The Importance of China's Currency

According to the August editions of Global Finance magazine, China is taking some baby steps in making the renminbi an international reserve currency alongside the US dollar, euro and yen.  A bilateral trade treaty with Russia was enacted to trade using rubles and renminbi without using the US dollar.  It loosened the relationship of the renminbi to the US dollar.  A new trade settlement process created by the People's Bank of China allows government approved Chinese export companies to conduct transactions with their international trade counterparties in renminbi instead of the common reserve currencies - the US dollar, euro or yen.

The new scheme was implemented to protect China from inflation caused by China's natural demand for commodities, the weakness of the dollar and the Federal Reserve Bank's policy of quantitative easing.  The currency used for international transactions is the US dollar.  Right now, 8.7% of China's imports and exports are in the local currency (according to Standard Chartered Bank in Hong Kong).  In 2015, this is expected to grow to 15% to 20%.  This will cut the cost of hedging currencies for trading counterparties.  For a non-US firm, they only have to hedge one currency in a Brazilian real to renminbi exchange.  Right now, they have to hedge two currencies in a real to dollars to renminbi trade.  Hedges against the renminbi are more available in Hong Kong.  In August 2010, a market in deliverable forward contracts was added to the nondeliverable forward contracts in renminbi.  A deliverable contract allows a company to take full delivery of the renminbi in exchange for the notional amount.  A nondeliverable contract only allows a company to take delivery of difference between the notional amount and the underlying currency.

Multinational corporations such as McDonald's, Caterpillar, Unilever and Volkswagen have taken advantage of the new trade settlement scheme to issue bonds in renminbi from Hong Kong.  The cost of funding is much lower than on mainland China.  On a two year bond, the difference is 3.7%.  These bonds issued from Hong Kong are called dim sum bonds.  The lower interest rates are a result of large bank deposits of renminbi.  The People's Bank of China has rules on foreign capital flows.  Since Hong Kong has not been integrated in the Chinese banking system, it is considered a 'foreign nation' and needs approval to move capital into the mainland.  The difference in interest rates allows companies to cherry pick their bond offerings, allowing them to issue in the cheaper market.

The renminbi should appreciate based on this plus China's growth in exports.  Investors are flocking to fixed income funds such as Barclays Capital's Renminbi  Bond Fund in Singapore.  This fund is seeing interest from investors globally.

However, I do not see the renminbi becoming a reserve currency until it becomes a true floating currency or the restrictions on capital flows are lifted.

The source for this post can be accessed here.