When China announced a flagship program to make its currency more international in the summer of 2009, it cited the growing call from Chinese trading partners to use the yuan in cross-border transactions. More than a year later, the Peoples Bank of China touted the program as a breakthrough, citing a surge in the amount of trade in the currency.
Not everything went according to plan.
The move had important, unintended side effects, including giving companies and investors a way to profit from the difference in interest rates between China and other countries, and opening a path for ‘hot money’ to flood the country.
It also has boosted, rather than reduced, the amount of foreign-exchange reserves piling up in China’s coffers─the opposite of what Beijing intended when it opened the yuan for foreign trade.
This, in turn, could add to China’s already difficult battle to tame an inflation rate running at more than 6%, as the central bank needs to print more yuan to buy up the dollars flowing into the country.
China’s stumbles in trying to get its currency more widely accepted outside its borders underline a fundamental contradiction at the heart of Beijing’s plans: The Chinese authorities want to keep a tight grip on the value of the yuan to keep exports booming, while at the same time encouraging more foreign companies and investors to use it.
China is trying to blunt the rise of the yuan by keeping its appreciation sharply controlled, but the internationalization program puts upward pressure on the currency.
There is a ‘tension in the short run between managing yuan appreciation and increasing the yuan’s prominence in global trade and finance transactions,’ says Brookings Institution China scholar Eswar Prasad.
On Tuesday, the People’s Bank of China said foreign-exchange reserves jumped by $153 billion in the second quarter to $3.2 trillion.
Of that increase, $48 billion, or about a third, was attributable to China’s decision to allow the yuan to be used in foreign-trade transactions, estimates Zhu Chaoping, head of research at ChinaScope Financial, a market-research firm in Hong Kong.
In the prior two quarters, the trade program added a total of $83.5 billion to China’s reserves, Mr. Zhu calculates.
China had hoped that allowing the yuan to be used more freely abroad would boost demand for the currency, also known as the renminbi or RMB, and reduce the amount of dollars entering the country.
For the long term, China wants to turn the yuan into a global reserve currency that is used for investment, trade and loans, as the dollar and euro are.
The yuan is widely seen as undervalued, so only overseas sellers are interested in the trade.
Nearly 90% of cross-border trade settled in yuan in the first quarter─totaling 360.3 billion yuan, or 7% of China’s total trade─involved China’s imports, according to data provided by the People’s Bank of China, a sign foreign demand for yuan hasn’t picked up much.
The fact that importers are using yuan means that dollars build up at a more rapid clip in the Peoples Bank of China’s vaults because importers don’t need to tap them.
Chinese economist Yu Yongding, a former adviser to the People’s Bank of China, recently told a Chinese newspaper that ‘to date, renminbi trade settlement hasn’t helped Chinese companies reduce foreign-exchange risks, but has helped foreign companies cut risks.’
Some companies also have used the trade-settlement program to profit from the difference between higher yuan interest rates in mainland China and lower U.S. dollar rates in Hong Kong, according to bankers and analysts.
Such transactions could be used by speculators betting on the yuan’s rise and have the potential effect of adding to China’s dollar reserves.
Asia Pulp & Paper Co., an Indonesian paper maker, recently directed its Hong Kong subsidiary to borrow U.S. dollars at low rates, using its yuan deposits as collateral, says a person familiar with its operations.
APP then took the dollars and paid for goods produced by its mainland subsidiaries, effectively using low-rate U.S.-dollar loans instead of higher-rate yuan loans.
At the end of a complex series of transactions, APP was able to repay the dollar loans with yuan obtained from the internationalization program.
APP benefitted in two ways: It borrowed in dollars at low rates and paid off the loan with yuan that had appreciated in value since the beginning of its dealings.
APP declined to comment.
Harvard economist Jeffrey Frankel said China is unusual in pressing to give its currency a bigger international role. Japan and Germany, after World War II, and the U.S. after World War I resisted such efforts because they worried their currencies would strengthen and make their exporters less competitive.
For now, China’s central bank is struggling to keep up with companies looking to use the internationalization program as a channel for so-called hot money, which can contribute to dangerous bubbles in China’s real-estate market and stock exchanges, as investors look to park their money in sectors seen as paying a high return.
Major problems in RMB globalization: fishing from interest rate difference between the mainland and overseas, hot money influx and more foreign currency flowing into China, not less! People’s Bank of China said foreign-exchange reserves jumped by $153 billion in the second quarter to $3.2 trillion. Of that increase, $48 billion, or about a third, was attributable to China’s decision to allow the yuan to be used in foreign-trade transactions, as foreign demand for yuan hasn’t picked up much. APP benefitted in two ways: It borrowed in dollars at low rates and paid off the loan with yuan that had appreciated in value since the beginning of its dealings.