February 6 marked the enactment of a new cross-strait currency settlement agreement between Taiwan and mainland China.Under the agreement, Chinese and Taiwanese companies doing business with each other across the Taiwan Strait would be able to avoid the U.S. dollar conversion and directly exchange the renminbi (RMB) and the new Taiwan dollar.The Central Bank of Taiwan approved of the Bank of China’s Taipei branch asthe RMB clearing bank of Taiwan, and individuals are now allowed a daily conversion limit of RMB 20,000.

China’s first major offshore RMB market was initiated in Hong Kong eight years ago.With the offshore RMB market in Hong Kong continuing its expansion in scale, China began to turn to other strategic partners, such as Taiwan and Singapore, to further raise the profile of the RMB among neighboring countries.According to a research report by Citibank Securities, this cross-strait currency settlement agreementis expected to help Taiwan become another major offshore RMB trading center,much like Hong Kong.

Boosting Trade Volume

Traditionally, China and Taiwan have used the U.S. dollar as their primary settlement currencyfor bilateral trade.However, “amid the global financial crisis, the value of the U.S. dollar has become highly volatile and suffers from an increasingly high risk of depreciation, which means that exporters will encounter greater risks of exchange rate fluctuation if they continue to use U.S. dollar as the bilateral settlement currency,” notes Tian Suhua, an international economics professor from Fudan University in Shanghai.“Since now the RMB is a comparatively stable currency backed by a growing economy, using it to settle trade deals as an alternative to the U.S. dollar could let exporters from both sides avoid exchange rate risks and reduce the transaction costs of bilateral trade accordingly, therefore boosting the bilateral trade volume.”

Zheng Hui, a finance professor from Shanghai Fudan University, further adds that, since the exchange rate between the RMB and the new Taiwan dollar has been quite stable for years, it becomes easy and convenient for the two sides to bypass the U.S. dollar and directly use RMB as the major settlement currency.“Taiwan now runs a huge trade surplus with respect to mainland China and China is now Taiwan’s biggest trading partner,” says Zheng.“Therefore, this currency settlement agreement will offer Taiwan a huge economic benefit, provided that the bilateral political relationship [between the two nations] will not deteriorate in the foreseeable future.”

The potential benefit of this agreement, with respect to bilateral trade, becomes even more significant when one takes into account the Economic Cooperation Framework Agreement (ECFA), a free trade agreement signed by Taiwan and mainland China in June, 2010, experts note. After ECFA was secured, Taiwan’s exports to Mainland China reached US$124.92 billion in 2011, which is 8% higher than the volume in 2010, and further up to US$132.19 billion in 2012.In a research report released in December,2012, Laurent Santin of the European Institute for Asian Studies, states that “the potential [of this agreement] has to be regarded in the context of a free trade agreement signed between both [countries] in 2010, widening the field of possible transactions to thegoods and not only to the financial market.”

Philip Swagel, former assistant secretary for economic policy at the Treasury Department in the U.S. and professor of international economic policy at the University of Maryland, notes that the bilateral currency settlement agreement should increase the usage of the new Taiwan dollar on a global scale since it will increase the liquidity of assets denominated in the currency.“Suppose there is an Australian companythat would like to conduct businesswith mainland China," he says. "[The firm] might now consider gaining access to the mainland China market through Taiwan by transacting its own currency with the new Taiwan dollar first, bypassing the U.S. dollar as an intermediary.”

From Trade to Financial Services

Besides using the RMB as the major trade settlement currency, the Financial Supervisory Commission of Taiwan is also studying and preparing to discuss with its Beijing-based counterpart — the China Securities Regulatory Commission — the possibility of listing so-called"T shares" on the Taiwan Stock Exchange, according to Santin.“This idea is modeled on the H shares [which allow companies incorporated in mainland China to be] listed on the Hong Kong Stock Exchange and would allow companies incorporated in mainland China to have shares traded on the Taiwan Stock Exchange,” Santin states.

