In just a few weeks, one of the world’s most important multilateral free trade agreements begins. January 1 marks the launch of the China-ASEAN free trade agreement (CAFTA), allowing zero tariffs on 90% of all goods traded between China and the Association of Southeast Asian Nations’ ten members. As that takes off, exporters in Guangxi and Yunnan provinces in southwestern China are lobbying for an arrangement to settle cross-border trade in renminbi with ASEAN members.


According to China’s General Administration of Customs, trade between China and ASEAN skyrocketed from US$106 billion in 2004 to US$231 billion in 2008. However, the use of the RMB in China-ASEAN trade only accounts for approximately 10% of that total today.


To increase the appeal of the RMB as a settlement currency in international trade, China’s government launched a pilot program in April this year to enable cross-border trade deals to be settled in that currency in five cities: Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan. Now, a similar arrangement is expected to be implemented in Guangxi and Yunnan provinces. These moves mark the beginning of a larger effort by Beijing to raise the profile of the RMB not only among neighboring countries, but also further afield.


Why Regionalize?


Traditionally, China and ASEAN’s members have used the U.S. dollar as their primary settlement currency for bilateral trade. However, “amid the global financial crisis, the value of the U.S. dollar has become highly volatile due to the Obama administration’s loose monetary policy,” notes Zheng Hui, a finance professor from Shanghai Fudan University. “Exporters from both sides will encounter greater exchange rate risks if they continue using the U.S. dollar to settle trade deals, and they are eager to seek alternatives. As a comparatively stable currency backed by a growing economy, the RMB is the best choice [for that alternative].”


Yet China and ASEAN countries face obstacles if they increase the use of the RMB as a settlement currency. According to Zheng, a settlement currency needs to possess a “hedge function,” that is, it should be freely convertible and be able to flow freely in capital markets. “China still pegs the RMB to the U.S. dollar and there is no offshore RMB market. Without the full convertibility of the RMB, the cost for China’s trading partners to hold RMB is high because first, they cannot gain on interest by trading RMB on capital markets and second, if the RMB depreciates, they would not be able to dump their RMB holdings and switch to other currency assets in a timely manner.”


However, Zheng also notes that the Chinese government has been wise to first focus on neighboring ASEAN countries. “The capital markets in most ASEAN members, such as Vietnam, Laos and Cambodia, are underdeveloped,” he explains. “It is very difficult for merchants in those countries to hedge the currency risk, regardless of whether it is in renminbi, euro or dollar. Moreover, with [China’s] current superior economic performance and a huge foreign reserve, expectations are high that the RMB will appreciate, which could offset the disadvantage that the RMB is still not fully convertible.”


Wang Yizhi, acting head and professor of information science at the Shanghai Academy of Social Sciences, predicts that CAFTA could “result in huge growth in bilateral trade between China and ASEAN, especially since the demand from the United States and Europe has plummeted during the global financial crisis.” As he notes, “If the Chinese government could push RMB regionalization successfully, there would be a huge potential gain for the Chinese exporters.”


Moreover, according to Wang, the central banks of China, Japan and South Korea might then improve how they coordinate their financial and exchange rate policies. “Compared to the offshore financial markets in London and New York, the development of the capital markets in Japan, South Korea and China are still inchoate,” he states. “It would be to the benefit of the three countries to cooperate and make the Chinese renminbi, Japanese yen and South Korean won become the three major settlement currencies in the area, especially amid the depreciation pressure of the U.S. dollar.”


Risks and Rewards


Initiating cross-border RMB trade between China and ASEAN is not the only way China’s government has been promoting the RMB. In June, it announced that it reached an “initial understanding” with Brazil to eliminate the U.S. dollar in their bilateral trade settlements, which will be an estimated US$40 billion in 2009. China also signed currency swap agreements with Argentina, Belarus, Hong Kong, Indonesia, Malaysia and South Korea, totaling RMB 650 billion, in a bid once again to bypass the U.S. dollar as an intermediary in bilateral trade.


