Thursday, Apr 17, 2014, 4:09 AM CST – China

Economy

Offshore Yuan

No Way Back

The offshore yuan market has become the fast-track for making the Chinese currency truly global. However, the further it travels, the more the yuan's success depends on overdue reform at home

From the 1780s up until the eve of the Battle of Britain, long before it became London's new financial center, Canary Wharf was home to the UK's oldest Chinatown. The capital's current Chinatown is just five stops away by tube from the old financial center, the City of London. Even in the cosmopolitan heart of this metropolis, Chinese immigrant families continue to run restaurants, grocers and laundries. However, a slicker, more modern China presence is building up in those renovated Gilded Age buildings in the City, as well as in the gleaming skyscrapers of Canary Wharf, London's modern financial center.

Managers with HSBC Holdings, Standard Chartered, Barclays, Deutsche Bank, ANZ and Bank of China operate their yuan-denominated services in those antique boroughs, conducting trade settlements, fund-raising and corporate treasury management on behalf of clients ranging from European telecom giant Telco and automaker Jaguar Land Rover, to Bank of Brazil and leading European manufacturers of textiles, medical equipment, mining supplies and luxury consumer goods.

"We have already seen evidence in 2013 of a significant increase in renminbi [yuan] trade in London," noted Chancellor of the Exchequer George Osborne in a February 22 press release.

Osborne was applauding an announcement by the Bank of England (BOE) about the proposed establishment of a currency swap line with the People's Bank of China (PBoC). Should such a system go online, these two central banks, representing the world's most diverse financial center and the world's fastest-growing economy respectively, will act as the lender of last resort in case of crisis in the London yuan market.

Hong Kong currently holds 80 percent of the world's offshore yuan assets and continues to be favored by the Chinese government for obvious political and practical reasons.  China's central bank has already established similar swap deals with a number of other countries, meaning that despite the fanfare from Downing Street, the London deal is neither significant nor new.

However, the London deal, if signed, will be the first such arrangement between China and a G-7 country. In addition, London was the birthplace of the Eurodollar (the offshore dollar market) and remains the largest foreign exchange market for both dollars and euros, far exceeding those in the US and the Eurozone. As London strides towards the status of "Western hub" for the offshore yuan, meaning the sun will never set on the British currency empire, it also looks set to become the heart of a truly global currency trade network for the yuan.

As George Norris, First Secretary of Financial Policy with the British Embassy in Beijing, explained to NewsChina, the pending agreement is about "providing stability and confidence for the global offshore yuan market in which London is the largest outside the Greater China."

London has its competitors. Confidence and enthusiasm for offshore yuan markets also abounds in Singapore, Taipei, New York, Paris and Frankfurt. This list will grow longer as China's pink 100- yuan banknotes become an ever more familiar sight overseas.

All of this is good news for China's strategy for developing the internationalization of its currency on offshore markets. The Eurodollar market in the 1950s and 60s is often cited as a tried and tested model, giving China's economic planners confidence that this previously heavily restricted currency could potentially be floated internationally with minimal risk to the country's financial strength.

However, the Eurodollar market was built on a very different foundation, and served as a catalyst for policy changes within the US market in the 1970s and 80s, triggering the globalization of financial markets under Ronald Reagan. This example shows that the health of a currency's domestic market will ultimately make or break its international prowess.

A Dance of Dragons

Basically following this well-trodden path for building an international currency, starting by encouraging yuan-denominated regional trade settlements in 2009, relaxing controls on inward and outward yuan-denominated direct investment and portfolio investment, then finally moving towards establishing reserve currency caches in a handful of mostly relatively undeveloped foreign countries, China is moving forward as expected on the internationalization of the yuan.

International bankers and industries have responded very positively. There have been persistent runs on so-called "dim sum bonds," yuan-denominated bonds issued on markets outside the Chinese mainland. More than US$200 million in yuan deposits flooded into banks in Taipei, Taiwan on February 6, the first day of yuan-denominated trading. Deutsche Bank estimates this amount could reach billions by the end of the year. On February 25, US dollar-yuan futures began trading on the Chicago Mercantile Exchange, with similar fanfare.

Today, more than 10 percent of China's foreign trade is settled in yuan. According to financial data manager SWIFT, in January 2013, the yuan leapt forward to become the world's 13th largest payment currency (it was 35th in October 2010). In another report it stated that "more than 1,050 financial institutions in over 90 countries are already doing business in the Chinese currency." A survey released by The Banker magazine in July 2012 claimed that the world's banking sector "has already envisioned a world where [the yuan] is a fully convertible reserve currency of comparable status to the US dollar," adding that European sectors outside the banking sector or lacking business relationships with China are "aware of the future significance of the Chinese currency."

Research by the City of London has found that a number of companies have embraced the yuan to simplify their foreign exchange risk management by eliminating the US dollar exchanges.Well-established and emerging financial centers worldwide provide yuan-backed businesses with space to consolidate or build up their positions on the global financial markets.

George Norris with the British Embassy told our reporter that more yuan-based transactions in the UK would help the country create a friendly environment for Chinese investors and anyone who wants to do business with China, thus further cementing London's role as one of the world's leading centers of commerce. In a world where jitters in the US or Eurozone can threaten global financial stability, having an alternative international reserve currency seems increasingly attractive.

"It is logical to ask whether the yuan could provide an alternative," said Barry Eichengreen, professor of Economics and Political Science at the University of California, Berkeley in the January/February 2012 issue of Foreign Affairs.

