminbi a viable option as central banks seek an alternative to the U.S. dollar for its foreign exchange holdings. More recently, it seemed the euro’s default position as the world’s second reserve currency has been shaken. “The euro was seen as a prime candidate for those seeking alternatives to the dollar, but it has unfortunately faced its own share of uncertainties arising from the debt crisis,” points out John Zhu, Greater China Economist at HSBC. “This has led to increasing interest across the world in holding non-traditional currencies [and] many global investors are increasingly seeing the yuan as an alternative.” Into the unknown It could take some time. Peter Zöllner, Head of the Banking Department at the Bank for International Settlements, told a March conference that the proportion of “If the renminbi is to be a global currency, London, Luxembourg, Singapore and Hong Kong want to play their parts in that.” global reserves denominated in U.S. dollars might fall from between 65 and 70 percent to between 50 and 60 percent over the next 20 years, with the yuan accounting for perhaps a third to a half of the substitution. Such moves, of course, are unlikely to threaten the greenback’s primacy. “In the short term, the U.S. dollar remains the major reserve currency and there’s a long way for the renminbi to go,” says Lee at KPMG. “They have to prove to the world that September 2014 29 Finance they’re as stable as the U.S. dollar.” In the meantime, the Chinese government is expected to continue to drop hints as to the likely direction of the yuan’s internationalization. “Developments in the Shanghai and other free trade zones will give some clues as to the Chinese authorities’ thinking in terms of the degree of freedom they are willing to consider or contemplate with regard to capital movements into and out of China going forward,” says Chander at ASIFMA. He sees only increased use of the yuan in trade and more central banks and fund managers invest in yuan assets. “Finally,” Chander adds, “there will be the convergence in both forex and interest rates between the onshore and offshore markets, leading to a de facto convertible currency even if de jure capital account convertibility 30 September 2014 “In the short term, the U.S. dollar remains the major reserve currency and there’s a long way for the renminbi to go.” in China is some way off.” CPAs involved in treasury and risk management are reminded to be aware of the complications surrounding the increased use of the Mainland currency. “You have to think about how to hedge the currency risk,” says Lee, adding that although many Hong Kong accountants are already familiar with the yuan. “I think some companies want to use it as a settlement currency because they know how to manage the currency exposure.” The main risk, say experts, is that the yuan is not really freely convertible and the PBoC sets the rate. “It’s very different from, say, the Australian dollar or the euro, where you have a mechanism,” says Lee. That creates a management risk. A company might want to establish a separate procedure to look after the fluctuation of the renminbi.” So when will we expect to see a more liberalized yuan environment? Experts say the time when it bypasses or even becomes comparable to the U.S. dollar is unknown. “I really cannot tell,” says Leung at PwC. “The important factor is full conversion of the currency, and for that, nobody can predict a timetable.” A PLUS Monetary milestones 1948 First renminbi or “people's currency” issued by newly founded People's Bank of China. It is also known as the yuan. 1949 Yuan becomes sole legal currency. 1955 Exchange rate set at 2.46 yuan to the U.S. dollar. 1960s-70s Yuan stable in terms of inflation, as government sets wages and prices in centrally planned economy. 2005 C hina shifts from a decade-old peg against the dollar to a managed float, based on a basket of currencies. It devalues the yuan by 2.1 percent overnight to 8.11 against the dollar. 2007 T he first yuan-denominated bonds are sold in Hong Kong. 2008 China pegs the yuan against the dollar at 6.83 as an emergency measure to help stabilize China's economy amid the worsening global financial crisis. 1971-78 Yuan gradually revalues to 1.50 yuan to the dollar. 1979 As China opens its economy, exporters are allowed to retain a percentage of foreign exchange. 2009 China launches trial programme allowing companies in select cities to settle imports and exports in yuan, naming Hong Kong the pilot city for yuan settlement outside the Mainland. 1981 First round of yuan devaluation. State Council introduces "internal settlement rate" of 2.80 yuan per dollar. The more realistic exchange rate is based on China's average export cost per dollar plus a 10 percent margin. 2010 (June) 1983 State Council decides the PBoC should function solely as central bank, not a commercial bank as well. China ends a two-year-long peg to the dollar, returning to a managed float based on a basket of currencies. 2010 (July) China's central bank and the Hong Kong Monetary Authority agree to expand the scope of yuan clearing in Hong Kong and offshore yuan trading takes off. 2010 (August) McDonald's becomes the first nonfinancial foreign company to issue yuan-denominated bonds in Hong Kong. 1985 Internal settlement rate abolished. China sets rate at 2.80 yuan to the dollar, ending dual exchange rate system. 1990s Exporters suffer increasing losses because of the yuan's overvaluation. 1993 U.S. Treasury labels China a currency manipulator for first time. 2010 China allows select exporters to keep some of (October) t heir foreign-currency earnings offshore in a trial programme. 1994 China unifies its dual exchange-rate system by (January) moving the official rate of 5.80 to the dollar to the prevailing market-determined rate of 8.70, devaluing the yuan by 33 percent overnight. 2011 C hina launches a pilot programme to let domestic (January) companies use yuan for investments outside China. 1994 (April) 1996 F irst foreign exchange trading centre opens in Shanghai, starting China's inter-bank foreign exchange market. Yuan rate is set around 8.28 yuan per dollar as part of a tightly managed floating exchange rate policy. China allows the yuan to be fully convertible into foreign currencies for trade purposes but maintains rules and limits on buying and selling foreign currencies to make loans and investments. 2011 (April) ong Kong-listed Hui Xian Real Estate Investment H Trust becomes first yuan-denominated initial public offering outside China but falls sharply on its debut. 2012 Cross-border trade settlement scheme expanded (March) to all Chinese companies with import or export scope on their business licenses. 2013 Shanghai Free Trade Zone is set up to test an (September) offshore yuan market in Shanghai. 1997-99 Y uan is pegged at 8.28 to the dollar through frequent central-bank interventions. 2013 China settles 20 percent of trade in yuan, up from zero in 2008. 2002 hina begins to relax its capital controls gradually C after joining the World Trade Organization, but international pressure mounts for China to let the yuan appreciate faster to help balance global trade. 2004 hina allows Hong Kong banks to offer limited retail C yuan banking services to facilitate cross-border tourist spending. 2020 Yuan will rank only after the U.S. dollar, euro (forecast) a nd the pound sterling as the world's fourth most-used payment currency and 30 percent of China's trade by then will be settled in yuan. Sources: Deutsche Bank, EY, HSBC, Ministry of Finance, Standard Chartered September 2014 31