Less Than Meets the Eye to Yuan Liberalization

Much has been made, particularly in Hong Kong, of China’s decision last week to allow settlement of certain cross-border trade in yuan. For sure, this is a step forward towards full convertibility which would increase the role of the nation’s currency. However, the notion that it will significantly reduce the role of the US dollar in trade transactions except in the very long term is dubious. Indeed, China has good reason not to want to see its currency in demand outside its borders, flattering though that might be.

China in fact could well look at the failure of the yen to play a larger role in trade despite many years of full convertibility and the enormous role that Japanese companies have played, and continue to play, globally. Indeed, if China wants to get away from dollar dependence it might do well to encourage more invoicing in the only two currencies which currently provide a realistic alternative – the euro and the yen.

China’s pilot project is to enable Hong Kong, Guangdong and Yangtze delta firms to use yuan in settling trade transactions. Likewise, the same will apply to firms in Yunnan and Guangxi in dealings with Asean neighbors – which for practical purposes means Laos, Burma, Vietnam and Thailand.

The Chinese announcement has been greeted by many in Hong Kong as another benefit given to the territory to help it through the crisis. But that does not seem to be Beijing’s real aim, which is more of an experiment that to some extent simply recognizes existing realities in the same way the Thai baht is sometimes used for border trade with neighbors with uncertain currencies. The yuan is already in limited use across both of the borders concerned at least for cash transactions, which can be on a large scale. It is however unlikely that the yuan will be used for the majority of Hong Kong-Guangdong trade because most of that relates to transshipment and processing trade with third countries, which will continue to be largely denominated and settled in US dollars.

Back in the late 1980s, it was often assumed that the yen would gradually become more important in trade, especially in Asia as a significant portion of Japan’s exports were invoiced in yen, a currency then becoming more important in other countries’ foreign exchange reserves. But yen usage stalled and never became widespread in trade between third countries. Reasons for this included the emergence of China, which was both reluctant to give face to Japan and anyway kept its currency pegged to the dollar and its exporting goals focused on the US.

In any event, Japan feared that making it easier for the yen to play a larger role would tend to push up its value at a time when Japan was trying to counter the deflationary impact of the yen’s huge rise between 1985 – when it averaged 240 to the dollar – and its 1995 peak of 85.

The yen’s tendency to appreciate excessively made the Bank of Japan reluctant to make its easier for foreign central banks to hold and trade yen-denominated paper. Thus the role of the yen in international reserves tended to decline. Other countries by extension preferred to stick with relationships with the dollar, thus making it unnecessary for them to encourage financing trade in any other currency. Even the collapse of fixed exchange rates at the time of the Asian crisis did not change that.

There is unlikely to be any significant non-local use of the yuan while it is otherwise not convertible and does not feature among foreign currency reserves. Nor is there any reason for China to encourage that while it is running a huge current account surplus and has far bigger dollar reserves than it needs.

A more immediate way to increase international usage of the yuan without adding to its foreign reserves would be the issue of offshore bonds which would be denominated in yuan but as buyer and borrower were both offshore the net impact would be zero. As Singapore has shown it is possible to develop an own-currency offshore market without losing control of the either the currency or local interest rates. Another possibility would be to allow foreign borrowers to issue yuan bonds to Chinese domestic investors – Panda bonds, a Chinese version of Japan’s Samurai issues. Two were issued earlier – by the International Finance Corp and the Asian Development Bank -- but on the understanding that the funds would be used locally not repatriated.

Now however China may be more willing to allow capital outflow with the proceeds of issues swapped into other currencies. In that way local institutions would acquire yuan denominated assets whilst official dollar reserves would fall.

Mainland institutions may be ready for such investments this but given the recent turmoil in global financial markets the Chinese authorities may be reluctant to encourage an developments which increase financial flows and hence carry the risk of adding to currency instability and pressures on domestic monetary policy.

As with most aspects of China’s liberalization, all steps to increase use of the yuan will be cautious and cumulative and – whatever the Hong Kong government likes to claim – be motivated by the government’s perception of overall national interest.