The Chinese yuan, also known as the renminbi, is already convertible under the current account - the broadest measure of trade in goods and services. However, the capital account, which covers portfolio investment and borrowing, is still closely managed by Beijing because of worries about abrupt capital flows.
Direct conversion between yuan and euro is on the way
G. Bin Zhao expects steady progress, given lack of geopolitical friction between Europe and China
Direct conversion between the renminbi and the yen, which began about two years ago, has been an important milestone in the process of internationalising the Chinese currency.
Although there has been a lot of progress towards the free conversion of the renminbi over the past two years, the outcome has yet to meet market expectations. Direct exchange with major Western currencies is a necessary component of this process and there is no doubt that the euro will be another important option.
China has recently overtaken the US to rank first in global trade and many countries maintaining large trading relationships with China want direct currency exchange with the renminbi, to reduce foreign exchange costs and boost bilateral trade.
Yves Mersch, a member of the executive board of the European Central Bank, said recently that the direct conversion of the euro with the renminbi would be conducive to growth in both economies. Although neither side mentioned the possibility of direct convertibility when President Xi Jinping visited Europe in March, expanding financial cooperation was undoubtedly a key reason for his visit.
As evidence, the Chinese government granted France a quota of 80 billion yuan (HK$100 billion) for its renminbi Qualified Foreign Institutional Investor programme, and the central banks of China and Germany signed a memorandum of understanding on establishing a renminbi clearing and settlement mechanism in Frankfurt.
In fact, once this business begins in Frankfurt, it could mean direct exchange between the euro and the renminbi would start in Germany. However, this would not necessarily signal the official start of direct convertibility in the entire euro zone.
Direct conversion between the renminbi and the euro is likely to be launched after consultations between the Chinese government and each sovereign European state, rather than being decided by the European Central Bank and the People's Bank of China.
China and the EU are major trading partners, with Germany being the largest euro trading partner. Thus, it is entirely reasonable to expect direct exchange to begin in Germany, to be gradually expanded to other countries.
Among these other countries, Britain has historically managed to reap significant profits as a US dollar offshore centre, so it is expected that direct conversion of sterling and the renminbi may happen soon. Within the EU, Britain has made the strongest effort for offshore renminbi business. These efforts have yielded fruitful results, as demonstrated by the 200 billion yuan currency swap agreement signed in mid-June last year.
Direct conversion of the renminbi and the euro would benefit both sides. In addition to the trade benefits, it would more importantly accelerate the free conversion process for the renminbi while enhancing the international status of the euro.
In the long term, it would help create an international financial and monetary system consisting of three pillars - the US dollar, the euro and the renminbi - thereby contributing to the formation of a multipolar world order.
Two years ago, China and Japan worked together to pioneer direct exchange of the renminbi and the yen, leading to deeper economic and financial integration, which reflected the far-sighted strategic vision of the two leaderships.
Unfortunately, due to disputes over the sovereignty of islands in the East China Sea, historical troubles, or perhaps because of a wedge driven in by external forces, the two sides have become isolated from each other politically.
There are no potential geopolitical conflicts between the EU and China, so the direct exchange of currencies can be expected to enhance deeper all-round economic and financial cooperation, including prompting Chinese enterprises to increase investment in the EU, facilitating the purchase of more euro-zone government bonds by China, and even enabling China to hold more euros in its huge foreign exchange reserves.
Finally, China still does not have a fully developed goal or schedule for implementing free convertibility and internationalisation of the renminbi. The Communist Party's third plenum guide for reform talked only of accelerating market-oriented financial reform and gradually implementing capital account convertibility. Therefore, it is difficult to judge the worldwide role the renminbi will play in future.
Some people are concerned that the renminbi will challenge the global dominance of the US dollar in future. That won't happen before direct exchange with the euro is comprehensively established. As a result, the free convertibility of the Chinese currency is at best only halfway there, and remains a lengthy process. It's too early to jump to conclusions.
G. Bin Zhao is executive editor at China's Economy & Policy, and co-founder of Gateway International Group, a global China consulting firm