Dollars and yuan

All signs point to the Chinese yuan emerging as a second world currency after the US dollar. A key step in this development was taken in late December when China and Japan agreed to conduct future bilateral trade directly in the Chinese currency.

A deal between these two countries - the world's second and third largest economies - carries weight. Last year, trade between them amounted to 260 billion euros.

"This is an important political step," said Hosuk Lee-Makiyama for the European Center for International Political Economy in Brussels. "It removes currency risks for Japanese companies."

Fluctuation risks

Currently, Japanese companies like those from other countries must first convert their payments into dollars and then into yuan. Each currency fluctuation poses a risk for companies.

For some time, China has been taking steps to establish its currency, also known as the renminbi or folk's currency, on the world's capital markets. Since 2010, securities can be issued in yuan in Hong Kong. Some national banks in countries such as Nigeria and Brazil have already invested some of their currency reserves in the Chinese currency.

In the future, the London and Singapore stock exchanges hope to trade securities in yuan as well. "The trend is toward liberalization," said Zhou Xiaochuan, head of the People's Bank of China. "Now we are not too far away from our goal of convertibility."

In 1996, China made the yuan convertible for trade settlements, but hasn't allowed transactions of local financial assets into foreign assets at market exchange rates. The country's push to convertibility would mean that capital investments in other currencies can be converted into yuan and the currency can be traded at market exchange rates.

Minor player today

But it still remains to be seen when the current trend will actually lead to convertibility. Although China is meanwhile the world's second largest economy and a key export partner on global markets, its currency until now has only played a minor role. Currently, the yuan accounts for less than one percent of global currency trading. The country is concerned about speculative capital flows.

The exchange rate of the yuan is presently set not by currency exchange markets but rather by the Chinese central bank. It defines the corridor in which the yuan can fluctuate in relationship to the dollar.

Transferring money between foreign countries and China is a huge bureaucratic endeavor. And investments of Chinese companies abroad and foreign companies in China require double approval: Chinese authorities must first approve the business deal and then the central bank must approve the exchange of yuan in dollars.

The move to internationalize the renminbi would mean "fully opening the Chinese financial markets to foreign investors," maintains economist Barry Eichengreen from the University of Berkeley. The state, he says, would have to keep out of banks' lending operations, state-owned companies and local governments would be subject to tighter budget controls, and China would have to end its practice of stimulating exports with low yuan exchange rates. All this, argues Eichengreen, "would require fundamental changes in China's development model."

Author: Mathias Bölinger / jrb
Editor: Gabriel Borrud