Is the Chinese yuan becoming a rival to the dollar?

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Well, not just yet. China’s controversial currency, the yuan or renminbi (RMB), is still too tightly controlled to be a major factor in international markets. But at the same time, Beijing has made a surprising amount of progress in recent months in its aim of internationalizing its currency. The yuan is showing up a lot more often in trade and finance.

The implications of that new reality are potentially huge. As China rises in economic power – it overtook Japan to become the world’s second-largest economy in 2010 – it seems inevitable that its currency will rise in importance as well, simply because the Chinese economy is becoming so large and so crucial in world trade. Recent advances in the yuan also show how much progress China could achieve in turning its currency into a major international player – if it reformed the distorted way in which the yuan is valued.

The most fascinating aspect of the rising yuan, in my opinion, is the emergence of the “dim sum” bond. These are bonds denominated in yuan and issued in Hong Kong. Though Chinese government allowed such bond to be issued since 2007, the market has really taken off in just the past several months. According to a Feb. 7 report from BofA Merrill Lynch, about $12 billion worth of “dim sum” bonds are on the market. The list of issuers is a surprising one. It includes HSBC, the International Finance Corp., U.S. construction equipment-maker Caterpillar, and McDonald’s. Why would anyone issue a “dim sum” bond? To tap the growing pool of funds available in RMB. That pool is likely to get larger and larger over time, which means “dim sum” bonds will likely become more widely issued and traded in the years ahead.

An important part of that pool of RMB available for investment is the growing deposits of yuan held in bank accounts in Hong Kong. The size of those deposits increased by 400% in 2010, according to Goldman Sachs, to a total of RMB314.9 billion (or $48 billion) at year end. That growth is a measure of how Beijing has expanded the kind of services and transactions that can be conducted in yuan outside of the country, mainly in Hong Kong. In 2009, for example, China started an experiment in allowing certain cross-border trade transactions to be settled in yuan for mainland firms through Hong Kong banks. That scheme has been routinely expanded ever since to include more and more companies. Another liberalization in July 2010 allowed RMB to be more freely used in Hong Kong, and as a result, an offshore RMB market is developing in the city. Some $400 million of yuan is traded a day, primarily in Hong Kong, according to The Wall Street Journal, and though that is still merely a tiny fraction of the trillions of dollars of currency traded each day around the world, it’s still a pretty impressive number given that the market is only a few months old. The emerging international RMB business is a huge boost to Hong Kong in its competition with New York and London in international finance. The city is becoming the primary offshore center for the yuan in the same way London is for the euro.

Despite these signs of progress, the fact is the yuan would probably have a much more prominent international role already if China didn’t wrap it up in so much regulation. Sure, Beijing is continually loosening its grip on the yuan with a steady stream of reforms. In January, the central banks announced plans to permit Chinese companies to conduct direct investments overseas in yuan. But the RMB is not fully convertible and does not trade freely around the world like the dollar, euro or yen, and that is a severe constraint on its use. China also controls the value of the yuan through a mysterious process that limits the freedom of its movement against other currencies. Thus it is impossible to determine the yuan’s proper value. As long as such political interference continues, there will be a ceiling to how much the yuan can be used around the world. Some “liberalization” efforts taken with the yuan appear little more than public relations ploys at this point. The Bank of China announced recently that its American customers could trade RMB in the U.S., but as my colleague Zachary Karabell found out, there really nothing you can actually do with the account, beyond holding some of your savings in yuan.

Beijing’s currency policy is working in two contradictory directions. On the one hand, Beijing wants the yuan to play a larger role globally, to decrease the country’s dependence on the dollar in its international business. But Beijing also wants to control the yuan to promote exports and protect the financial sector and other special interests at home. Eventually, one of those goals is going to have to go if the yuan is to reach the global status it rightly deserves. Perhaps one day, we all will be investing in yuan. But until Beijing allows some real reform of its currency, the yuan’s power in the international economy will lag behind China’s economic power.