How China has begun to replace the dollar with its own currency, the renminbi yuan. Yuan's reach widens with currency swaps

How China has begun to replace the dollar with its own currency, the renminbi yuan.

Yuan's reach widens with currency swaps

Caijing Magazine | 04-07-2009

The cross-border exchange of regional currencies has become an important way to defend against the global economic downturn and promote trade. To circumvent a shortage of dollars and other currencies, as well as reduce exposure to exchange rate volatility, developing countries in eastern and central Asia as well as South America have implicitly recognized the Chinese yuan as a currency for settlements and, in some cases, reserves.

Central banks in China and South Korea signed a 180 billion yuan currency swap framework agreement on December 12. That was the first of a number of formal currency agreements, which included a 200 billion yuan swap January 20 between China's central bank--the People's Bank of China--and the Hong Kong Monetary Authority. The central bank also signed an 80 billion yuan agreement with Malaysia's central bank February 8, a 20 billion yuan deal with the National Bank of Belarus on March 11, and a 100 billion yuan swap with the central bank of Indonesia on March 24. Additional central banks have indicated a willingness to enter currency swap agreements with China as well.

Currency swaps between central banks are an innovation. A central bank, through the exchange, injects the partner country's currency into its own financial system, allowing domestic businesses to borrow the other country's currency and use it to pay for imports of that country's goods, thereby easing the pressure on trade caused by an insufficiency of dollar.

Lu Lei, a Caijing economist and Guangdong Institute of Finance professor, says currency swap agreements are simply two-way loans between central banks. Foreign central banks generally use borrowed yuan to settle trades with China or as a reserve currency. China, on the other hand, uses foreign currency holdings as collateral.

Consequently, regional circulation of the yuan expands. The system hinges on confidence in the yuan among all parties.

"As liquidity of the U.S. dollar, the international settlement and reserve currency, moved from surplus to shortage, difficulties in borrowing and exchange rate risks emerged," a deputy director at China's central bank told Caijing. "As a result, regional demand for settling trades in local currency appeared. It isn't something China could simply decide to establish by itself.

"The development of the scale of currency swaps is not affected by any one party's choice, but is determined by market demand," the bank official said.

Genesis of Swap

"That foreign central banks would seek us out shows there is increasing demand for the yuan," the bank official said, explaining origins of the latest currency swaps.

It began last July at a two-day meeting of East Asia and Pacific area central bank executives in Xi'an. The chairman, China central bank Gov. Zhou Xiaochuan, held talks with representatives from several countries on the subprime crisis. Meanwhile, central banks officials mapped out a cooperative model for currency swaps. The plan quickly received approval from South Korea's central bank.

"Korea and China could sign an agreement worth at least US$ 10 billion," a Bank of Korea representative said at the time. In short order, Bank of Korea officials put forward a request for a US$ 30 billion bilateral currency swap.

On December 12, Chinese and South Korean leaders signed a bilateral currency swap framework for a two-way swap of 180 billion yuan for 38 trillion won, values based on December 9 exchange rates. Each side can, under the agreement, pledge its own currency in exchange for an equivalent sum of the other country's currency. The agreement is valid for three years, and can be extended by mutual consent.

Since then, China has signed additional currency swaps with Hong Kong, Malaysia, Belarus and Indonesia for a total 580 billion yuan.

Obviously, China's central bank is considering the needs of its trading partners. The bank official said the main focus is on "nearby economies, particularly those with which China will have close economic and trade exchanges in the future.

The deal with South Korea was rooted in the fact that China is that country's largest trading partner, the official said. "While Korea certainly needs U.S. dollars, a local currency swap agreement could be used for trade financing."

The official said the amount of currency to swap is determined "mainly in relation to the two sides' trade and investment requirements. But so far, no swap agreement has exceeded 200 billion yuan."

Everyone Wins

In general terms, countries are signing currency swaps with China to fight atrophying trade and protect regional financial stability. However, each country has its own particular focus.

The most obvious goal is to promote international trade and direct investment. The yuan is already frequently used for payments and settlements in East Asia--uses that have become more common as dollar supplies dried up. Central banks using currency swaps for trade can obviously reduce the pressure of demand for the dollar.