And in May last year, China’s State Council granted approval to two foreign financial institutions registered in Hong Kong — HSBC and Bank of East Asia — to issue RMB-denominated bonds in that city as part of China’s plan to develop its offshore RMB market. According to a report by Bank of China, RMB-denominated bonds issued in Hong Kong has grown rapidly, from RMB 5 billion in 2007 to RMB 38 billion in 2009.


Against this backdrop, it’s clear that China is not satisfied to simply regionalize the RMB. Rather, the Chinese government wants to internationalize its currency by promoting its use around the world. “The government’s effort to facilitate the establishment of an offshore RMB market shows that it is paving the way for the RMB to develop into an international currency,” notes Wang.


The reasons why are clear. Due to the growing U.S. budget deficit and the Obama administration’s loose monetary policy, the value of the dollar is expected to weaken. To reduce its reliance on the dollar, the Chinese government is seeking ways to internationalize its own currency.


However, the RMB’s internationalization faces significant challenges. In a recently published report titled, “Is China Ready to Challenge the Dollar – Internationalization of the RMB and its Implications for the United States,” Melissa Murphy, a fellow at the Center for Strategic and International Studies (CSIS), a Washington, DC-based think tank, wrote that China needs to “open its capital market, allowing full RMB convertibility and move to a floating exchange rate regime.” According to her, without full convertibility, “the quality of the RMB is inferior since it has no mobility.”


Murphy also stated, “It would not be possible for China to open its capital market, eliminate the peg to the U.S. dollar and let the currency be freely convertible for transactions as long as it remains heavily dependent on its export sector for economic growth.” To push the RMB’s further internationalization, China has to “fundamentally reform its economic structure and transform itself from being an export-driven economy to an economy that mainly relies on domestic consumption.” Moreover, she called for the reform of China’s banking and financial system. “An opening of China’s financial market will expose its banking and financial institutions to more foreign competition.” What’s needed is further reform of its regulatory and governance system “to bring it up to accepted international standards.”


Brendan Kelly, another trade and economics expert at CSIS, adds that if China wants to internationalize its currency, it needs to run an external deficit. “China must be a net debtor, or at least accumulate very significant external liabilities,” he notes. “Other countries must run current account surpluses so that they can invest in these debt securities.”


However, Zheng of Shanghai Fudan University, looks at the issue from a different perspective. “It is worth pointing out that, theoretically, after China opens its capital market, enterprises in China can issue RMB-denominated securities and bonds to other countries,” he notes. “These enterprises will become net debtors with other countries holding their debt securities. However, China can, at the same time, continue to run a trade surplus and build up its foreign currency reserve. A dominant reserve currency nation can be a creditor.”


Cao Yuanzheng, Hong Kong-based chief economist at Bank of China International Holdings, an investment bank, adds that to internationalize the RMB, China could have either a current account or capital account deficit. He says regionalizing the RMB as the settlement currency with ASEAN members is a good start “since China is already running a current account deficit with them,” and adds, “as for the capital account, China could continue pushing corporate investment in Africa. As a less developed region longing for foreign aid and foreign direct investment, Africa is a huge market with growing investment opportunities for China to dig into.”


The Future of the Dollar


In the short term, the impact of the RMB’s internationalization on the U.S. is limited. But how should the United States respond?


According to William Helkie, adjunct professor at University of Maryland, College Park, and former senior adviser at the U.S. Federal Reserve, the crucial task for the U.S. is to rebuild a strong dollar. However, the Federal Reserve “has no other choice but to over-print money to finance [the high] government deficit, which inevitably leads to inflation and depreciation of the U.S. dollar,” he notes. “To prevent the depreciation of the dollar and rebuild investor confidence, U.S. policymakers should focus on cutting the sky-high deficit and finally achieve a slight surplus.”


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