For China, the gradual internationalization of its currency was originally designed to help Chinese importers and exporters hedge against foreign exchange risks and facilitate trade with other Asian economies in the context of the global financial crisis. In 2012, particularly, the offshore yuan, along with more foreign capital, was allowed to invest in China's capital market mainly to help rescue a floundering yuan-denominated A-share market. The relaxation of yuan-denominated outbound direct investment regulations facilitated the overseas expansion of Chinese companies and banks. An international yuan would also give the world's second largest economy a bigger stake in the global economy, and thus further legitimize China's voice in international trade.

As the offshore yuan pool bloats, those in charge of it are speculating as to how best to make use of the Chinese currency. With interest rates very low worldwide, few are keen to put their yuan-denominated savings in the bank. Re-investment in the Chinese mainland is subject to strict quotas. As a result, many investors are believed to be hoarding yuan in anticipation of further appreciation, causing yuan deposits in Hong Kong to tail off from time to time since the end of 2011 when the yuan depreciation loomed. The somewhat cynical stockpiling of yuan is seen by some analysts as a threat to the currency's future stability.

Indeed, even international major currencies like the dollar and the pound sterling have been repeatedly attacked by speculators, triggering currency crises. This risk is much higher for the yuan, with the existing regulatory framework, according to Professor Sang Baichuan at the University of International Business and Economics, simply too rigid to cope with massive, often erratic, free capital inflow and outflow. China cannot afford a massive fluctuation in interest rates or inflation, a likely consequence of a sudden loosening of restrictions on the Chinese currency. Similarly, its banking sector, designed to serve the State rather than the market, could easily collapse if prematurely turned entirely over to market forces.

Old Roads, New Obstacles

Unlike the Chinese yuan, the Eurodollar never had to face a shortage of investment opportunities. While some circumstances in China today are comparable to European and American markets in the postwar period, specifically tight controls on cross-border capital flow and domestic interest rates prevailed both in Europe and the US at least till 1970s, the dollar was widely used to price and settle the trans-Atlantic trade and investment. Much more importantly, the dollar dominance was institutionalized by the Bretton Woods charter, the cornerstone of the postwar financial system which compelled other Western economies to peg their currencies to the dollar which was fixed at US$35 per ounce of gold. As a result, the dollar had already become the dominant world currency at the time when the Eurodollar market was launched by London's bankers. Neither of these favorable circumstances exists for the yuan.

Indeed, history seems to indicate that a major international currency cannot be made through offshore operations alone. The postwar US market, supported by a booming manufacturing economy and robust middle class was a melting pot of entrepreneurship funded by a strong capital market, while Europe was still rebuilding its economies. US dominance failed to collapse even when the Bretton Woods system was abandoned in 1971.

Even if China's leaders lifted strict capital controls today, yuan-denominated assets in the country could never match up to the appeal of 1950s US investments. International business communities, dominated by those from the US, were very eager to find ways, legally or illegally, to acquire US dollar assets in everything from stocks and bonds to factories. Even today, China's bond market is fragmented and inflexible. The eurozone, despite constituting a larger single economy than that of the US, has constantly struggled with a fragmented bond market, widely blamed for the failure of the euro to displace the US dollar as the world's default currency.

China's bond market is similar to Japan's, according to Barry Eichengreen, typically nurtured to maturity by domestic investors, leading to lukewarm international transactions. The Japanese yen has never quite made the transition to a truly global currency. The recent SWIFT report concluded that "full convertibility does not make a currency international."

The stock market, another popular choice for international capital market investors, is also the most active part of China's capital market, however, it is also highly volatile. Investing in the already overheated Chinese property market is slowly being seen as too risky for even the most hotheaded investor. In China's real industry, the main engine which propelled the US to global dominance and China's economic rise, the sheer number of restrictions on private investment, either foreign or domestic, prevents this vital market from coming close to realizing its potential.

Ma Jun, chief economist with Deutsche Bank Greater China, has repeatedly stated that if the yuan is only used in world trade, not for direct or portfolio investment, it will only realize a maximum ten percent of its international potential.

Uncertain Times

The solution to the manifold problems confronting the yuan, however, may also lie in the lessons of the Eurodollar. Rapid growth in the Eurodollar market made it impractical for the US to maintain effective capital controls. This mounting pressure finally forced the US to launch sweeping financial deregulation, setting off a trend which spread to the rest of the developed world and ultimately created the global financial market in which China now hopes to increase its dominance. This tortuous journey, in the view of Chinese analysts like Professor Sang, is very likely to be repeated by China. Reforms set in motion during China's campaign for WTO membership already set the country on this path.

Predictably, independent economists are calling for the immediate removal of restrictions on private investment in China's domestic financial market. So far, while even foreign banks have been granted limited access, there are more doors closed than open to private Chinese capital seeking to invest in China. A reform project aimed at allowing private investment in the credit market was launched in Wenzhou in 2012, but such baby steps have turned the investor optimism of a decade ago into deep disillusionment with the slow pace of reform.

Analysts also call for a similar wave of liberalization in the Chinese stock market, still crippled by a State apparatus which sees its opinion as more relevant than those of actual traders. The result of the blurring of government and marketplace is rampant insider trading and accounting fraud.

"A dynamic, fair market will in turn force regulators to improve their competence," said Professor Sang. "With both strong domestic markets and regulators it will be¡K much more likely for China to benefit, rather than suffer, from free capital flow."

Unfortunately, such demands have been made for decades and have gained unprecedented momentum in the past few years, but have largely fallen on deaf ears.

It seems that despite market consensus on the importance of economic growth, China is still held back by minority interests, those with exclusive privileges in market access. This reluctance to unleash the full extent of market forces in China is perhaps rooted in concerns that were China to truly open up to the globalized world, the country's powerful economic planners and the enterprises they favored might have to forfeit absolute control over their main trump card - a muzzled, if bullish, economy with their best interests at heart.

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