China Takes Tentative Steps Towards Global Currency

By: Trader_Mark

The move of the yuan as a global currency is a very important one in the long run, as it will have potentially dramatic effects on the U.S. dollar as the sole reserve currency but for now things are going along at a snail pace.  In the interim, the Chinese currency is essentially pegged to the U.S. dollar (for better or worse).   Until the % of growth in China from exports is reduced, and they are far more reliant on internal consumption I don't see this loose peg changing anytime soon. Longer term, with 3 ugly ducklings (euro, dollar, yen) dominating the world's FX markets, the cart will eventually be turned over when a country (or region) coming from a position of fiscal strength rather than weakness enters the fray.  Via NYT:

• Now that it has passed Japan to become the world’s second-largest economy after the United States, China is considering the next step as a world power: making its money a global currency.  No one expects that to happen immediately. And even the Chinese government is wary of making some of the free-market moves that would enable the renminbi to take its place alongside the dollar, euro and Japanese yen as a fully convertible reserve currency.
• Still, over the last year Beijing has begun to gradually loosen its tight currency controls. For the first time, for example, American companies like McDonald's and Caterpillar have been allowed to finance their China projects by selling renminbi-denominated bonds in Hong Kong.
• Meanwhile, in Russia, Vietnam and Thailand, some cross-border trades with China can now be settled in renminbi, so that trading partners do not have to convert in and out of dollars. One pilot program lets Russian companies like Sportmaster, a retail chain based in Moscow, buy or sell goods using Chinese currency.
• And in New York, the Chinese government has permitted an overseas branch of Bank of China to accept deposits in renminbi. That enables depositors outside China to bet on a currency that is widely expected to appreciate against the dollar over the next few years.
• “This is all encouraging the internationalization of the renminbi,” Kelvin Lau, an economist at Standard Chartered Bank who is based in Hong Kong, said of Beijing’s recent moves. “They want to make the Chinese currency a popular currency.”
• At Thursday’s exchange rates, renminbi were trading just below 6.59 to the United States dollar — a level that many experts say values the Chinese currency artificially low, as a result of Beijing’s intervention efforts. Five years ago, the renminbi was trading at slightly more than 8 to the dollar.
• Beyond mere bragging rights, China has economic motives for trying to go global with the renminbi. Analysts say the moves, if successful, could strengthen China’s influence in overseas financial markets and begin to erode the dollar’s dominance. Beijing could also eventually reap the rewards, like cheaper debt financing, that come with being recognized as a world reserve currency. 
• Global importers and exporters could reduce their currency-fluctuation risks by settling China-related trade deals in renminbi rather than dollars or euros. 
•  Robert A. Mundell, a Nobel laureate economist whose research is credited with helping develop the euro, says the renminbi’s rise is all but inevitable. “The RMB is likely to become a reserve currency in the future, even if the government of China does nothing about it,” Professor Mundell said in an e-mail response to questions. He noted that the renminbi was already a regional currency in Southeast Asia, where China had become the dominant trading partner of many countries.
• If China does eventually open its capital market by eliminating currency exchange controls, he said, “the progress of the RMB as an international currency will be assured.”
• But analysts caution that right now the renminbi is far from ready to mount a serious challenge to the United States dollar as the world’s leading reserve currency. For one thing, China needs to assure investors that its political system is stable and that its economy still has plenty of growth ahead. For all its rapid growth over the last 30 years, China remains relatively poor compared with the United States, the Europe Union or Japan.
• As an influence on global financial markets, the renminbi is “still a distant, distant, distant fourth,” said Albert Keidel, a China specialist at the Public Policy Institute at Georgetown University in Washington. “People are going to start holding more renminbi, but it will be at least a decade or two for it to become a leading world reserve currency.”
• China is the world’s largest exporter and one of the biggest destinations for foreign direct investment, but the Chinese government still maintains strict control over its currency and banking system and the flow of money in and out of the country. 
• Economists say these restrictions allow Beijing to manage — some say manipulate — the renminbi exchange rate, keeping the currency undervalued enough to bolster exports. The policies also restrict the amount of capital that can enter the country — or exit in the event of a sudden downturn. 
• China has been reluctant to make its currency fully convertible because its banks and financial system are still immature. What is more, allowing money to flow in and out of the country with few restrictions would effectively mean surrendering control over vital aspects of the state-run banking system.
• But analysts say Beijing may eventually be forced to change its approach because its self-imposed financial restrictions leave the door to international markets only half open for China, undermining its global ambitions.  China’s tight management of exchange rates also leads to complex market distortions that analysts say force Beijing to accumulate huge foreign exchange reserves — much of them in the form of American Treasury bonds.
• As long as China continues tightly linking the renminbi to the dollar, analysts say, the People’s Bank of China is effectively outsourcing the nation’s monetary policy to the United States Federal Reserve. And as the value of the dollar has dropped in recent years, Beijing has begun complaining that the United States’ soaring budget deficits are eroding the value of China’s huge dollar-denominated holdings.

By Trader Mark

http://www.fundmymutualfund.com

Mark is a self taught private investor who operates the website Fund My Mutual Fund (http://www.fundmymutualfund.com); a daily mix of market, economic, and stock specific commentary.

See our story as told in Barron's Magazine [A New Kind of Fund Manager] (July 28, 2008)

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