China’s Yuan Strategy in the Post-Crisis Era

Written by Elsa Yan || January 18 2011

After over thirty years of opening up and economic reform, in 2010, China officially overtook Japan to become the world’s second largest economy, trailing only the United States. Undoubtedly, the global financial crisis that took hold in late 2008 has served as a turning point for China to rapidly transform itself into a global engine of growth.

However, in comparison to the leading role played by China in the international trade arena, its clout in global financial market is far from impressive, largely due to the inconvertibility of China’s currency, the yuan, also known as the RMB.

Meanwhile, despite a weaker demand from western consumers, China’s foreign trade still maintains a massive surplus against its major trading partners, which are still grappling with their fragile domestic economic recovery and stubbornly high unemployment rates. In 2009, China's trade surplus was $196.07 billion and is likely fall slightly to $190 billion in 2010, according to China’s Commerce Minister Chen Deming. This has prompted the US and European Union to increasingly criticize the yuan for being artificially undervalued, thus enhancing China’s own exporters’ competitiveness in the international market.

As the yuan has not yet gained status as an international reserve currency, its swelling foreign reserves, derived from the mammoth trade surplus, has made China the biggest creditor of U.S. treasury bonds. Nonetheless, the increasing depreciation of U.S. dollar, triggered by the huge public deficits of the American government has led to a growing concern from the Chinese government about the potential significant losses of its dollar-based currency assets.

Given all these dilemmas, it is of widespread view that China’s yuan should play an even bigger role in the post-crisis international financial and economic activities, which will be in the good interest of China and the world. As a result, since the middle of last year, the Chinese financial regulator has accelerated its efforts with regard to its currency regulation policy, chiefly on the following four respects:

RMB Appreciation

On June 19, 2010, China ended its two-year-long peg to the dollar and pledged to increase the flexibility of its currency’s exchange rate; since then, the yuan has risen 3.2% against the dollar. With a long-term sustainable growth prospect, the yuan is widely bet to continue to appreciate in the foreseeable future, although the Chinese authorities hope it will be achieved in a gradual manner. The pace of yuan appreciation, however, is expected to be accelerating in 2011, as part of Chinese government’s efforts to combat domestic high inflation problem and address trade imbalances with its major trading partners.

Expansion of Trade Settlement in Yuan

Traditionally, Chinese companies receive payment for their goods in U.S. dollars. They then must convert the dollars into yuan through official government channels. However, in recent years, Chinese authorities have begun to encourage their enterprises to settle their cross-border trade in yuan, in a drive to internationalize its currency. Such a program was launched in July 2009, with companies in five Chinese cities eligible to participate. By November 2010, it was rolled out by the People’s Bank of China to 67,359 companies in 16 regions from 365 companies. Meanwhile, China has also made currency-swap agreements with eight countries, with many now able to invoice and settle trades in yuan. The growing number of commercial trade transactions settled in Yuan will help China reduce its reliance on the dollar and increase the influence of yuan within the region and emerging markets.

Flourish of Offshore Yuan Trading

Determined to internationalize yuan, Chinese government is leveraging Hong Kong as a test ground for offshore yuan trading. Thanks to an experimental loosening of the restrictions, daily trading in the yuan outside mainland China, once nonexistent, has grown into a $400 million market centered largely in Hong Kong.

The explosive growth of offshore yuan trading has made banks and investment firms in Hong Kong rush to launch yuan-denominated products and set up back-end services, in a bid to cope with the robust demand from foreign and Hong Kong-based investors. Banks such as Citigroup Inc. and HSBC are offering investors yuan-priced options and interest-rate derivatives. Mutual funds dedicated to yuan-priced investments have also been launched.

However, one of the largest trends in the past few months is a wider issuance of yuan- denominated bonds. Multinationals such as McDonald’s Corp., Caterpillar Inc who are optimistic about China’s long-term growth prospects and yuan appreciation, have recently become the first U.S. non-financial corporations to sell debt priced in yuan, with the raised proceeds to fund their China’s operations. It is expected that offshore yuan trading will continue to grow strongly in the coming years, potentially leading to full convertibility of yuan over the long term.

Easing of Capital Controls

For decades, China has adopted strict capital control systems, with an aim to stabilize the domestic financial market and accumulate sufficient foreign reserves. That strategy has worked well in the past, largely leaving China intact from the global financial meltdown outburst two year ago. Nevertheless, it has also posed some challenges to the Chinese government.

According to the prevailing foreign currency regulation policy, Chinese export companies are required to bring back their dollar-based revenues to China and exchange them with the central bank for yuan. The influx of foreign currency has further exacerbated domestic inflation, which is already high and constantly on the mind of the Chinese regulators.

In a move that could over time dampen inflationary pressures and slow growth in the massive foreign-exchange reserves, as of January 1st, 2011, the State Foreign-Exchange Administration permitted Chinese qualified exporters to keep their foreign-currency earnings overseas instead of changing them into yuan. On the other hand, the swelling foreign reserves has given China's government an increasingly large global clout as an investor, yet, China still often struggles to find attractive investments for its reserves.

Last October, the regulator started a trial program that allowed 60 exporters in four cities and provinces to keep their hard currency abroad. The quick expansion of the program to exporters nationwide has largely reflected the government’s mounting concerns over hot money inflows and inflation - which have accelerated since last November. However, the implementation of the program could is a clear indication that China has taken a major step toward a full opening of its capital account.