China ratchets up FX pressure

China allows renminbi settlement for cross-border trade ahead of the G8 summit.

China has been supporting rhetoric with action ahead of this week's G8 summit in Italy, as it aims to promote the use of its currency in international trade and finance, and reduce its reliance on a volatile US dollar.

Last week, China said it would let its importers and exporters use the renminbi to settle cross-border trade. Until now, companies have had to convert renminbi into dollars or other currencies to settle international transactions.

The People's Bank of China (PBoC) announced on its website that it would encourage banks to offer renminbi settlement services from July 2. Approved companies will be able to settle and invoice transactions through financial institutions in Shanghai and four other cities in southern China, and foreign banks will also be able to buy or borrow renminbi from Chinese mainland lenders to settle trade deals in Hong Kong and Macau under a pilot scheme, and to a limited extent in Southeast Asian countries. Supporting documentation will be required to ensure China's capital controls are not breached.

Moving rapidly, on Saturday the Bank of China, the mainland's largest foreign exchange bank, said it had concluded a renminbi trade settlement agreement with HSBC in Hong Kong, following the signing of a memorandum on June 29 by the central bank heads of China and Hong Kong. "With the signing of these agreements, the Bank of China [through its separately listed Hong Kong unit] can begin carrying out cross-border settlements and clearances using renminbi funds with these banks," it said in a statement.

"Hong Kong will be the natural place for arranging these transactions," said Hong Kong Monetary Authority chief executive Joseph Yam. Bank of China will be the clearing bank in Hong Kong and Macau.

The incentive for Hong Kong companies to use the mainland currency to settle trade transactions is the renminbi's expected regular appreciation against the US dollar. It has already strengthened by 21% since a dollar peg was abandoned in 2005, although China has restricted the renminbi's appreciation since July last year in order to help exports. Non-deliverable forward contracts based on the currency's value in a year's time show investors are betting the renminbi will rise less than 1% to 6.77 per dollar. The central bank has kept it within a range of 0.08 renminbi since July 1, 2008.

Ostensibly, China seems to be more concerned about the effect of dollar volatility on export revenues.

"Companies in China and neighbouring countries are facing relatively large risks of exchange-rate fluctuations because of big swings in the US dollar, the euro and other major currencies used for settlements," the PBoC said on Thursday.

But a concurrent comment by He Yafei, a vice-foreign minister, that China supported reserve currency diversification in the future is perhaps more pertinent. In March, China's premier Wen Jiabao had said that a weakening dollar causes losses to the country's holdings of US assets, and he called for a diversification of the international monetary system. China, the largest foreign holder of US government debt, cut its investments by $4.4 billion to $763.5 billion in April, the first monthly reduction since February 2008, according to US Treasury Department data.

China's advocacy for a shake-up in the system has been supported by Russia and most recently by India. On Saturday, Suresh Tendulkar, an economic adviser to Indian Prime Minister Manmohan Singh, said he is urging the government to diversify its $264.6 billion foreign-exchange reserves and hold fewer dollars. Meanwhile Russian President Dmitry Medvedev has often called for creating a mixture of regional reserve currencies to help solve the global financial crisis. Russia's proposals at the Group of 20 summit in London in April included the creation of a supranational currency.

The PBoC has previously agreed to provide Rmb650 billion ($95 billion) to several countries, including Argentina, Indonesia and South Korea through currency swaps, while China and Brazil have been discussing the use of each other's currencies for trade settlement.

China has recently launched other initiatives to promote the renminbi as a regional currency.

In May it said it would support offshore renminbi bond issuance by locally incorporated overseas lenders; and on June 25 HSBC launched a Rmb1 billion, two-year floating rate note at a spread of 38bp over the three-month Shanghai interbank offered rate (Shibor), targeting institutional investors.

Then last week, Bank of East Asia (China) said in a statement that it planned to offer more than Rmb3 billion of bonds, with a fixed annual coupon rate of 2.8%, for subscription until July 17. An attractive rate compared to the near zero interest paid on savings deposits.

Foreign banks are also keen to tap the renminbi bond market to access mainland savings in order to grow their China business; and HSBC and Standard Chartered said in June that they were planning to become the first foreign firms to issue renminbi bonds in the mainland after gaining approval from the PBoC.

Also last week, Guo Shuqing, the chairman of state-controlled China Construction Bank and a former head of China's foreign exchange administration, told Reuters that the US government and the World Bank should sell renminbi-denominated bonds in Hong Kong and Shanghai to encourage the development of debt markets there and to promote the renminbi as a major international currency. He was quoted by the news agency as saying that it was in American interests to see the renminbi become a currency that is traded across the globe. He argued that is largely because of the symbiotic relationship between US purchases of Chinese goods and China's purchases of US assets with the proceeds.

Guo added that he was confident that the renminbi will become a global currency in the medium-to-long term, and that China is likely to continue to progressively ease controls on the convertibility of the currency, with cross-border direct investments one of the next targets.

Yet despite all this noise, the IMF said on June 30 that the share of dollars in global foreign- exchange reserves increased to 65% in the first three months of this year, the highest since 2007.

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