by Joanne Masters

Jo Masters uses her 14 years experience working in currency markets and economic research in Australia to explain what’s happening to China’s currency.

The internationalisation of China has long been a ‘hot topic’. Ever since those early reforms by Deng Xiaoping in the late 1970s/early 1980s, the world has been captivated by China’s emerging role in the global economy. And it hasn’t disappointed, with China now cemented as a key global player.

Trade and business with China is now commonplace and less restrictive than ever. One area, however, where reforms have been slower has been in financial markets, particularly currency reform.

However, there is movement under-foot. Chinese policymakers are committed to a gradual move toward a ‘fully convertible’, global currency, with the pace of that reform accelerating in the past three years.  Some even wonder if perhaps, one day, the Yuan will be a competitor to the US dollar’s standing as the global reserve currency of choice (although this seems a long shot given that the euro has struggled to compete). 

The Hong Kong market for the Yuan is now well established. In March, London became the first hub for financing and trade in the Yuan outside Asia, and now operates an official clearing service for the currency.

Around the same time, China’s Central Bank (the Peoples Bank of China, PBoC) doubled the daily trading band for the Yuan to 2% either side of the set rate [the Yuan is still a managed float, with the central bank setting a mid rate based on a basket of currencies].

Meanwhile, the offshore Yuan can now be priced directly against a handful of currencies. Australian Dollar pricing was introduced in April 2013, while direct pricing against the New Zealand dollar was announced just two months ago.  The Yuan is also quotable against the US dollar and Japanese Yen, and both the UK and Singapore have signed agreements to make their currencies convertible for Yuan. Other currencies will no doubt follow in coming months.

Also in April 2013, the Reserve Bank of Australia announced it would invest 5% of its foreign reserves in Chinese Government Bonds, with RBA Deputy Governor Lowe noting that it “provides greater diversification of our investments and will help with our understanding of the Chinese financial markets”.

The reforms undertaken by Chinese policymakers have not been without result: The Yuan has surpassed the euro to become the second most used trade financing currency and it has risen to the 8th most traded currency in the world.  At present, the Yuan accounts for about 16% of China’s trade settlements, but this is forecast to expand to 30% by 2015.

That said, there is more work to be done, and many believe that full convertibility is still five or more years away (although the time frame could shrink if the trial loosening of restrictions in the Shanghai Free Trade Zone goes smoothly).

One remaining key issue is the limited investment options for foreign companies receiving Yuan as payment for goods and services. China is trying to broaden the investment channels, but as with the currency, it is a slow process.

The offshore Yuan bond market (commonly known as ‘dim sum’ bonds’) is still developing, and access to ‘onshore’ Yuan by foreigners is governed by investment quota schemes. In addition, the local stock and bond markets remain relatively under-developed.

Another key issue is the value of the Yuan. Most analysts – and vocally US policymakers – continue to argue that the managed float has kept the Yuan under-valued. And no wonder Chinese policymakers are reluctant to relinquish this, given China’s reliance on exports!

Analysing the ‘fair value’ for a currency (especially one that is ‘managed’) is a work of art, not science, and there are various estimations for the Yuan. Last year, the International Monetary Fund (IMF) assessed that the Yuan was “moderately” undervalued, which many read to mean 5-10%.

Undoubtedly, a move to full convertibility will see the Yuan stronger than it currently is, and arguably with greater volatility. Volatility is not necessarily something to be feared, indeed, it is volatility that allows a currency to stabilize the economy – depreciating to boost growth, and appreciating to quell inflation.  Moreover, the adjustment to a stronger, more ‘fairly valued’ Yuan should be easier to absorb in an environment of a strengthening US dollar.

US Treasury Secretary Jacob Lew has put the currency on the agenda for his meetings in Beijing this week, with the recent weakening of the Yuan setting off alarm bells in some sectors. Some are wondering if China’s policy of allowing a slow appreciation will be reversed as economic growth slows.

I can’t see China slowing, or reversing, moves to liberalise financial markets. The pace may slow, but the commitment is not in doubt. In this instance, history seems a good guide to the future: the continuation of a slow, cautious approach to financial reform.

Globalisation of the Yuan is a positive for Australian business – notably it has provided the ability to hedge and manage currency exposures better. China is Australia’s largest export market, and largest source of imports. It is a critical component to the commodity sector.

Certainly the ability to directly price the A$ against the Yuan is a bonus when negotiating contracts. It allows Australian corporates a bargaining chip, a point of differentiation against competitors (particularly in the commodity sector). Australian companies can avoid a two-stage currency approach (Yuan to USD, USD to A$), they can negotiate discounts, engage in longer term planning and contracts and build better relationships.

Importantly, Australian importers can also use the forward market to their advantage. With Chinese interest rates across the yield curve above those at home – and set to remain so - importers can access a discount on forward pricing.

As Yuan investment opportunities continue to expand, the Yuan’s managed ‘band’ continues to widen, Chinese investment markets become more sophisticated, the process  of doing business in Yuan will become easier and more familiar.