The first step towards a global currency

Published on China International Business, by Isabel Ding, June 10, 2009.

On April 9, China’s State Council announced a pilot program, allowing importers and exporters in five major cities,  Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan,  to settle their cross-border trade in RMB. This move — besides giving Chinese companies more control over currency risk during the current financial crisis — is the first expansion of the Chinese currency’s use in international trade in over ten years.

The basic rationale for the program is that, with the RMB trending upwards, Chinese companies can lose a considerable amount of money from the time a USD denominated deal is signed, and the time the account is paid. If the currency is going to continue  to appreciate, allowing Chinese companies to settle in RMB protects them from fluctuations in the currency relative to the USD.  

But the bigger concern is the long-term implication of the deal. “The trial cross-border trade settlement in RMB can actually be seen as the first formal step towards the internationalization of the RMB,” said Ma Fangfang, an economics professor at the Capital Economics and Trade University, Beijing.

WHY NOW?:

This isn’t the currency’s first foray into internationalization. In the late 90s there were already a few attempts to turn the RMB into an international currency. Back then, China opened the RMB for use in trade settlement with eight neighboring countries: Vietnam, Mongolia, Laos, Nepal, Russia, Kirghizstan, North Korea and Kazakhstan. Last year the volume of this trade reached RMB 23 billion …

… RISKY BUSINESS:

According to Ma, the RMB-based settlement pilot program will be carried out slowly. “We need to see the experimental results first, then it can be implemented in a large range,” she says. “China’s financial market is comparably under-developed and we lack a strong regulatory system, so the RMB’s internationalization is dependant on our financial system’s adjustments.” During the Asian Financial Crisis, several countries faced significant problems because their economy couldn’t handle the free inflow and outflow of currency. Since then, China has been cautious not to repeat their mistakes.

Hua Min, director of the World Economy Research Institute of Fudan University, Shanghai, argues that the RMB’s internationalization will be a road littered with risks. He states three reasons: first, China hasn’t opened its capital accounts and won’t banish its foreign exchange controls any time soon, leading to comparatively high costs of exchange. Also, unlike the Euro and the Yen, even if China stops explicitly linking its currency to the dollar, the currency is implicitly linked through the country’s large foreign reserves, leaving it open to a run if something suddenly happens in the market.

Second, China has yet to find an alternative to export-oriented growth, and because major countries that import from China are unlikely to be willing to use RMB for trade settlement, this means a continued build-up of reserves, and continued currency instability.

Lastly, China’s economy is more volatile than those countries whose economies are held-up mainly by domestic demand. “Until the economic structure in China changes, the RMB’s international position is unlikely to progress very far,” says Hua. (full text).

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