CNY: Renminbi Trade Settlement to Begin

On June 29, the Peoples Bank of China (PBoC) and the Hong Kong Monetary authority (HKMA) paved the way for the implementation of the pilot scheme for the use of renminbi in settling cross-border trade transactions between Mainland China and Hong Kong. This should reduce dependence on US$ as the medium of exchange for international trade and expand the scope of renminbi financial services in Hong Kong.

Renminbi trade settlement to start in Hong Kong
The PBoC and the HKMA sealed the supplementary Memorandum of Cooperation on June 29, paving the way for the implementation of the pilot scheme (initiated in early April) for the use of renminbi in settling cross-border trade transactions between Mainland China and Hong Kong (aka, "pilot scheme"). Hong Kong is the first location outside of Mainland China to conduct such transactions, consistent with Hong Kong's broad theme of reaping increasing benefits from becoming the first offshore renminbi center. The growth in intraregional (Asia) trade has been a dominant trend in the last decade and has brought with it a ballooning volume of transactions independent of the U.S. economy, but dependent on US$ as the medium of exchange. The painful experience in 4Q08 - when the liquidity crunch in US$ exacerbated the plunge in regional trade - proved to be rather damaging and perhaps prompted the regional (especially Chinese) governments to look at ways to reduce their dependence on the US$.

The latest pilot scheme essentially extends Mainland China's current account convertibility to an offshore location - Hong Kong. This expands the customer base for Hong Kong's renminbi financial services to the business sector, from resident individuals and limited designated retailers (that receive renminbi from Mainland tourists) at present. Specifically, companies that both export to (or have other renminbi-denominated revenues) and import from Mainland China should benefit most from the improved convenience and lower transaction costs under the pilot scheme, while net exporters to and importers from Mainland China also gain unlimited (backed by proof of current account transaction) access to renminbi-foreign currency exchange. Upon the growth in renminbi-denominated trade transactions, the renminbi-denominated portion of the Hong Kong banking sector balance sheet is set to expand, catching up with other foreign currencies. The improved convenience from the expanded choice of settlement currency could be appreciated by numerous companies and help to secure Hong Kong's role as mature financial link between China and the rest of the world. To put things in perspective, Hong Kong's re-exports that involve China (either as source or destination) totaled HK$2.5 trillion in 2008, more than 90 percent of total re-exports or 42 percent of Hong Kong's total trade. This is much larger than the RMB53.4 billion outstanding renminbi deposits in the Hong Kong banking system at the end of May. Meanwhile, it is estimated that exports of trade-related services (of which we can assume that half is probably China-related) account for close to 19 percent of Hong Kong's GDP.

While the pilot scheme opens a new line of business for Hong Kong banks, it does not yet resolve the shortage of options on the asset side of their balance sheets - currently limited to renminbi bonds and deposits with the clearing bank (BoC HK) - upon the expansion of renminbi deposits (banks' liabilities). Although it could be a logical next step, it is certainly not included in the latest agreement that Hong Kong banks will be able to offer renminbi trade financing. Some believe this to be a risky development because it might involve the PBoC allowing credit extension by non-Mainland financial institutions, challenging China's monetary management as well as capital account controls currently in place. This is also consistent with the current policy of only allowing Mainland financial institutions to issue renminbi-denominated bonds in Hong Kong. That said however, this progress would continue to help the PBoC develop its governance and skills in this area.

The introduction of renminbi trade settlement in Hong Kong and the associated growth in the renminbi-denominated portion of the banking system's balance sheet should not affect the HK$ monetary base and the currency board system. Over the longer term, increasing cross-border economic integration will likely increase the dominance of the renminbi as a medium of exchange in Hong Kong and this could reduce the fundamental demand for HK$ as a medium of exchange.If that should happen, it would not necessarily cause downward pressure on the HK$ exchange rate as the supply of HK$ would be automatically reduced under the currency board system (upon "capital outflow") in response to the fall in demand.

In recent years, Hong Kong has harvested immensely from opportunities provided through its economic links with Mainland China. Specifically, Hong Kong's financial sector has been exploiting its comparative advantage which lies in China's weakness, namely its financial inflexibility. Needless to say, Hong Kong's first mover advantage is facing erosion by the day, as other Mainland cities and regional financial centers beef up their financial infrastructure and become increasingly competitive to Hong Kong. The development of renminbi financial services in Hong Kong has taken years to materialize, and to Hong Kong's frustration, the pace had been limited by Beijing's relative conservative stance towards financial liberalization. Looking ahead, we should continue to see the Hong Kong government pushing ahead for further opportunities from the Mainland.