There is no doubt that China is determined to fully internationalise its currency. The only question is the speed at which this will occur.
Professor Eswar Prasad, of Cornell University, discussed the subject in a recent talk at the Foreign Correspondents' Club in Hong Kong. The snappily entitled 'Will the renminbi rule the world?' certainly made people sit up and pay attention, but Prasad, like a lot of the world's investors, is sensibly hedging his bets.
Prasad co-wrote a study for the US policy think tank Brookings Institution in February, assessing the currency's role in the global monetary system. Prasad thinks the yuan will become a reserve currency in the next decade, but that it won't displace the US dollar.
While many investors await every titbit of news that heralds further liberalisation of the yuan, some think it's a case of Beijing expecting to have its cake and eat it. Prasad refers to this as 'capital account liberalisation with Chinese characteristics'. In other words, Beijing wants to open its financial markets but retain some control over capital flows.
One vital concern Beijing is testing is the settlement of cross-border trade transactions in yuan, in which Hong Kong plays a key role. Although cross-border trade settlement is not confined to Hong Kong, Prasad's study reveals that the city's banks handled 73 per cent of China's trade settlement in 2010, which rose to 86 per cent in the first quarter of last year.
The chart displayed shows the rapid acceleration of cross-border trade in yuan from the first quarter of 2010 to US$93 billion by the end of the third quarter of last year.
Although the breakdown for settlement of exports and imports is not available beyond the first quarter of last year, it is clear that there is far more settlement of the latter than the former.
Settlement of imports in yuan gives foreign firms the ability to acquire the currency, which Prasad says is due to foreign traders' desire 'to go long' on it in anticipation of its appreciation. Trade settlement is one way of doing this. Prasad calls it an 'indication of how China's rising trade and financial integration with global markets will make it difficult to tightly manage the currency's external value'.
What the chart doesn't show, however, is that trade settlement in yuan has slowed. Although it remained steady at US$89.6 billion in the first quarter of this year, the Hong Kong Monetary Authority said on May 31 that the use of yuan for trade settlement was down 25 per cent in April from its peak last December. Deposits in the currency fell for a fifth consecutive month to 552 billion yuan (HK$672.5 billion) in April, down 12 per cent from November's 627.3 billion yuan.
The yuan is no longer seen as an appreciation play. China is facing an economic slowdown of its own, while the US dollar - in contrast to dire rumours of its demise just a year ago - is increasingly seen as a safe haven. Meanwhile the euro zone continues to be troubled by political and financial uncertainty.
Nonetheless, the use of trade settlement in yuan will continue, its speed determined by domestic factors such as the development of its financial markets, and the strengthening of its banking system. Prasad goes as far as to say that Beijing's ability to do so will not only affect the yuan's role in the global monetary system, but also determine the balance and sustainability of the country's economic development.
Topics: Currency Foreign Exchange Market Currencies of China Business