One of the fundamental characteristics of the global financial
architecture is that the world's second largest economy maintains a
rigidly controlled currency. The concept of currency wars, as
initially articulated last year, seemed to have been a criticism of
the easy monetary policy of the Federal Reserve. But it is being
appropriated and used as a criticism of the lack of flexibility of
the Chinese yuan.
The reluctance of Chinese officials to allow its currency to
be another shock absorber in the circuit of capital means that
other liquid flexible or floating currencies have to shoulder a
greater burden of the adjustment. Some, like a well respected
analyst at a recent industry conference in New York, suggest that
as long as Asian currencies remain under-valued, that the
European currencies will remain over-valued, and by implication
other currencies as well.
Given the tightly controlled yuan market, the extent of its
use offshore is a development that is capturing the imagination
of many observers and participants. Entities like the World
Bank's International Financial Corp, the Asian Development
Bank, McDonald's (
), Caterpillar (
) and some of the largest banks in the world have issued yuan
denominated bonds in recent months. Billions of dollars in
trade is being settled in yuan. The amount of yuan on deposit
outside China is growing rapidly. Some observers suggest that
this is the beginning of the Chinese yuan becoming a truly
global currency and a rival to the privileged place of the U.S.
There is both less and more than meets the eye in terms of the
internationalization of the yuan. The internationalization of the
yuan is less than it may seem because it has been largely confined
to Hong Kong, a special administrative region of China. Yet at the
same time, it reveals the savvy financial prowess of the Chinese
government and is pregnant with vast potential. At the very least,
China has found a way to profit from the speculative interest in
the yuan; betting as it were, on its appreciation.
China has allowed an interbank market for the yuan to flourish
in Hong Kong since last July. If there is a consensus among hedge
funds and other speculators, it is that the yuan is going to
appreciate in the short and long-term. On the other side are
businesses, often Chinese companies owned or backed by the
government, who want to borrow yuan to fund onshore operations.
Owing to the strong demand for yuan denominated financial products,
the cost of (yuan) capital is less than half of what it is
The yuan raised in Hong Kong is regarded by Chinese officials as
a foreign currency (the common mnemonic is CNH to distinguish it
from the onshore yuan CNY). The process by which CNH can be brought
onshore-transformed into CNY-is not yet transparent. It has not
been standardized as are the procedures for dollars, for which
there is a clear channel and necessary steps. The yuan raised in
Hong Kong is brought into China on a case-by-case basis.
It appears to be guided by Chinese officials to help achieve
policy objectives. The location of the borrowing company's mainland
operation seems to be important as the provincial governments are
ultimately behind the process. The sector the borrowing company
operates in is also important. If it is for a sector that officials
worry about overheating or excess investment, it is reportedly more
difficult to get authorities to bring the funds onshore.
Domestic Offshore Market
The number of institutions in Hong Kong authorized to do yuan
banking business has increased from around 65 at the start of 2010
to more than 100 by the end of the year. Yuan deposits in Hong Kong
)) was near 300 billion (~$43 billion) at the end of 2010, more
than quadrupling over the course the year. To put that in
perspective, the deposits in the mainland ((
)) are on the magnitude of 60 trillion. CNH accounts for roughly
4.5% of Hong Kong's M2 money supply and about 10% of the foreign
currency component of M2.
China has also been encouraging the use of the yuan to settle
trades. In October 2010, the most recently available data suggests
that trade worth some $10 billion was settled in yuan in October,
doubling from the month before. Overall, imports plus exports were
near $70 billion, but a more appropriate metric may be imports from
the mainland. In that respect, more than half of Hong Kong's
imports from China were settled in yuan. Note, too, that nearly
half of Hong Kong's imports get re-exported.
Arbitrate opportunities have made the gap between the CNH and
CNY nearly disappear. The mid-October 2010 CNH was as much as 2.6%
richer than CNY. In recent days, the gap was 0.07%. The wide spread
drew Chinese companies' interest.
Consider a chip maker which was to build a new fabrication plant
in the province of Fujian. It would need to import capital
equipment. The supplier was unwilling to accept yuan as it is not
convertible. The company could send yuan to its Hong Kong
subsidiary which can swap it for dollars at the better offshore
The Future of Two Currencies- One Country
The Hong Kong dollar has been pegged to the U.S. dollar since
1983. The peg has come under attack in the past, most notably
during the 1997-98 Asian financial crises. Officials creatively
defended the band and remain committed to it. Some observers
suggest that over time, the yuan will supplement and then supplant
the Hong Kong dollar.
Hong Kong banks are allowed to issue yuan raised in bond sales.
Hong Kong depositors can increase yuan savings by converting up to
a fixed amount of Hong Kong dollars a day to yuan. That cap is
currently around $2500 a day. Hong Kong registered companies can
convert foreign currencies into yuan in lieu of U.S. dollars.
Indeed some recent pressure on the Hong Kong dollar, well above the
floor permissible by the peg, may have been stemmed from moving
Yet we should not believe for a moment that it is a free market.
Chinese officials still retain control of the process; regulating
the speed and quantity that CNH can become CNY. Hong Kong Monetary
Authority maintains strong local control. It requires that banks
document trades and discourages speculation.
The HKMA Chief Executive Norman Chan has outlined four
conditions that would need to be met to peg the Hong Kong dollar to
the Chinese yuan instead of the dollar:
China has an open capital account
China has a freely convertible currency
China has a mature financial system
China and Hong Kong economies are closely aligned
In late 2010, Chan said that none of the criteria had been
China wants to control the pace and draw advantage from the
seemingly insatiable demand for yuan exposure. Dim Sum bonds
exploded on the scene in 2010. Thirty-three deals raised a
cumulative sum of about CNY42.5 billion.
The pace picked up a bit in early 2011, but the bigger story may
be synthetic yuan bonds. Investors buy the bonds with U.S. dollars
and are paid back in yuan. In January, there have been more issues
than all last year and they have raised five times more. Nearly
four times more money was raised in January in synthetic yuan bonds
than in the Dim Sum market. This market is dominated by Chinese
In mid-January, China announced that mainland fund managers
could raise money in Hong Kong for investment in the domestic
market, but 80% of the funds raised must be invested in the Chinese
bonds market. Around the same time, China indicated it would allow
its companies to make foreign acquisitions using yuan. Also
starting in January, the Bank of China (BACHY.PK), the country's
fourth largest bank began offering yuan deposits at its U.S.
These are still early days of the internationalization of the
yuan and the Sino-ification of Hong Kong. The yuan accounted for
0.3% of the turnover in the foreign exchange market according to
the BIS 2010 triennial survey (actually slightly less than in the
prior 2007 survey), which is 1/8 the turnover of the Hong Kong
dollar. The internationalization of the use of the yuan is largely
a function thus far of converting the special administrative region
into an "offshore" center.
More steps toward the internationalization of the China's
capital markets are likely. There is talk that in the coming
months, China may allow foreign companies to list their shares on
the Shanghai stock exchange. There may be efforts to encourage the
Panda bond market (foreign companies issuing yuan bonds on the
mainland). The development will take place under the guiding hand
of China, for whom stability remains a guiding principle. This
evolution will build institutional capacity, but a fully open
capital account and full convertibility of the yuan still appears
to be at least several years away. It is far too premature to speak
of a challenge to the greenback by the redback (yuan), though it
continues to catch the fancy of many observers.
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