Trading places


12 Oct 2012
Week in China

“With these pieces of paper, he causes all payments on his own account to be made; and he makes them to pass universally over all his kingdoms and provinces and territories. And nobody, however important he may think himself, dares to refuse them on pain of death.”

Such was Marco Polo’s description of how Kublai Khan, grandson of Genghis, convinced merchants across his dominions to accept the new paper currency of his Chinese empire.

China’s currency reformers today lack an equivalent mortal threat. But they are relying on trade to drive acceptance of the renminbi in lands far from home.

In Rise of the RMB last year we talked to HSBC specialists in Hong Kong and China about some of the benefits of settling cross-border trade in yuan, as well as how they were working to encourage more of their customers to do so.

But in this latest edition WiC steps back to look at the bigger picture to see what it tell us about the renminbi’s journey as a trade settlement currency.

Total trade settled in renminbi increased by a factor of four in 2011 to reach Rmb2.1 trillion ($330 billion) or about 9% of China’s total trade last year.

Total trade settled in renminbi increased by a factor of four in 2011 to reach Rmb2.1 trillion ($330 billion) or about 9% of China’s total trade last year. That meant that a period of consolidation was almost inevitable this year, especially as the earlier surge in trade settlement was prompted by two major expansions of the scheme, the first to 20 provinces in June 2010, and then to the remaining provinces in August last year.

Without similar triggers, volumes were unlikely to explode as they did before. Events this year have also been shaped by an export slowdown, as well as changing expectations for renminbi appreciation. Even so, the latest quarterly data (from the end of June) still suggests that settlement in yuan is ahead of where it was this time last year, at Rmb1.7 trillion. The share of China’s foreign trade being conducted in RMB (about 10% of the total) has also been maintained – further evidence of a trend holding solid rather than skyrocketing once again.

Data from SWIFT, a global messaging provider for financial transactions, gives more background. In the most recent totals (for August), the renminbi moved up one position to fourteenth in global payment volumes, with a market share of 0.53%. To give that some context, it means that the renminbi overtook the Danish Krone and now trails the Russian rouble one place above it. It has been climbing the rankings this year – back in January it was in 20th place, with 0.25% global share – but the ascent has been solid rather than spectacular.

For instance, to be one the top five payments currencies, the RMB will need to quadruple its global share to at least 2%. And that would still leave it trailing the euro and the US dollar by a huge distance, with their 44% and 30% shares respectively.

The SWIFT data is also useful in outlining where the yuan is starting to enjoy more say in payments made between trading countries and Hong Kong or China.

In the leading group in July were trading relationships where at least 10% of payments were settled in yuan. Here the Gulf countries topped the list, with nearly 40% adoption. Singapore also scored well, with more than 30% of its China payments in renminbi.

Next up were trade partners with 4-10% usage of the yuan, including Germany, Canada and South Africa. After that were the laggards, with volumes below 4%. This group includes some of China’s key trade partners like the United States and Japan. Without getting more traction among these key trading partners, the yuan is going to struggle to establish a deeper international presence.

For instance, to be one the top five payments currencies, the RMB will need to quadruple its global share to at least 2%.

Behind the reams of data, a more nuanced understanding of the numbers is starting to emerge. At the forefront is a change in the composition of who has been paying with the renminbi. Previously, this was heavily skewed towards Chinese buyers, something noted by the HSBC executives interviewed in our earlier publication. They pointed out that as much as 80% of renminbi payment was made by Chinese paying for imports into the country, with only 20% coming from foreign buyers paying for exported Chinese goods or services.

The conclusion: usage of the renminbi was rising as a payment currency for imports arriving in China, but less so for exports sold overseas.

This year has seen a rebalancing, away from the 80:20 ratio towards something less weighted to the foreign exporters. The split is now thought to be closer to 60/40.

Why has that happened? One take is that until the beginning of this year foreign firms selling goods into China were happy to take payment in renminbi but reluctant to purchase goods with it, because they expected it to make more gains against other currencies. But when hopes of further gains began to erode, so too did some of the preference for payment in yuan.

Another explanation is that the imbalance between imports and exports suggests that something other than trade was going on.

One area given particular focus was inter-company transfer of the Chinese currency, as firms sought to capitalise on the difference in exchange rates between the renminbi offshore (often referred to as the CNH) and its equivalent in China (known as the CNY).

These arrangements were highlighted by Yu Yongding, an academic at the Chinese Academy of Social Sciences and a former member of the Monetary Policy Committee at the PBoC, in an article picked up by media in July.

In Yu’s view, much of the trade that seems to have been paid for with Chinese currency may not have been settled in it. Instead, Chinese importers were sending their renminbi to Hong Kong and then switching into dollars at better rates, before using the proceeds to pay international vendors.

“It is not unreasonable to conclude that the bulk of yuan used in the name of import settlement is actually used to buy dollars in the CNH market and imports in fact are still settled in dollars,” Yu warned.

This trend also goes some way to explaining a sudden reversal of flows at the end of last year, when anxiety about Eurozone debt and the US economy saw a sudden scramble for safe haven dollars.

It is not unreasonable to conclude that the bulk of yuan used in the name of import settlement is actually used to buy dollars in the CNH market and imports in fact are still settled in dollars,

As a result, investors started selling down their holdings of CNH (offshore RMB), forcing the exchange rate with the dollar below the equivalent with the CNY (RMB in China) for the first time. The arbitrage trade then reversed as Chinese exporters bought cheaper renminbi via their offshore trading arms and sent the money back to China through the trade settlement scheme.

This looks like an arrangement in which currency was being channelled through the cracks in China’s capital controls – not part of the plan when the trade settlement scheme was established.

From a similar standpoint, the Financial Times highlighted another discrepancy in May this year, this time between the percentage of international payment showing up in renminbi (0.34% at that point) and the global share of letters of credit (4% by value) issued in the Chinese currency.

This also seemed like an anomaly, the FT reported. In global payment terms, the renminbi was in sixteenth position but in letters of credit (LCs) it was the third biggest currency.

The newspaper’s explanation was that this was another arbitrage opportunity between the onshore and offshore markets for the RMB, although in this case on differences in interest rates. This time it was more of a financing ploy. Companies were making renminbi deposits at a bank in China on a higher interest rate than in Hong Kong. Then they got RMB-denominated letters of credit to pay for shipments of goods from their Hong Kong subsidiaries. But the subsidiaries used the documentary credit as collateral to obtain US dollar loans in Hong Kong at lower interest rates than they could onshore, with a currency swap to eliminate the foreign exchange risk.

That may look trade-related. But it’s really a way of raising money more cheaply offshore. For some firms in China it proved a useful option, especially when the policy cycle was tightening last year, making credit difficult to get.

This matters because trade settlement is held up as the flag bearer for a wider international acceptance of the yuan, as well as the first phase of the three-step plan (a trade currency; then an investment currency; and finally a reserve currency). If the numbers aren’t all that they appear, what might this mean for renminbi internationalisation?

The comeback is that the most lucrative days for arbitraging between the two markets for the renminbi (onshore and offshore) may already be over. Lower expectation of an ever-appreciating yuan has helped to reduce the discount in the offshore exchange rate. But also important is the steady increase in channels for cross-border capital flow, as well as wider scope for a greater number of investors to access them. This opens up more opportunity to take advantage of pricing anomalies between the two exchange rates, ensuring that major pricing mismatches won’t survive for long. Policy changes in China, like the PBoC’s decision to widen the daily trading band of the USD-CNY exchange rate, are also driving this convergence process.

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