A Convertible Redback

Renminbi banknotes

Image via Wikipedia

One of our readers made a very thoughtful comment on our recent article regarding the internationalization of the yuan, which some now refer to as the “redback.”

My reading of China’s monetary policy is that the country is more concerned about domestic inflation and the stability of the yuan than it is of the yuan’s appreciation or an enhanced role in international finance. Thus what you will have will be a strange alternate international banking system with Chinese characteristics. China will retain its exchange controls and capital controls…While the upper limit may be raised to accommodate increased trade there will be little free floating yuan that hedge funds can accumulate for speculation. While China’s economy is too big for hedge funds to attack, their speculative bets can ruin the economies of smaller countries…Also the yuan’s stability, based on a basket of currencies for valuation, is highly desirable.

In commenting on the article, the reader hinted at a few of the reasons why China is making specific bilateral currency deals with Russia, the United Arab Emirates and Turkey, and why we can expect to see more of these types of arrangements in the future.

If I had been asked in early 1997 when China would make the renminbi fully convertible, I would have said that it would occur by the year 2000. Statements from the government seemed to point to that timetable, and it was the next logical step in China’s economic reform program. Then, in July, 1997, the Asian Crisis hit, and everyone looked on in horror as hot money from global hedge funds, fueled by the steroid of high leverage, brought the economies of Thailand, Malaysia and Indonesia to their knees, first creating asset bubbles when it flowed in, and then causing the local currencies to collapse when it was suddenly withdrawn. I believe that, then and there, China decided to go slow on making its currency convertible and subjecting it to such temperamental capital flows.

Instead, China has kept control over its currency and largely out of the hands of speculators, although this can never be done completely. The bilateral deals that China has reached with Russia, the UAE and Turkey are an interesting way of ultimately reaching the same destination of convertibility in a much more controlled way.

First, they are limited to settling trades and are capped in amount.

Second, they build demand for the renminbi outside of China.

Third, they enable China to diversify its holdings of currency reserves without risking a destabilization of the global currency markets, i.e. China can reduce the percentage of its currency reserves that it holds in U.S. dollars without actually having to go into the market to sell dollars and buy other currencies.

Fourth, transaction costs are lower because the need for each trading partner to purchase a common currency such as the dollar or the euro is eliminated.

And finally, by its willingness to accept their currencies, China is, in effect, telling Russia, UAE and Turkey that it trusts their handling of their respective economies, thereby building a long term economic relationship that is built on respect and trust.

Full convertibility of the renminbi is inevitable and will come at some point. When it does, though, it will be a fait accompli. Moreover, when the renminbi becomes convertible, it will already be accepted the world over as a currency that can be used for settling trades.

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