Why the yuan is on the rise in Seoul
With the fourth-largest offshore yuan pool, Seoul will help expand the currency's rolein trade and financial transactions in region
China's move to develop financial infrastructure for trading the yuan in South Korea is a key step in facilitating the currency's internationalisation - and one that could have an even bigger impact than a previous plan to set the ball rolling in Japan.
Assigning Bank of Communications as an offshore yuan clearing bank in Seoul will greatly expand the role of the currency in bilateral trade and financial transactions in northeast Asia, not just in the hedging of foreign-exchange risks between two trading partners, but also by establishing Korea as an investment destination for Chinese cash as Beijing gradually opens its capital account.
Korea has amassed the fourth-largest yuan pool in the offshore market after Hong Kong, Taiwan and Singapore, thanks to the trade surplus it has with mainland China. Re-denominating more of China's trade deficit with Korea in yuan will further increase its yuan pool.
Already the yuan's use for international payments in Korea has soared. In June, 69 per cent of all direct payments between China and Korea were made in yuan, up from 33 per cent a year ago, according to payments platform Swift.
To get an idea of the potential ahead, think back to December 2011. That was when China and Japan entered into an agreement to promote the yuan's use for trade and financial transactions. Under the agreement, Japan would use the yuan as an investment currency for its foreign direct investment into China; develop a yuan-yen foreign-exchange market to facilitate yuan trade settlement in Japan; and encourage Japanese entities to issue yuan bonds in Tokyo. Japan would also invest in China's sovereign debt as a reserve asset.
The planned Sino-Japanese deal could have boosted yuan internationalisation significantly because China runs a large trade deficit with Japan, averaging more than US$30 billion a year for the past five years. If more of this trade deficit were re-denominated in yuan, the resultant increase in the outflow of yuan to Japan would expand the currency's role in northeast Asia and erode the dominance of the US dollar.
The dispute over ownership of islands in the East China Sea derailed the plan. Enter Korea, with which China runs an even larger trade deficit than with Japan.
If the Sino-Korean trade deficit, which stood at U$91.9 billion last year, were to be re-denominated in yuan, the potential currency outflow to Korea would exceed that under the proposed Sino-Japanese collaboration.
Among all the offshore yuan centres, mainland China's trade deficit with Korea is the second-largest after that with Taiwan. This would give Seoul the advantage of using a large yuan pool to expand its yuan-denominated financial transactions to the point where Seoul would rival all other offshore centres outside Hong Kong.
Hong Kong enjoys clear advantages in growing its yuan pool as it has the largest amount of exports to the mainland settled in yuan and enjoys preferential policy treatment from Beijing.
Korea's opportunity would be to use its yuan pool to facilitate the use of the currency in bilateral trade while also encouraging the development of a range of yuan-based financial transactions.
Its challenge is to expand and deepen the country's capital market to accommodate such new financial business while potential rivals eye the opportunity with envy.
Europe's offshore centres, for example, are very keen on developing yuan financial transactions. And while they as yet have only small yuan currency pools, if Seoul fails to fully exploit its natural trade advantage, any other offshore centre that can offer better investment opportunities and returns could stand to benefit instead.
