The Chinese Currency’s Great Leap Forward
China is set to overtake the US as the world’s largest economy in less than a decade, but its currency, the renminbi, still accounts for just a tiny fraction of global trade settlement. While there’s a long way to go before it’s viable as a global reserve currency, we think that the renminbi will challenge the US dollar’s dominance in the Asia-Pacific region sooner than many expect.
The first step toward reserve currency status for the renminbi would be to increase its use in settling cross-border trade. Trade in Asia has traditionally been settled in US dollars, but in the past few years, there have been signs of a dramatic shift. As of the end of 2011, just over 8% of China’s trade was being settled in renminbi, but that share has been growing fast, as the display below shows. Argentina’s soya bean crop is already settled in renminbi because China is such a huge market for that crop.
To promote the use of the renminbi in international trade and financial transactions, China has established swap lines with 11 central banks in the past 12 months, including those of South Korea, Malaysia and Turkey. In effect, the agreements allow companies in these countries to bypass the US dollar when trading with China. That reduces Chinese importers’ and exporters’ exposure to foreign-exchange risk.
Companies in China and many other emerging economies are keen to reduce their reliance on financing from US and European banks. After the collapse of Lehman Brothers in 2008, many of these companies were unable to obtain US-dollar trade financing, as Western banks became unwilling to extend letters of credit. The credit crunch—coupled with a drop in final demand—resulted in plummeting trade volumes, and Asia was unable to decouple from the global downturn to the extent that many investors expected.
If China’s trade partners are going to start settling their trade in renminbi, they’ll need to be able to park their reserves in renminbi-denominated assets. Thus, the next step for China is to provide foreign investors with deep and liquid markets for renminbi-denominated assets. This is where the so-called dim sum market comes into play.
The issuance of dim sum bonds—which are denominated in renminbi and issued outside mainland China—has exploded in the past year, in line with a surge in offshore renminbi deposits in Hong Kong banks. So far, many of the issuers have been mainland Chinese companies, most of them financial institutions. But a growing number of foreign multinationals are entering the market, as well. Caterpillar, the world’s largest manufacturer of construction equipment, recently completed its third dim sum bond issue, raising RMB¥1.26 billion (around US$200 million). Ford Motor also tapped the market recently with its first-ever renminbi-denominated bond.
China still has a lot of work to do before the renminbi becomes a global reserve currency. Its authorities are gradually relaxing restrictions on capital inflows and outflows, but there are still extensive capital controls in place. Foreign investors and central banks will need to be given greater access to China’s debt markets to satisfy their demand for creditworthy renminbi-denominated assets. And while China has pledged to allow more flexibility in its exchange rate, we think the renminbi remains significantly undervalued, as explained in my last post .
These steps will be challenging. But history suggests that changes in reserve currency status can happen quickly. In 1914, the US dollar accounted for just a tiny share of global trade and payments. But by 1924—just 10 years later—it had overtaken the pound sterling as the leading international currency.
Within a decade, we expect the majority of China’s trade to be settled in renminbi. This would help insulate asset prices and trade in the Asian region from global financial shocks. Eventually, we expect the dim sum market to merge with the onshore Chinese bond market, which currently remains closed to foreign investors. When that happens, Chinese bonds will become a core holding of global investors, along with US and eurodollar bonds. This change is not going to happen overnight, but we think it could come sooner than many expect.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Hayden Briscoe is Director—Asia Pacific Fixed Income at AllianceBernstein.