Baby steps toward a free-trading Chinese currency

May 10, 2011: 10:04 AM ET

The once locked down renminbi is starting to get traded outside the mainland. Why now?

By Katherine Ryder, contributor

FORTUNE -- Will the renminbi be sold at a bank near you? Perhaps not immediately, but a push to open up overseas trading of China's notoriously restricted currency does seem to be underway.

In a late-April move that drew significant attention, Singapore bid to become the first offshore trading hub for China's currency, the renminbi (RMB), outside Hong Kong and Mainland China. The announcement follows China's decision last summer to allow the currency to be bought and sold in Hong Kong, and a similar move in January that paved the way for a Chinese bank to trade renminbi in New York.

Together, the three announcements weave a complicated story of shifting economic and political realities. The most obvious aspect of the story: global demand for RMB is increasing. As China's economy continues to post steady growth, investors have warmed to the idea that the currency will inevitably appreciate over time, and that, as a result, RMB-denominated assets will be a good long-term investment, particularly as sovereign debt concerns in the United States and Europe have eroded confidence in the U.S. dollar and the euro.

The percentage of China's international trade that is conducted in RMB has correspondingly spiked from zero percent in 2009, when the government first allowed Chinese firms to settle deals using RMB, to nearly 7% today, according to data from the Chinese government. Standard Chartered expects the share of China's imports purchased with RMB to reach 20% in 2015 from about 1% at present.

Analysts have long expected such a shift, but why is it happening now? One reason may be the Chinese government's concerns about inflation. Raymond Hung, an analyst with TD Securities in Singapore, says offshore RMB trading serves as a way to counter Chinese inflation. By allowing capital inflows from trade to remain offshore, the Chinese government will stem the tide of money rushing into China and thus dampen inflationary pressure. The move could also potentially open up new investment options for Chinese business people, though Hung notes that it is still unclear exactly how account holders will be allowed to invest RMB held in offshore accounts.

Another factor may well be a desire to conduct less business using the U.S. dollar. "The move is not because they're particularly interested in internationalizing the currency," says one trader based in Singapore, "But to facilitate greater bilateral trade agreements that would exclude U.S. dollar." This could help China diversify its reserve holdings that are overwhelmingly held in U.S. dollars.

Even if China is now testing the waters, there is still a long way to go before China lets its RMB swim freely around international markets. For starters, the logistical obstacles to offering offshore banking services with RMB are considerable, as transactions typically require approval by executives or government officials on the mainland. Nor would China necessarily want rapid RMB outflows, especially if overseas trading limits its ability to manage its currency against the U.S. dollar. Most analysts agree that it is in the long-term interest of both China and the global economy for some rebalancing to take place, but a rapid rebalancing could prove jarring. While the measures are novel, they certainly won't move markets in the short-term.

Still, the slow opening of RMB trade seems to correspond with a desire to gradually loosen the renminbi's peg to the dollar. In this context, more dynamic RMB trading markets could have broad economic implications. For instance, some Asian economies that have their currencies pegged to the U.S. dollar (Hong Kong, for example) could eventually choose to peg to the RMB instead. But given that China is still so reliant on the U.S. dollar's movement, that is unlikely to happen anytime soon.

More broadly, a move to free up trading of the RMB and loosen China's currency peg could help facilitate a trend in which many countries move away from the U.S. dollar as their reserve currency. Such a shift, though it could prove to be a healthy rebalancing if it unfolds in an orderly manner, could also have unpredictable economic and political consequences if it happens too swiftly.

These are the concerns China's government is likely to keep in mind as it slowly moves toward currency normalization. In the course of this march, the current moves to open up small trading operations overseas are baby steps, but they are important to watch nevertheless.

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