Don’t believe the hype about the “internationalisation” of the renminbi.

That’s the message from Yu Yongding, an academic economist and adviser to the Chinese government, who has just published a paper titled Revisiting the Internationalization of the Yuan.

Yu takes a machete to the great expectations of banks like Standard Chartered and HSBC, which predict that the renminbi will rapidly become an important currency in global trade and investment.

Beijing’s plan for renminbi internationaliation is “flawed with many missing links and wishful thinking”, says Yu, who was formerly a member of the monetary committee of the People’s Bank of China.

Not only does China lack a sensible path to turn its currency into a global one, says Yu, but much of the apparent success in the renminbi’s internationalisation to date is in fact an illusion.

From next to nothing, the volume of cross-border trade settled in renminbi has surged in the last three years. According to the Hong Kong Monetary Authority, renminbi cross-border trade conducted through Hong Kong reached Rmb1.9tn ($300bn) in 2011.

Yu has two points to make about this.

The first is a subtle one, to do with the distinction between trade settlement (the currency that is paid from buyer to seller) and trade invoicing (the currency in which the deal is priced.) From Yu’s paper, with our emphasis:

Most researchers will assume that in the PRC’s case, if the yuan is used for settlement, it must also be used for invoicing. But … this is simply wrong. Investigations show that while indeed many PRC importers use the yuan for settlement, most of them still use the US dollars for invoicing.
[our emphasis]

An interesting point. But there is more.

The true motivation behind the PRC importers to use the yuan for settlement is the existence of opportunities for exchange rate arbitrage.

Strong stuff. As the FT first reported in January 2011, Chinese companies have used the renminbi trade settlement scheme to take advantage of price differentials in the onshore (CNY) and offshore (CNH) currency markets. Essentially, the scheme allows them to shift renminbi to Hong Kong to purchase dollars at a better rate than the one available on the mainland. While there are no official figures on the scale of this arbitrage activity, Yu suggests it is enormous (our emphasis):

On the surface, the trade settlement scheme merely allows the PRC enterprises to use yuan to settle their trade transactions. In reality it enables enterprises, especially large enterprises with subsidiaries outside borders, to channel funds across the border between the PRC and Hong Kong, China. The starting point of yuan internationalization is supposed to be the use of the yuan for import settlement. But in practice, many PRC importers did not use the yuan to pay for their imports—let alone to use the yuan for invoicing. Instead, they utilize the opportunity provided by the trade settlement scheme, to conduct exchange rate arbitrage.

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

Blimey. We should add that the renminbi trade settlement scheme also allows Chinese companies to arbitrage onshore and offshore interest rates, although Yu doesn’t get into that in his paper.

All that deals with the past. Yu is also concerned about the future, and believes that Beijing has failed to properly think through the process by which the renminbi could take on a bigger global role.

In particular, says Yu, “the road map for yuan internationalisation has said nothing about the need for interest rate liberalisation and a flexible exchange rate regime.”

Sequencing is important. Without the initial realisation of establishing market-determined interest rates and exchange rates, yuan internationalisation could easily go astray.

The process of yuan internationalisation essentially is a process of capital account liberalisation. Due to the unprecedented and complex global financial crisis and the PRC’s huge imbalances, capital account liberalisation should be pursued in a cautious way. The PRC should first put its own house in order.

Before the internationalisation of the yuan can make progress, the PRC must speed up the reform of its financial markets. Interest rates should be liberalised. At the same time, the yuan exchange rate should be allowed to float freely. Only when the PRC’s financial reform makes an important breakthrough, can the internationalisation of the yuan be able to make meaningful progress.

Indeed, while Beijing has made lots of noise about renminbi internationalisation, it has been less forthcoming about capital account liberalisation and reform of its domestic financial markets.

Yu’s recommendations make sense. The question is whether Beijing is listening.

Related reading:
Guest post: RMB internationalisation – too big to ignore
, beyondbrics
Steps to making the renminbi international
, FT

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