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Beijings Dollar Trap

By Peter Garnham
From FT.com

Published: July 30 2009 17:19 | Last updated: July 30 2009 19:00

New role for renminbi?China is caught in a dollar trap that has prompted a concerted effort to “internationalise” the renminbi and promote its use outside the country.

Fears over the value of China’s massive dollar holdings, accumulated over the past decade as the country pursued an aggressive policy of export-led growth, have been the trigger for the move.

The market’s focus thus far during the financial crisis has been on China’s call for less dependence on the dollar as a reserve currency and repeated calls for the US to avoid debasing its currency through aggressive monetary and fiscal easing.

But many analysts believe China’s calls for a change to the international monetary regime – earlier this year it suggested using the International Monetary Fund’s special drawing right as a reserve currency – are merely a distraction.

Indeed, China has little incentive to talk down the dollar and such calls are regarded as little more than pleas to the US authorities to keep their finances in check.

Simon Derrick, at Bank of New York Mellon, says China is not in a position to sell a significant portion of its dollar holdings in the open market without causing considerable damage to itself. This means that it must explore a number of different short- and long-term strategies to deal with the problem.

“Developments this year indicate that China now believes that its best long-term strategy is to increase the international role of the renminbi, including its use as a reserve currency,” he says. “This might be the first signal that China is now considering a potential timetable, presumably over years rather than months, for moving towards capital account convertibility.”

It is no wonder the Chinese are concerned about their exposure to the US.

China announced its foreign exchange reserves, the world’s largest, had risen by a record $178.3bn to $2,130bn in the second quarter. Although the exact breakdown of the stockpiles is a secret, analysts estimate that 65-70 per cent are held in dollars.

The largest increase in reserves was in May, when the dollar weakened sharply as Treasury yields in the US rose. Fear of a weaker dollar contributed to inflows to China, sparking offsetting intervention by the Chinese authorities to stem strength in the renminbi.

Clearly more dollar weakness – it hit its lowest level against a basket of six leading currencies this week – is not in China’s interest. Qu Hongbin, chief China economist at HSBC, says this has prompted Chinese policymakers to rethink the root causes of the “dollar trap” they find themselves in.

“There is a growing consensus in Beijing that one of the fundamental reasons the country has fallen into this trap is that its own currency is not yet an international currency,” he says.

This means Chinese exporters and importers have to rely on the dollar for invoicing more than 70 per cent of the country’s $2,600bn annual trade flows.

With China’s exports surging nearly 30 per cent annually from 2002 to 2007, and government controls on overseas investment by domestic corporations and households, most of the dollar receipts can be recycled out of the country though just one channel: the central bank’s reserve accumulation.

“To find an ultimate solution to this issue, apart from gradually loosening controls on capital outflows, Beijing has realised that it is time to push the internationalisation of the renminbi,” says Mr Qu.

Mr Qu says this move is long overdue, given China’s rising economic power relative to the limited use of the renminbi overseas.

China’s nominal gross domestic product topped $4,300bn last year and is estimated to reach $4,700bn this year, implying that China may overtake Japan as the world’s second-largest economy in 2010. HSBC says China was already ranked as the world’s third-largest trading country last year, and is likely to overtake Germany as the world’s second-largest trading nation by the end of this year.

In order to kick-start the process of internationalisation, China has begun an ambitious scheme to raise the role of the renminbi in international trade and finance and reduce reliance on the dollar.

Earlier this month, China announced a pilot initiative that expanded settlement agreements between Hong Kong and five big trading cities, including Guangzhou and Shanghai.

On top of this, to provide seed money to its trading partners, this year the People’s Bank of China has signed a total of Rmb650bn ($95bn) in bilateral currency swap agreements with six central banks: South Korea, Hong Kong, Malaysia, Indonesia, Belarus and Argentina.

HSBC says China is still in talks with other central banks to form additional swap agreements and was likely to expand them to cover all the country’s trade with Asia, excluding Japan.

This would be followed by an expansion to take in other emerging market countries, including those in the Middle East and Latin America, that needed renminbi to pay for their imports of Chinese manufactured goods.

Mr Qu believes the process of internationalising the renminbi may be quicker than many expect, estimating that more than half of China’s total trade flows, primarily bilateral trade with emerging market countries, are likely to be settled in renminbi in the next three to five years.

“This means that nearly $2,000bn worth of cross-border trade flows would be settled in renminbi, making it one of the top three currencies used in global trade,” he says.

But not all analysts believe that China can solve its dollar dependency so quickly.

Indeed, Marc Chandler at Brown Brothers Harriman describes China’s efforts so far in providing currency swap lines as a “drop in a bucket” compared with its trading volumes.

He says China’s dollar dependency is a problem of its own making, given that its reserve accumulation has sometimes been larger than its trade surplus as it sterilises foreign direct investment and speculative inflows into the country.

“I don’t see how use of the renminbi, even if it could be foisted on other countries would solve any of China’s problems,” says Mr Chandler.

He says a more flexible currency will help the Chinese authorities avoid painting themselves deeper into a corner, but it will not change China’s competitive position very much, given the way it really competes is cheap labour costs. I think the talk of international monetary regime change and the renminbi as an invoicing currency is largely political posturing.”

Copyright The Financial Times Limited 2009