Uneasy jingle on currency

The internationalization of the renminbi requires a look at distant horizons as well as the local market

The announcement by the People's Bank of China to grant settlement-bank status to the Bank of China's Taipei branch signifies a new era of the renminbi's internationalization. Multiple offshore yuan centers will likely emerge to compete with Hong Kong's dominant status, allowing a faster pace of internationalization and a wider use of the currency in international trade and finance. The yuan business will also inject life into Taiwan's financial system and bring the two economies closer.

Indeed, the offshore yuan business has experienced a rapid growth over the past three years. Hong Kong's renminbi deposits have reached around 560 billion yuan ($89 billion, 68 billion euros) from less than 60 billion yuan in 2009. As of now, close to 50 percent of Hong Kong's trade and 10 percent of the Chinese mainland's are conducted in yuan, which has made the renminbi the third-largest trade invoicing currency globally, eclipsing the Japanese yen and narrowing the gap with the euro.

Meanwhile, the offshore yuan bond market in Hong Kong has also flourished, attracting not only Chinese firms but also transnational firms to tap into the market for funding.

Another two promising offshore renminbi centers will be Taiwan and Singapore. The Taiwan offshore center is expected to experience a rapid growth next year after the central bank's announcement, and more details of the Singapore offshore market are expected to be announced soon. Both centers have close trade ties with the Chinese mainland, and their economies also run substantial trade surpluses with the mainland.

It is natural to expect the renminbi to quickly become widely circulated in Taiwan and Singapore. As these two offshore markets will have a similar operating mode to the Hong Kong market with their own settlement banks, they have the potential to challenge the dominance of the Hong Kong market. While a London offshore yuan market has also been established, the lack of a currency swap arrangement between the Bank of England and the People's Bank of China, along with its reliance on Hong Kong's renminbi liquidity and settlement facilities, will likely cap London's potential.

In addition to allowing more offshore renminbi markets to emerge, China has also started experiments in direct trading of its currency with key trading partners. For the first time, the Japanese yen and the Chinese yuan were able to be traded directly in both the Tokyo and Shanghai markets on June 1. Though the ensuing territorial disputes have cooled both sides' enthusiasm to encourage the markets' fast development, the direct conversion of the two currencies has set a precedent for other currencies to follow.

The next most promising currency could be the Australian dollar given Australia's strong economic and trade ties with China and the enthusiasm by the government and private sectors to see the yuan's wider use in bilateral trade and finance. If both economies can reduce the need to convert their currencies to the US dollar before they can trade with each other, importers and exporters from either country will be able to save on transaction costs from currency exchanges and hedging.

Such costs can then be passed on to consumers, thus driving a significant efficiency gain in both economies. Similarly, China's other key trading partners' currencies - such as those from key ASEAN nations - are also potential candidates for direct trading with the yuan in the near future.

Unlike other economies, China took its currency abroad while continuing to maintain capital controls. This approach has naturally limited the scope of its use, as well as the renminbi business abroad. Because of this constraint, China appears to have a deliberate sequencing strategy to drive the yuan's internationalization. The country would like to encourage the yuan to be used first as a trade invoicing currency, then as a trade financing currency, and as an investment and reserve currency after the eventual removal of capital controls. Despite its impressive overseas achievements, the key to the further success of the yuan's internationalization actually lies in its home market. The authorities must engage in fundamental financial sector reforms to facilitate the eventual adoption of the currency by foreigners.

At this stage, China's financial system is still under many controls and is subject to distortions. This has impeded efficient allocations of capital and lowered China's growth potential. Despite previous attempts to gradually remove interest rate controls, Chinese commercial banks still cannot set their own lending and deposit rates. Instead, these rates are set by the central bank. Interest rate controls have also prevented the central bank from relying on price-based policy instruments to conduct monetary policy.

Meanwhile, entry to China's financial system is highly regulated and controlled. It is still extremely difficult for privately owned banks to emerge in China's financial system, leading to limited competition and inefficient financial intermediation.

Indeed, China's plentiful savings have not been allocated to where the economy needs them most. For example, small and medium-sized enterprises still have great difficulty in getting funding from the state-dominated banking system, notwithstanding their huge contributions in generating employment and supporting China's economic growth. Such controls have also led to rampant shadow banking activities in the form of underground banking, off-balance sheet activities by commercial banks and unsecured trust company loans. Because such activities are not transparent and regulated, they pose even a bigger challenge to the overall stability of China's financial system.

Furthermore, China's state-owned banks have a penchant to lend to large and state-owned enterprises. But large SOEs and listed companies, because of their better quality of information disclosure, are supposed to rely on direct financing from the capital markets for funding, from the bond market in particular. This means their over-reliance on bank loans has stymied the development of China's bond market.

Without a large, deep and efficient bond market, China will also be quite reluctant to open its capital account for fears that large and sudden capital flows will lead to a sharp increase in the volatility of China's domestic interest rates and its currency exchange rate, which in turn may lead to increased financial risks and rising costs of foreign exchange hedging.

The lack of domestic financial liberalization has also given rise to increased financial risks owing to rapid offshore renminbi market developments. Allowing for a wider use of the yuan abroad has also forced capital accounts to open at a fast pace, creating arbitrage opportunities between onshore and offshore accounts. When China's monetary policy is tightened onshore, many firms could then go offshore for financing. This then reduces the effectiveness of monetary policy and leaves Chinese firms exposed to the risks of currency and maturity mismatches.

Thus, the key to the success of the yuan's further internationalization actually begins at home. The lack of comprehensive financial reforms has also led to heightened risks in China's financial system. The swift emergence of shadow banking activities is a case in point. Such activities, if left unchecked, could endanger China's financial stability, risking a repeat of the US subprime crisis.

Rapid capital account liberalization associated with renminbi internationalization will also lead to the ineffective monetary policy and the increased exposure of Chinese financial institutions and firms to currency risks. Therefore, sweeping financial sector reforms will be needed to head off such risks.

The author is chief China economist with Australia and New Zealand Banking Group. The views do not necessarily reflect those of China Daily.