China looks to expand currency’s global reach

China still maintains strict controls over its currency and banking system

The shop assistant thumbs the red, 100-yuan bills that bear Mao Zedong's distinctive face, checks the amount is correct and places it in the till next to Hong Kong dollar notes and coins, without a sideways glance.

It's a typical day in Bonjour, a cosmetics store popular with the vast numbers of shoppers from mainland China who are spending their newfound wealth in the former British colony.

From vending machines selling soy milk near the Chinese border to the luxury boutiques and High Street chains in Hong Kong's financial district, payment in China's currency - known as the renminbi or the yuan - is an increasingly common sight.

And it is the most visible of the steps that China, which still exerts strong control over the flow of money in and out of the country, is taking to expand its currency's global reach.

Some analysts predict that the yuan will become a dominant force in international financial markets in five years and rival the dollar, euro and yen.

But no-one expects the yuan to take its place alongside the world's most traded currencies quite yet, as China is still reluctant to enact many of the reforms that would make the yuan freely convertible.

"It's more rapid than many people had been anticipating but it is a gradual process," says Mitul Kotecha, foreign exchange strategist at Credit Agricole in Hong Kong.

Small steps

China has been allowing the yuan to be used more widely in a number of different ways.

Banks in Hong Kong, which has a freely traded currency and a separate legal system, have been permitted to hold renminbi deposits since 2004.

They now total 407bn yuan ($62bn; £38bn).

Chinese bank branches in Singapore and New York now allow customers to open yuan bank accounts.

In 2009, China began allowing its currency to be used to settle cross-border trade between companies in five Chinese cities and Hong Kong, Macau and Southeast Asian countries.

That scheme was expanded worldwide in 2010 and includes some 67,000 Chinese firms in 20 provinces. It means that trading partners do not have to convert in and out of dollars.

Multinational companies like McDonald's and Caterpillar have issued yuan-denominated bonds in Hong Kong and these bonds can be bought and sold by investors who want to bet on an expected appreciation in the Chinese currency.

China is reluctant to enact many of the reforms that would make the yuan freely convertible

And soon investors will be able to buy yuan-denominated shares, following the world's first yuan initial public offering outside China. It is due to take place in Hong Kong at the end of April.

Dollar dominance

If successful, these steps could strengthen the yuan's global role and go some way to challenge the dollar's dominance in international trade and finance.

Beijing has expressed concern at the dollar's status as the world's reserve currency and says it wants the global monetary system to be reformed to reduce reliance on the US currency.

It fears that low US interest rates and soaring budget deficit could undermine the dollar and thus the value of its huge dollar reserves.

China has the world's biggest holdings of dollars, largely because it still tightly manages its exchange rate in relation to the dollar.

Great power, great currency?

Alistair Thornton, a China analyst at IHS Global Insight in Beijing says that China's push to make the yuan more global is also an issue of pride.

"There's huge privilege in being the dominant reserve currency in trade and in finance and China looks at that with envy," Mr Thornton says.

"China's is the world's second largest economy and sees itself as a great power but the yuan is not anywhere near the yen or even the pound," he adds.

Figures from the Bank for International Settlements make clear that the yuan is still a long way from mounting a challenge to the dollar.

The yuan made up 0.9% of daily market turnover on the foreign exchanges in 2010, up from 0% in 2001. The dollar makes up 85%.

Obstacle

The main obstacle preventing China's yuan from becoming a truly international currency is its reluctance to make it fully convertible.

China still maintains strict controls over its currency and banking system and the flow of money in and out of the country.

If these controls were removed quickly, it would be difficult for China to prevent its currency from appreciating rapidly - something its leaders have long resisted.

They have preferred to keep its currency relatively undervalued to boost the competitiveness of its exports on international markets.

It is a policy heavily criticised by the US and other trading partners and will again come under scrutiny as the International Monetary Fund meets in Washington.

China's banks and financial markets are still relatively unsophisticated and China wants to guard against speculative inflows and outflows of money, such as those it believes were responsible for the Asian financial crisis in the 1990s.

"It's a serious policy dilemma for China's leaders," says Mr Thornton.

"They have to weigh up how much they want an international currency with the risks that could bring."