Foreign Exchange Market

Mainland faces currency battle

PUBLISHED : Monday, 07 May, 2012, 12:00am
UPDATED : Monday, 07 May, 2012, 12:00am


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Hong Kong investors have responded more than enthusiastically to the arrival of yuan-denominated products and, voting with their savings, have helped the city quickly assume pre-eminence as an offshore centre for the currency.

Now, though, with the central government and central bank making clear their aim of seeing the yuan one day attain reserve currency status, businesses and individuals are asking what that could mean in terms of relative values, potential returns and opportunities for strategic investment planning.

'Looking at it from China's perspective, there might be several advantages,' says Thomas Poon, HSBC's head of business planning and strategy in Hong Kong. 'But remember that such status is driven by market consensus. It is not a 'tick the box' approach with hard and fast rules. Essentially, if other governments and central banks are increasingly comfortable about investing a portion of their currencies in the yuan, then a critical mass is reached.'

At a policy level, Poon notes that China's ambitions in this respect are partly symbolic and partly a consequence of its position as one of the top dogs in the global economy.

Down the line, though, there could also be direct financial benefits. Wider acceptance of the yuan could lead to cheaper borrowing costs, with the currency seen as something of a safe haven. It would also help mainland companies save on hedging, reducing the incidental expenses of doing international trade.

However, any move towards reserve currency status depends first on Beijing meeting basic conditions. One is the complete opening up of capital account items. Another is to remove restrictions on capital flows to and from the mainland. A third is to clarify intentions on whether the yuan would be fully convertible - like the Hong Kong dollar - or freely convertible, making it subject to certain approvals.

'Also, the exchange rate regime and the domestic interest rate system in China should be market-driven,' Poon says. 'These things are not quite there yet. The recent widening of the yuan's trading band is a step in the right direction, but there is still long way to go.'

The overall size of China's currency is not an issue, given the country's huge volume of trade. However, the international markets want to see a greater breadth and depth of yuan-related financial instruments, and they need evidence of liquidity and ease of trading in these products.

'People can invest in the US dollar any time, anywhere, they like,' Poon says. 'China has to work hard to offer the range of instruments and investments both onshore and offshore. They also need to develop a strong and credible monetary authority so that people have confidence to invest in the currency. The People's Bank of China has to evolve some way to become that body.'

Suggesting a possibly conservative timeline of five to 10 years for all this to happen, Poon warns that reserve currency status would not automatically mean a higher valuation for the yuan. Markets would decide and exchange rates would fluctuate, just as they do for the US dollar, euro and Japanese yen.

'We can't link the strength of a currency to its status,' Poon says. 'Moves up and down are determined by market forces, so if supranational bodies such as the IMF and World Bank include the yuan in their reserve drawing rights, it is just one kind of signpost.'

Addressing the concerns expressed in some quarters - notably the United States Congress - about the rise of the yuan, Poon takes a pragmatic view.

'We will see growing use of the yuan in international trade, but that doesn't mean the demise of the US dollar. At the end of the day, this scepticism is probably misplaced. It needs time for China to develop the yuan in international markets and we should take it in the right way.'

Jan Poser, head of research and chief economist for Bank Sarasin, similarly sees no reason why the yuan can't take its place next to the dollar or euro. 'Clearly, further steps are required,' he says. 'The Chinese authorities are testing the water and, by widening the trading band, are effectively increasing independence from the dollar.'

Logically, Poser believes, the next move would be to allow free exchange of the yuan outside China and then further loosen controls on capital flows into the mainland. Doing so would boost the attraction of the yuan as investment currency and as a viable alternative. A possible restraint is the concern about 'hot money' rushing in - and out - creating large swings in the exchange rate.

'Convertibility requires a developed capital market within China, open for foreign investors,' Poser says.

'There need to be more investment vehicles such as government and corporate bonds and instruments to hedge default risks but, over time, I think the yuan will fundamentally strengthen against the dollar as productivity growth in China is higher.'