Yuan Settlement – What is it, Who will benefit, and What is the End Objective?

Background

On 29 June 2009, Zhou Xiao Chun, Governor of the People’s Bank of China (the Chinese central bank) and Joseph Yam, Chief executive of the Hong Kong Monetary Authority (the de facto central bank and bank regulator in Hong Kong) signed a Memorandum of Understanding (“MOU”) putting into place a pilot scheme to allow the settlement of trade between HK and Mainland Chinese enterprises in Yuan (the Chinese currency also known as Renminbi or “RMB” i.e. “people’s currency”). The international currency symbol of the Yuan is “CNY”.

The MOU was quickly supplemented by detailed directives issued 2nd and 3rd July 2009 which laid out the conditions for the Yuan settlement.

What is it?

Under the Yuan settlement scheme, enterprises in China and Hong Kong trading with each other will be allowed to settle those trades in Yuan. The scheme will now allow enterprises whose costs are mainly in Yuan to reduce their foreign exchange exposure by using Yuan as the currency of trade. Previously, trades have been settled in foreign currencies, mainly US dollars which had weakened against the Yuan over the past 3 years.

Under the pilot scheme just announced, qualified enterprises in certain cities in the Yangtze (Shanghai) and Pearl River (Guangzhou, Zhuhai, Shenzhen and Dongguan) deltas will be allowed to participate. The list of eligible enterprises has yet to be announced but it is expected that no more than 500 enterprises will be eligible in the initial phase.

It is expected that all companies in Hong Kong and Macau trading with mainland enterprises will be allowed to participate.

In addition to companies Hong Kong and Macau, companies in the 10 Association of South East Asian Nations (“ASEAN”) will also be allowed to participate in using Yuan as the currency of trade and settlement with the to be designated Chinese enterprises.

In order to encourage the Chinese enterprises to use Yuan for trade and settlement, the Chinese Government will provide certain tax incentives.

What is the impact?

Since 2004, Hong Kong banks have been allowed to conducted limited Yuan business. This has been limited primarily to accepting deposits of Yuan from companies and individuals in Hong Kong. Most of these deposits are generated by retailers in Hong Kong from the spending of Mainland Chinese tourists travelling under the “independent travellers” scheme.

As of the end of March 2009, the Yuan deposits held by Hong Kong banks amounted to CNY 53 billion (USD 7.7 billion). While this may appear to be fairly substantial, it pales in significance when viewed against the USD 200 billion bi-lateral trade between Hong Kong and China.

Mainland banks will also allowed to lend Yuan to Hong Kong banks as part of trade finance settlement. However, under the detailed rules issued on 3 July 2009, the trade finance lending can only be for up to 1 month and is capped at 1% of the Mainland banks Yuan deposits as of the end of 2008. Foreign banks borrowing Yuan on the Chinese Mainland interbank market is capped at 8% of the its Yuan deposits at the end of 2008. Chinese banks will be required to provide the PBOC with detailed breakdowns of Yuan lending to foreign banks.

The limited amount of Yuan deposits in Hong Kong can be supplemented by a CNY 200 billion currency swap facility between the HKMA and the PBOC. Hong Kong banks requiring Yuan funds may borrow from the HKMA which will drawdown on the swap.

Under a separate arrangement, Hong Kong banks will also be allowed to issue Yuan denominated bonds on the Mainland and in Hong Kong to fund their Yuan business.

The stringent controls are put in place to discourage the flow of “hot” money into the Chinese economy if foreign banks were to be allowed to borrow unlimited amounts of Yuan.

What is the End Game?

China has been running massive trade surpluses with the US and has nearly USD 2 trillion in reserves. In march 2009, Premier Wen Jiao Bao of The People’s Republic of China indicated concerns about the huge amount of the country’s reserves held in US dollars and Zhou Xiao Chun the PBOC Governor has been talking about the need for a new world reserve currency.

The introduction of a limited pilot scheme to settle trade in Yuan is the first step towards the ultimate goal of internationalising the Yuan as an international currency of trade and settlement.
The inclusion of the ASEAN countries is an attempt at creating a Yuan currency block in South East Asia with smaller trading partner nations. For example, China is trying to create an ASEAN free trade zone based in Nanning, Guangxi.

In the meantime, as more Yuan circulate in the Hong Kong economy, it is conceivable that the Yuan will one day replace the US dollar as the base currency in the Hong Kong dollar peg.