Swagelnotes that if Chinese companies were to be listed on the Taiwan Stock Exchange, it would become more attractive for global investors to put money into the mainland Chinese firms through the T shares.Meanwhile, it would also facilitate access for Chinese firms to the Taiwanese capital market.“It is logical for the two sides to first move on the trade side [by] signing the bilateral currency settlement agreement and gradually move to the financial side — that is, facilitating closer investment ties,” says Swagel.“However, whether the two sides could move further on this path will heavily depend on whether both sides could further free up their capital flows.”

Tian offers a slightly different opinion.“Due to the continuous administrative support from the Chinese government, many Chinese companies, including big state-owned enterprises, have branches in Hong Kong,” says Tian.“By stark contrast, there are very few mainland China companies in Taiwan.Therefore, it will be difficult for the T share market of Chinese firms to mature with few clients willing to be listed.” 

Advantages and Obstacles

Based on statistics from the Chinese customs, Taiwan enjoyed a US$95.4 billion trade surplus with China in 2012.“If just 10% to 20% of cross-strait trade is settled in RMB, Taiwan’s RMB deposits will automatically increase from 60 billion to 120 billion. This would make Taiwan the place with the largest reserve of offshore RMB liquidity,” researchers Yi-shan Chen and Judy Lin noted in Taiwanese finance magazineCommonWealth.

With the increasing volume of offshore RMB liquidity, it is likely that Taiwan will become another major offshore RMB trading center.Jackit Wong, an economist for the Asian Pacific Region at Natixis Global Asset Management, a global asset management company, stated in a February research report that, “the development of the offshore RMB market in Taiwan is likely to accelerate” since “Taiwan can easily and closely follow the existing successful Hong Kong’s offshore RMB business development model.”Moreover, Wong also noted that, since the support from the Chinese government appears to be strong and Taiwan investors possess a huge appetite to expand their RMB business, it should be fairly easy for Taiwan to build a sizable and liquid offshore RMB pool.

Tian states that the first step for Taiwan is to issue RMB denominated bonds.“At this juncture, the RMB is still not freely convertible and could not flow freely on the international capital market,” says Tian.“The currency settlement agreement will allow the exporters in Taiwan to hold a lot of RMB.However, if Taiwanese exporters cannot gain interests by trading RMB on the Taiwan capital market and cannot hedge currency risks if ever the RMB depreciates, it will not be attractive enough for them to hold the RMB.Therefore, the key issue that needs to be addressed is how to let the RMB generated from the trade channel to move freely on Taiwan’s capital market.Issuing RMB denominated bonds will be a proper way to solve this problem.”

Yet, Taiwan faces additional obstacles.Zheng notes that,unlike Hong Kong and Singapore, Taiwan has never been a financial hub in East Asia, and its capital market is still developing compared to that of Hong Kong and Singapore.“Offshore financial markets also follow the rule of the economics of scale,” says Zheng.“When the market is mature, there are numerous transactions coming up each day and the transaction cost will decrease accordingly, attracting more businesses to that market.Therefore, Hong Kong still possesses a strategic advantage of being a leading international financial center, with an integrated network of financial institutions and low market transaction costs that will continue to attract global investors to conduct RMB businesses in Hong Kong, and it would in turn make it difficult for Taiwan to compete with Hong Kong.”

Guoyou Song, a professor of international relations at the Shanghai Fudan University, further points out that the potential political instability between the two sides remains a risk factor that troubles the Taiwan authority.“Mainland China is now Taiwan’s most important trading partner, and if there is any political conflict between the two sides, the possible economic damage triggered by the political or military conflict will inevitably harm Taiwan,” notes Song. “Without a comprehensive mechanism ensuring the free flow of the RMB and a healthy cross-strait relationship from a political perspective, it will be difficult for Taiwan.”

I. M. "Mac" Destler, a professor at the University of Maryland's School of Public Policy, argues thatthe attitude from the United States also needs to be taken into consideration.“From the U.S. perspective, in principle the United States will welcome the move since the U.S. wants a peaceful cooperative relationship between Taiwan and the mainland China,” says Destler.“However, the U.S. also wants to avoid any issue that will trigger tension between the two sides.Hence, the major concern from the United States about this agreement would be whether one side might unilaterally cut off the agreement, which might render political spillover and possible tensions.”