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Internationalizing the Yuan

A Hong Kong bond issue is a small but important step

By Christopher A. McNally

(Note: This commentary originally appeared in The Walt Street Journal's Asia edition on Sept. 10, 2009)

Beijing's announcement earlier this week that it will sell yuan-denominated government bonds in Hong Kong has caught a lot of attention. The Ministry of Finance bills it as a measure to "promote the yuan in neighboring countries and improve the yuan's international status." The move comes in the context of Beijing's larger goal of transforming the yuan into a global currency. While on its own this is a relative baby step, it is more significant than at first appears.

The bond issue, set for September 28, will consist of six billion yuan ($879 million) in government debt sold to retail and institutional investors in Hong Kong. This is a drop in the bucket compared to Beijing's overall outstanding government debt of 6.3 trillion yuan and especially relative to a world-wide United States Treasury market of nearly $7.5 trillion. But it's a strong signal of Beijing's future plans to internationalize the yuan.

China has taken several steps down this road since late 2008. Beijing in early July established yuan settlement agreements between Hong Kong and the five big cities in China that form the bulk of Hong Kong's trading partners on the mainland. This trial program allows local firms in Hong Kong and China to settle their trade in yuan, insulating them to some extent from risks associated with currency fluctuations. The Chinese central bank also has established bilateral currency swap agreements with the central banks of South Korea, Hong Kong, Malaysia, Indonesia, Belarus and Argentina. China reportedly is in talks with other central banks to create additional swap agreements with the goal of being able to conduct most of China's trade with Asia, excluding Japan, in yuan. Longer-term plans even call for the expansion of currency swap agreements in the Middle East and Latin America.

China's motives are straightforward. In the second quarter of 2009 China had accumulated $2.13 trillion of foreign exchange reserves. While the exact breakdown of China's holdings is unclear, most analysts agree that 65%-70% is held in dollars. As the dollar has weakened, Beijing's fears over the value of China's massive dollar holdings have increased. These fears have become especially pronounced since the beginning of 2009 amid aggressive monetary and fiscal easing in the U.S.

For now China is stuck with the dollar since it is not in a position to sell large amounts of its dollar holdings in the open market without driving the value of its holdings down further. Although China has called for the establishment of an international currency based on the International Monetary Fund's special drawing rights, Chinese policy makers appear to have decided that the only long-term way out of China's dependency on the dollar is to gradually internationalize the yuan. These efforts should be seen as natural, since China is already the world's third-largest economy and trading power.

Internationalizing the yuan will probably take years, however, and must involve substantial moves to allow the yuan to be used as a viable reserve currency. The biggest obstacle is that capital account convertibility for the yuan is still a long way off. In this respect, the internationalization of the yuan poses certain dilemmas for the Chinese leadership. The Chinese economy in general still lacks a high degree of institutional and legal certainty and predictability. Chinese leaders prefer ambiguity that allows them to intervene with administrative commands when needed. The barrage of Chinese bank lending unleashed in the first half of 2009 in reaction to the financial crisis is an example of how this system has its handy features.

Capital account convertibility for the yuan would subject Beijing's policies to the judgments of individual investors at home and abroad capable of contributing to large capital flows, including highly temporary and speculative gushes. It would put China's economy much more at the mercy of global financial forces.

In view of this, it is unlikely that the Chinese leadership would move quickly toward full capital account convertibility. Rather, the Chinese will try to get the best of all worlds: to reduce China's reliance on the dollar for international payments, strengthen the yuan's role in trade and central bank reserve allocation, and yet keep in place legal and institutional barriers to short-term speculative capital flows.

This can best be accomplished in the short run by creating an offshore market for yuan financial instruments that foreign central banks and investors can trust. China's latest move to create an offshore market in Hong Kong for yuan-denominated Chinese government bonds does just that. While the first step is very small, it might mark the beginning of a scheme to provide opportunities for central banks and investors to store capital in a secure, tradable and liquid form of yuan deposits. In addition, Chinese government bonds issued overseas and perhaps bonds issued by Chinese state firms and banks with quasi-sovereign guarantees could provide the pricing benchmarks, liquidity and security that an internationalized market for yuan needs.

The yuan's role as one of the premier international currencies is still some way off, but Chinese policy makers are moving in the direction of establishing an international alternative to the dollar, yen and euro. They have to start somewhere, and that "somewhere" is with relatively small steps like this week's bond announcement.

Christopher A. McNally is a research fellow and political economist at the East-West Center in Honolulu. He can be reached at mcnallyc@EastWestCenter.org .

Reprinted from The Wall Street Journal Asia © 2009 Dow Jones & Company, Inc.  All rights reserved.