China is the world’s largest exporter and ranks second globally in terms of total trade – but for now, more than 70 per cent of all Chinese cross-border trade is settled in US Dollars. Trade settlement in RMB has been piloted since July this year: with companies in Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan permitted to use RMB to settle cross-border trade with Hong Kong, Macau and Southeast Asian nations. Bilateral agreements to allow direct settlement have also been signed with neighbouring countries.

Some China economists believe that around half of China's annual cross-border trade will be settled in RMB rather than US Dollars within the next 3-5 years. Given the high volumes in China trade, even if half the trade flows were settled in RMB, that would make it one of top three international currencies.

Chinese authorities are already promoting Steps 1 and 2, facilitating the use of the RMB in international financial transactions and using Hong Kong as a test market. Major Chinese banks were given the right to issue RMB-denominated corporate bonds in Hong Kong as far back as 2007, and five of the banks have issued RMB30 bn in bonds to date. On 8 September, the Government announced that it would issue RMB6 bn in public bonds in Hong Kong. Hong Kong has a new role to play as the offshore hub for RMB inflows into Asia.

However, the RMB has a long and tough path to tread before it can hold any pretense of becoming an international reserve currency.

Challenges

The main challenge for the Chinese authorities will be to keep the currency stable. As soon as financial institutions start to issue RMB-denominated corporate bonds overseas and the RMB begins to trade freely outside Chinese financial markets, domestic economics will be harder to control, turning monetary policy into a more complex exercise. The major risk will come from potentially enormous capital inflows into the domestic market, which could seriously affect the RMB exchange rate.

However, there are two important measures that can overcome the challenges. The first is a necessary change in the structure of the Chinese economic development model, requiring a shift from the current export-investment based economy to a domestic consumer-focused economy. Private consumption currently accounts for 35 per cent of Chinese GDP, a small number when compared to most other Asian economies (50-60 per cent) and the United States (70 per cent). The current model relies on foreign demand, especially American demand; allied with a lose monetary policy, this could impact negatively on currency stability. A model based on domestic consumption – acknowledged by the Chinese Government as a means of avoiding this risk – is already being encouraged.

The second measure is the development of the financial services industry, a necessity if China is to create healthy financial markets. Local providers of services such as insurance, re-insurance, risk rating, accounting and auditing are still well behind in their development of global best practices. The development of Shanghai as an International Financial Centre should accelerate the process. The Chinese Government is aware of the challenges and is actively working on solutions. Even if the RMB does not become an international reserve currency in the short-to-medium term, it is not unrealistic to believe that ambitions for internationalisation will succeed sooner rather than later – allowing it a place amongst the strongest and most important currencies in the world.

Part I of this article is available at: http://www.bizchina-update.com/content/view/2749/44/
 
This article is contributed by Capital Eight - an investment banking advisory firm headquartered in Shanghai. The company specialises in Mergers & Acquisitions and Structured Finance, advising companies active in China. The team combines more than forty-five years of deal-making expertise in Asia, Europe and North America. For more information please contact This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
 

Keywords : RMB, Yuan, Chinese Currency, International Reserve Currency, Monetary Policy

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