This Article is From Oct 23, 2013

France talks about currency: How the Chinese yuan is threatening the dollar's hegemony

France talks about currency: How the Chinese yuan is threatening the dollar's hegemony

Will the yuan dethrone the dollar one day?

The Chinese currency may have just moved a step further in that direction with the October 10 signature between the European Central Bank and the People's Bank of China (the country's central bank) for the establishment of a "currency swap" mechanism.

The terms of the deal are a bit technical but the goal is simple: facilitating commercial exchanges between the Eurozone and China by giving European banks access to 350 billion yuan (42.4 billion euros) and giving Chinese banks access to 45 billion euros. The banks will be able to make these sums available to their clients.

"It is the third-largest arrangement of its kind" signed by the People's Bank of China, declared Europlace, an organization promoting the Paris financial marketplace in an enthusiastic statement.

Most of all, this "swap line" shows the willingness of Chinese authorities to internationalize their currency. "Their dream is to see the yuan become as important as the dollar in international exchanges," says Philippe Waechter, economist for Natixis Asset Management. "And they will do whatever they can to succeed."

Their efforts have already bore fruit. Central banks in developing countries (Chile, Nigeria, Thailand, et al) are starting to use the yuan to diversify their reserve currency. "It's a way of reducing their dependence to the dollar and at the same time of reinforcing their relationship with China," explains Claude Meyer, Asia specialist at the Paris Institute of Political Studies.

According to the Bank for International Settlements, the yuan entered last month the top 10 of the most-exchanged currencies in the world. In 2004, it was only in 35th place.

This rapid evolution is surprising since the currency is only partially convertible. Contrary to other currencies, whose exchange rate depends on supply and demand, the People's Bank of China fixes the RMB's exchange rate daily, with maximum variations of 1%.

Beijing started to soften its positioning in the middle of the 2000s. In 2005, the Chinese authorities partially unlinked the yuan from the dollar, pegging it instead to several currencies. But the first major change took place in 2010 when the government authorized companies to use the currency to pay for imports and exports, which until then were paid in dollars. Some 16% of China's exterior commerce is now done in yuan. And according to HSBC, the proportion should reach 30% by 2018.

At the same time, Hong Kong has been turned into an offshore financial center to promote the Chinese currency. In 2010, the People's Bank of China agreed to let a subsidiary of the Bank of China (owned in majority by the state) to manage the international supply of the yuan from the former British colony.

"It is now one of the main sources of Chinese currency for foreign banks," explains Bei Xu, economist for Natixis.

Life-size lab in Shanghai

Still in Hong Kong, some companies are now allowed to issue bonds in yuan to finance themselves. At the beginning, investors rushed to buy these assets as they saw it as a way of benefiting from the progressive value of the currency. But since then, they realized that the finances of Chinese companies lack transparency, and their enthusiasm waned.

This shows that China still has a long way to go to see its currency dethrone the dollar. "Chinese financial markets are still too small and too opaque," Meyer says.

Foreign companies still need to get a license from the government before they can be traded on the market in Shanghai and Shenzhen; and even then, they can only invest up to $3 billion. "Beijing fears that too fast a liberalization of its market will lead to speculative operations, such as the ones that take place on the stock markets of Sao Paulo or Mumbai," Bei Xu explains.

But most of all, the yuan can only become a reference currency when it is fully convertible. China is still proving its pragmatism. Such a move will first be tested in Shanghai's free-trade zone, an 11-square-mile area that was inaugurated on September 29. This life-size laboratory will enable the authorities to try out several market-opening reforms such as the liberalization of interest rates from January 2014.

Still for some, enthusiasm is muted. "It's still unclear what the project is, because it seems difficult to liberalize this zone without extending it to the whole of China," Bei Xu admits.

In any case, the rise of the yuan will also depend on the dollar's evolution. "As long as the United States is the first financial power, the dollar will remain the reference currency for investors," Claude Meyer reckons. In 10 or 15 years, he says, the balance of power between the two could be reversed. But the United States will do all that it can to stop it.