Yuan internationalisation would rewrite global monetary order
The next step involves developing non-trade demand for the currency
The most important mechanism behind the expansion of offshore yuan-denominated assets has been the ability of mainland Chinese importers and exporters to settle their foreign transactions in the currency, with non-trade demand yet to be fully developed.
In other words, yuan internationalisation remains a function of foreign trade; offshore yuan financial transactions are only a derivative of it at this stage.
As the mainland’s non-trade capital flows are still largely blocked, a current account surplus will only shrink the offshore yuan pool because if all current account transactions were settled in the currency, a surplus means more yuan would flow back to the mainland than would flow out. So what should Beijing do?
The next step involves developing non-trade demand for yuan. This includes capturing the demand from the official sector as one of its reserve currencies and from the foreign private sector both as a form of foreign currency savings and as an investment currency in an international portfolio.
This demand for yuan is closely related to the availability of a deep and mature mainland capital market, with mainland financial products and hedging tools made available to foreign players. But such development remains slow due to the deep-rooted structural and institutional reforms needed to facilitate it. It could be argued that most of the offshore non-trade demand for yuan remains speculative. This can be seen in the behaviour of yuan deposits in Hong Kong.
The share of yuan deposits in the Hong Kong banking system is still only around 12 per cent. Evidence shows that the sharp rise between 2009 and 2011 came mainly at the expense of a fall in the share of other foreign currency deposits, as investors speculated on yuan appreciation. There was no long-term demand for yuan by switching out of the Hong Kong dollar.
When the market started to bet on yuan depreciation in the second half of 2011 and again late last year and early this year, yuan deposits in Hong Kong also started to drop. Granted, as Beijing gradually liberalises capital inflows, more avenues for offshore yuan to flow back to the mainland have also prompted the decline. But speculation on yuan depreciation was the major reason for investors abandoning it between 2011 and 2012 and in late 2014-early 2015.
Such erratic and speculative behaviour in yuan-deposit growth is not sustainable for internationalising the currency. To deepen internationalisation, Beijing must create an incentive for foreigners to use and hold yuan other than for trading good and services.
Foreign firms and individuals in many economies can already buy yuan with their home currencies, and various financial institutions can already offer yuan-denominated fund management and foreign exchange services. But having a clearing bank locally makes a difference in terms of yuan liquidity and funding cost.
The clearing banks in the offshore yuan centres can access their yuan funds on the mainland (within the quotas granted by People’s Bank of China) to cater for demand from their foreign customers in these offshore centres. These quotas represent additional liquidity that the clearing banks bring to their respective offshore markets. Other non-clearing banks are limited to bidding for the existing supply of offshore yuan, and are thus more likely to suffer from liquidity constraints and higher yuan funding costs than clearing banks.
This situation should change over time when Beijing starts to allow free capital flows. This would attract more customers to use the currency, thereby adding liquidity and reducing transaction costs. When that time comes, the yuan (along with the euro, pound and yen) will play bigger international roles, reducing (and eventually displacing) the US dollar’s unreasonable privilege.
Meanwhile, the clearing banks serve as an extension of the central bank’s control of yuan liquidity overseas. In essence, they are a gateway for yuan flows before full capital account convertibility. Hence, Beijing’s move to designate yuan clearing banks in the offshore centres is, in effect, a step towards fostering a new international monetary order with several global currencies; a step towards creating a better match between a multipolar global economy and its financial system. The role of the clearing banks will disappear when Beijing eventually allows full capital account convertibility. However, deep and liquid markets are not built in a day.
The yuan will eventually erode the US dollar’s global dominance, but not just yet. Beijing is not waiting though. It has been deepening its yuan internationalisation effort, albeit slowly, by sanctioning a “full” onshore derivatives market for yuan, granting full access to the onshore interbank bond market by foreign central banks, opening up the onshore repo market to designated offshore yuan clearing banks and making the yuan daily fixing mechanism more market-driven. The list of liberalisation measures will grow as the effort to internationalise the yuan continues.
Chi Lo is senior economist at BNP Paribas Investment Partners