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August 12, 2013

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Promoting the yuan in offshore strategies

Since the introduction of cross-border yuan settlement in 2009, the yuan has become increasingly popular. This year, usage has expanded to Singapore and Taiwan. China is gradually opening up its capital accounts and deepening the yuan’s penetration in existing offshore centers. Development thus far has been mainly in Asia. Although China is trying to “internationalize” the yuan, there is yet no blueprint for expanding its use outside of existing markets.

Suitable targets for yuan usage are not immediately obvious. At this stage, it could be very difficult to make the yuan popular in many large countries. China’s largest trading partners are the United States, European Union and Japan, but it would be futile to try to persuade them to use the yuan on a major scale. Transaction costs of using the yuan would likely be much higher than using their own currencies.

Politically, these regions are not especially interested in helping China to realize its currency ambitions. Moreover, those countries more willing to cooperate with China do not have the financial infrastructure to facilitate yuan usage. Pakistan, Sudan, North Korea, Iran and Zimbabwe fall under that category. Clearly, there needs to be a framework to identify targets for popularizing the yuan.

To get the strongest hint of where China is hoping to promote yuan use — beyond Hong Kong, Taiwan, Singapore and London — look at countries with which China has signed currency swap agreements. Since yuan cross-border trade settlement took off in 2009, China has signed currency swaps with more than 20 countries.

Geographic proximity, trade interdependency and synergy are important considerations. Currency swap agreements have been signed with a batch of Asian countries that are located close to China and exhibit high trade interdependency with China.

Political friendliness is a necessary but not sufficient condition for the promotion of yuan. For instance, China and Pakistan have a close strategic relationship, but at present only modest economic benefits could be reaped from promoting yuan use there. On the other hand, strained political relationships probably stymied the promotion of the yuan in the Philippines, even though its trade interdependency with China is ranked in the top 10.

Energy diplomacy is also a factor.

China has signed currency swaps with countries like Mongolia, Kazakhstan, Uzbekistan, Ukraine, Belarus, Turkey, Argentina, Brazil, the United Arab Emirates, and Iceland, even though their level of trade interdependency with China is not considered high.

Many of these countries are strategically important to China from an energy security standpoint. For instance, Kazakhstan provided about 4 percent of China’s imported crude oil in 2011, and Iceland sits on strategic Arctic waters.

Many of these swap lines are unlikely to be mobilized at all. In a deal with Argentina, for example, an Argentine Central Bank official openly said the main objective of the accord was to restore confidence in the peso. The deal with Iceland can also be seen as a vote of confidence because the agreement was signed when Iceland was mired in a deep recession after the global financial crisis. This is a form of yuan diplomacy where the currency is merely a tool in a broader strategy of securing political or economic interests.

Beyond Asia, there have been difficulties promoting yuan in resource-rich countries.

China’s diplomatic efforts hitherto have been focused on securing immediate business opportunities or for the purposes of energy security. The classic example is China’s granting loans to developing countries in exchange for opportunities to participate in large infrastructure projects. On the energy security front, China is actively engaging resource-rich countries. Energy security is imperative for a country with 1.3 billion people. However, this form of diplomacy does not necessarily help to promote the yuan.

Take Saudi Arabia as an example. From an energy security perspective, it does China no harm to be on good terms with a major oil producer that is one of the top 10 in terms of trade interdependency with China. China imports oil from Saudi Arabia, but that oil is denominated in dollars. It is not easy for China to alter the embedded petrodollar system.

Then there is the problem of trade imbalances. China runs large bilateral trade deficits with many resource-rich countries. Even if China were to settle some purchases in yuan, the exporting country would end up holding too much idle yuan. Such a country cannot utilize much of its yuan holdings via trade channels. Unless there is a case for investing in China, there would be little incentive to accept yuan as a means of payment.

So what should China do to popularize the yuan?

1.  Establish and strengthen the role of regional anchors

Geographical proximity, trade interdependency and synergy are important considerations in promoting the yuan. As physical trade is the quickest way to promote the yuan, China needs to identify regional “magnets” or “nodes” where trade with neighboring countries is high.

China has chosen Singapore to be its regional node in the Association of Southeast Asian Nations. The Asean region is a good example of synergies from yuan promotion. Interrelationships between target customers help to create synergies.

For instance, if Singapore uses a large amount of yuan for trade settlements, neighboring countries like Malaysia would want to replicate that success by trading with China in yuan.

Synergies can be derived if regional trade can be conducted in yuan to minimize transaction costs. For instance, that could happen in the case of China exporting raw materials to Malaysia, and Malaysia in turn exporting semi-finished goods to Singapore.

2.  Keep the yuan attractive

At this stage, a key attraction of the yuan is its appreciation potential. The most straightforward way to propel yuan popularization is to maintain steady yuan appreciation. However, this is complicated by the fact that China is trying to increase exchange-rate flexibility. When economic growth is slowing, traditional market fundamentals dictate currency depreciation. The challenge for the government is to reconcile this contradiction.

We foresee a few developments stemming from this contradiction. First, because yuan popularization and exchange-rate flexibility are important, the exchange rate is unlikely to move in either direction by too much. Should economic growth slow further, we are likely to see transitory bouts of slight yuan depreciation, but the government will not allow trend depreciation lest it cripple efforts to popularize the currency.

Secondly, because people are no longer so sure about sustained yuan appreciation, China can focus more on deepening the use of the yuan in existing markets. This can be done by gradually relaxing controls on the capital accounts.

3.  Infrastructure for a globalized currency

At some point, the yuan will find its true value and stop appreciating. Thus, the longer-term success of the globalization effort will then depend on China’s soft “infrastructure.”

Strong leadership is required to instill confidence in the international community about China’s economic transition. Despite lower GDP growth, the country needs to show that its economy can fare well over the long haul.

Encouragingly, the new leadership has moved ahead with interest rate liberalization and made clear its intentions to shun excessive credit-fueled investment.

Looking ahead, further improvements in financial infrastructure, such as the development of the corporate bond market, will offer foreign investors more options to use their yuan.

China also needs to improve its legal infrastructure. Laws and regulations must be transparent, consistent and understandable by foreigners.



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