Moreover, when two sides use local currencies for trade, export companies can borrow money in local currencies, reducing the exchange rate risk tied to the dollar and cutting exchange fees. This is particularly important in the current environment, which is marked by stalling trade and increasing exchange rate volatility.

Sources familiar with the China-Indonesia currency swap told Caijing that a preliminary investigation by Indonesia's central bank found a number of big companies already using yuan to settle transactions. Indonesia concluded that signing a currency swap deal would promote bilateral trade.

For Belarus, promoting investment was an important motive for the currency swap. China has substantial investments in Belarus, which hoped to receive credit in yuan for paying various costs to China linked to projects such as new power plants.

For South Korea, the currency swap agreement was signed not only to "advance the development of trade settlement business" but because also it would protect the stability of the nation's financial sector. When the financial crisis hit, many Chinese banks were unwilling to make short-term loans to South Korean banks operating in China. But after the currency swap, the Bank of Korea could use yuan to support the nation's financial institutions.

International demand for yuan settlement is gradually expanding, and even some South American countries are requesting currency swaps. Countries such as the Philippines, Mongolia and Belarus have started using the yuan as a reserve currency, although not on a large scale.

According to industry experts, the yuan's advance as a settlement currency and currency swaps catalyzed by the financial crisis are deeply intertwined. Concurrent with the signing of bilateral currency swaps, China has been exploring the use of yuan for bilateral trade. Gradually, the yuan may be increasingly used for trade settlements in the future.

Caijing learned that related government departments have completed plans for a pilot yuan settlement program. After getting approval from the State Council, the pilot is expected to encourage currency exchanges between the Yangtze River Delta region, Guangdong Province, and Hong Kong, Macau. Also included would be settlements between entities in Guangxi Autonomous Region and ASEAN-member nations.

A central bank official told Caijing the test should substantially raise China's experience in trade settlements with nearby countries in their local currencies.

Yuan's Internationalization?

The gradual acceptance of the yuan as a currency for international trade and financial markets raises a number of technical concerns and macroeconomic issues.

It is generally believed that central banks will mainly lend yuan to other banks, which will lead to the use of yuan-based bank account services, and provide yuan that businesses can use to pay for Chinese imports, thus supporting bilateral trade.

"Although China currently doesn't let Chinese banks operating abroad conduct yuan deposit and loan business, it doesn't oppose such activity by foreign banks," the central bank official told Caijing.

In addition, the official said, the yuan settlement pilot project signifies a gradual relaxation of rules for Chinese banks conducting yuan deposit and lending activities abroad.

As the number of overseas enterprises holding yuan gradually grows, an offshore market for yuan is expected to develop. When conditions are ripe, channels would open for foreign yuan holders to invest that money.

Will an overseas market for yuan lead to a loss of exchange rate control for Chinese authorities? No, according to one industry expert who spoke with Caijing. Currency swap agreements so far have totaled only 580 billion yuan, but more than 20 trillion yuan are circulating in China. As a result, the domestic market will continue to determine yuan exchange rates for the foreseeable future.

The central bank official told Caijing that, in the future, yuan investment channels could be diversified through the issuance of yuan-based loans. "Yuan debt has been issued in Hong Kong. I doubt it will be a special case," the bank official said.

According to Caijing contributing economist Ye Xiang--a former member of China's State Administration of Foreign Exchange and the Hong Kong Monetary Authority--currency swaps are beneficial.

"As a trading engine that alleviates the effects of a lack of (dollar) liquidity on trade among nations, currency swaps are a useful financial innovation," Ye said.

Ye's analysis shows international financial transactions in the future will largely take the form of commercial activities. Whether a commercial organization is willing to adopt the yuan as its currency for trade, investment and account settlements rests entirely on the convenience and stability of the currency.

Ye compared this cross-border trade to a highway between two towns. If there is no trade between the towns, there's no need for a highway. But when there is demand for trade, people will walk a route until a highway is built. Similarly, Ye said, even if banks aren't providing settlement services, some corporations will use yuan to settle transactions, leading to the internationalization of the yuan. But this is not expected to happen overnight.