Cross Border RMB Settlement: The First Step Towards Internationalization

China has recently taken the first step towards the internationalization of its currency, renminbi (RMB). On July 2, China announced that Shanghai and four cities in the southern Guangdong province - Shenzhen, Guangzhou, Zhuhai and Dongguan - are allowed to settle international trades using RMB on a pilot basis.

There will be multiple phases for this program. In the first phase, selected companies in Hong Kong and Macau, as well as those selected in China, will be able to make their import and export orders with Mainland firms in RMB. In later phases, this cross border arrangement will likely expand to other Asian countries as China has signed a series of "swap agreements" with six other central banks to allow them to acquire RMB for use in trade with China. Banks participate in cross border RMB settlements are able to introduce settlement services including: documentary LC, documentary collection, remittance, pre-receipt and prepayment, RMB trade financing and export buyers' credit. By widening RMB's application in the global trade market, China hopes to gradually increase the status of RMB as a global currency.

China's motive to boost the global standing of RMB ties to its recent call for an alternate reserve currency. Ever since U.S. bank failures triggered the global crisis, China has frequently talked about a USD substitute to protect against instability from one country's poor economic policies. By internationalizing the RMB, China can extract itself from the automatic accumulation of huge amount of USD through trade. With $805 billion in U.S. Treasuries in its reserve, China is vulnerable to Washington's mismanagement of the U.S. economy. China worries that the huge budget deficit spending will eventually cause the USD to depreciate and erode the value of its USD investments.

This pilot program runs against the Chinese policy philosophy of having total control of its currency in order to shield it from speculative forces and flows of capital in and out of China. By focusing on trade settlement in this program, China hopes to gradually open the door for the offshore RMB market to develop and eventually become an international currency, while continuing to retain control on the RMB's value. In any case, this experiment will help lay the infrastructure and control that are necessary for China to promote RMB global usage.

With the help of trade flows with Hong Kong and Macau initially, then with its trading partners in Asia and eventually with the international community, cross border RMB invoicing and investments among these countries could eventually build up underlying natural demand and supply for the currency. Natural trade and investment activities are essential in developing market liquidity and diluting the impact of any speculative plays in a freely traded market.

Cross border RMB trade settlement will also enhance the competitiveness of Chinese exporters as they don't have to worry about the foreign exchange risk. Chinese commercial banks will also be in an advantageous position as they benefit from playing the multiple roles: settlement bank in China, correspondent banks in China, overseas banks participating in cross border RMB settlement and clearing banks in Hong Kong and Macau.

Will this lead to a freely traded RMB soon? Cross border settlement will lead to greater use of the RMB internationally, but China is far from ready to allow RMB to be traded freely. Over the past year, the People's Bank of China has maintained the RMB in a virtual peg to the USD, as the global financial crisis slowed China's economy significantly. With its foreign trade falling, it is unlikely to allow the RMB to appreciate much in the coming months.

In order to have a freely traded RMB market, several factors need to be in place. First, RMB deposits need to grow more offshore. Simply relying on firms to change their invoicing habits and hoping this will spur demand for RMB settlement and create a sustainable RMB liquidity environment over the long term may not be enough. Second, offshore banks have to be able to broaden the scope of RMB services and lend out their deposits. Third, investors will be looking at increasing the return of their RMB deposits. The availability of RMB denominated investment assets are key to RMB liquidity. That means that until we see a RMB yield curve developed, the currency will not be ready to be traded freely.