As the Americans pursue quantitative easing (QE) and the world worries about the US dollar's future, the internationalization of the yuan is set to take off.

If there is to be a rival to the dollar as the world's reserve currency in the 21st century, it surely must be the yuan. Already the world's second largest economy, China is likely to be the biggest by the 2030s. It is already the world's biggest exporter. To date, its currency has been severely under-represented in global trade and capital markets. Yet we may be on the verge of a financial revolution of truly epic proportions.

The Chinese talk about yuan internationalization. Their aim is doubtlessly helped by America's pursuit of QE, a policy which has been interpreted in many emerging nations as a direct attempt to export US economic problems to the rest of the world via a much weaker dollar. Whether or not this interpretation is correct, it surely will only encourage governments, reserve managers, companies and individuals to think about alternatives to the dollar. Given China's heightened gravitational pull in the world economy, the yuan is an increasingly credible rival. The world economy is, slowly but surely, moving from greenbacks to redbacks.

Demand for yuan as a trade settlement currency lies in emerging, not developed, economies. Emerging markets now account for nearly 55 percent of China's total trade, versus 47 percent 10 years ago. As the center of global economic gravity shifts further towards emerging market countries, this share is expected to rise rapidly. Yet most emerging trade is invoiced in neither yuan nor their own currencies. A switch from the dollar to the yuan for trade settlement is likely to be an appealing option for emerging nations eager to bolster their relations with fast-growing China.

As a strategic priority, Chinese policymakers have already (and will continue to) introduce accommodative taxation, trade finance and capital account measures to facilitate the yuan internationalization process. More importantly, cost savings on foreign exchange transactions and the appreciation of the yuan should increasingly encourage exporters and importers, both in and out of China, to switch to the yuan at the dollar's expense.

Sniffing the potential for business, banks - especially multi-national ones - have also been eager to get involved in yuan cross-border trade; their early participation effectively helped launch a global clearing system for the yuan within a matter of months. Supported at the highest political levels, this catalytic mix of drivers means that the acceleration and contours of the yuan internationalization will be faster and more varied than many expect.

If the current trend continues, we expect that at least half of China's trade flows with emerging market countries could be settled in yuan within three to five years, from less than 3 percent currently. In other words, nearly $2 trillion worth of trade flows could be settled in yuan annually, making it one of the top three global trading currencies.

The yuan trade settlement scheme is triggering a chain reaction in China's capital markets. Rising demand for the yuan overseas is smoothing the path for Chinese firms to invest abroad with the yuan. As yuan trade revenue accumulates outside China, so too will the path be smoothed for foreign companies wishing to invest in China with yuan.

More than five Chinese and foreign institutions have issued benchmark yuan-denominated bonds in Hong Kong over the past three months, ranging from McDonald's to China Development Bank and the Asian Development Bank. Recent steps towards easing of restrictions on offshore yuan use have also created the first ever offshore yuan interbank market and deliverable spot trading of the currency in Hong Kong.

At the same time, the pool of offshore yuan cash deposits has seen an impressive upsurge, most noticeably in Hong Kong where total yuan deposits in the banking system rose 240 percent to nearly 150 billion yuan in the first nine months of 2010.

Combined with the gradual opening of onshore yuan capital markets to selected foreign institutions, this offshore build-up will help widen and lengthen the runway for more yuan product launches in Hong Kong for years to come. Future products just around the corner include yuan-denominated IPOs, yuan-denominated QFIIs (qualified foreign institutional investors), and offshore yuan bonds issued by non-financial mainland companies.

These developments are firing up the rapid expansion of the yuan's role in both trade and investment flows, upping its attractiveness to reserve managers. A few central banks have already expressed an interest in holding yuan assets as part of their foreign exchange reserves.

That said, China is unlikely to free up the yuan to full convertibility until it has put its internal financial house in order.

The author is chief China economist at HSBC. The opinions expressed here are entirely his own.

(HK Edition 11/11/2010 page2)