Saturday, July 23, 2011

China's Rising Currency

As the mid-year passes, investors need to look for trends that will influence global financial markets.

One of these trends which has been largely ignored by Wall Street is the emergence of the Chinese currency – the yuan or renminbi. China is slowly but surely internationalizing its currency. This will have a tremendous impact on trade and global financial markets.

Perhaps the real surprise is how little the yuan is used outside China's borders. China is now the second largest economy in the world, the largest exporter of manufactured goods and the largest holder of foreign exchange reserves. Yet the amount of its currency held overseas is negligible. This is a result of China's strict capital controls and restrictions on currency trading.

But that is about to change. The financial crisis has changed attitudes in Beijing. There is now growing support for a greater international role for its currency. China's long-term goal is to have the renminbi become the main currency for doing business in Asia and other emerging regions of the globe.

China's Baby Steps

China is already taking some small baby steps toward making their currency a global currency.

Over the past two years, it has tried to boost the availability of the yuan. China signed currency swap agreements, worth $800 billion renminbi, with central banks in eight countries. These countries are: Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Singapore and South Korea.

Beijing is now strongly encouraging that international trade settlement to be conducted in renminbi. That process accelerated in last June when China expanded its plan to every country in the world and to 20 Chinese provinces and municipalities.

Then last July, the government allowed yuan-denominated financial markets to spring to life in Hong Kong. A month later certain investors, including some central banks were given limited access to China's onshore bond market. Malaysia's central bank is believed to be the first to hold mainland renminbi bonds in its reserves.

The purchase by Malaysia underlines the potential demand for renminbi assets among governments, banks and companies in Asia. A demand that will swamp the current limited investment opportunities.

And just last fall, China and Russia agreed to allow their currencies to trade against each other in spot inter-bank markets. This move will eventually allow the two countries settle their $40 billion in bilateral trade in their own currencies.

The effect of even these small measures has been dramatic. Two years ago, there was zero trade settlement in renminbi. Last year saw about $77.5 billion in trade settlement.

In addition, trading in the offshore renbinbi has gone zero two years ago to about $2 billion a day currently.

For Chinese companies, the attractions of settling cross-border trade in their own currency are clear. Avoiding the US dollar allows them to cut transaction costs and minimize foreign exchange risk. A huge benefit in a world at risk of a global currency war.

Trade Finance Growth

And an increasing number of multinationals are also experimenting with using the yuan in trade deals. This include American multinationals like McDonald's. Additionally, it and Caterpillar are the first two multinationals to issue bonds which are denominated in the renminbi.

This is very likely the beginning of a major trend. Shivkumar Seerapu, the Asia head of trade finance at Deutsche Bank, said “For our corporate clients, US dollars and euros are no longer the de facto currencies of trade.”

Deutsche Bank, Citigroup and JPMorgan are among global banks rapidly building the infrastructure needed to process renminbi transactions across the world.

However, two banks are already well-placed because of their strong positions in Hong Kong, the designated offshore center for the Chinese currency. These banks are HSBC Holdings and Standard Chartered.

The head of transaction banking for North Asia at Standard Chartered, Neil Daswani, says demand for the yuan has been strongest from Hong Kong. But he has also seen strong demand coming from Singapore, Malaysia, South Korea, Japan, the Middle East and the UK.

Trade finance experts believe the use of the renminbi in trade is likely to take off first in Asia. And then between China and other developing countries.

HSBC estimates that within three to five years at least half of China's trade flows with other emerging economies will be conducted in renminbi. This trade flow is valued at about $2 trillion! If this does occur, it will make the yuan one of the top three global trading currencies.

Chinese Currency Investments

It is no wonder then that some people in China have begun calling their currency the hongbi or “redback”. They believe the redback will become a true global rival to America's greenback.

Qu Hongbin, China economist at HSBC, believes the redback-greenback rivalry is for real. He said, “We may be on the verge of a financial revolution of truly epic proportions. The world economy is, slowly but surely, moving from greenbacks to redbacks.”

There are still many hurdles remaining before the renminbi becomes a true global currency. Such as the dense wall of capital controls that limit foreign inflows and outflows of funds.

However, as the yuan starts to play a bigger role in Asian trade settlement, it will lead to a buildup of the currency outside China. Asia's banks and companies will become a powerful lobby of investors wanting increased access to renminbi investments.

Eventually this will lead to China's currency becoming fully convertible. And as Adam Gilmour, co-head of foreign exchange sales for Asia at Citigroup, said “When that happens, I expect a significant amount of the world's reserves to go into renminbi.”

So it is a legitimate investment theme worth putting money into. The problem is that unless you're a major corporation which trades with China, no American can directly get a hold of any redbacks.

The only direct currency options investors have are an exchange traded fund and exchange traded note. They are the Market Vectors Chinese Renminbi/USD ETN and the WisdomTree Dreyfus Chinese Yuan Fund.

Neither offers direct exposure to the Chinese currency. Both are intended to match the currency's movements through the use of various derivatives.

With China gradually widening use of its currency, hopefully better alternatives appear for American investors in the near future.

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