By Caijing guest economist Ye Xiang

(Caijing Magazine) A forthcoming pilot project to use the yuan for trade settlements marks the beginning of an effort to make the yuan an international currency. An international yuan would play a role in global economic activities as a currency for reserve, settlement and accounting.

What is the relation between the pilot project for yuan settlement and exchanges based on yuan capital accounts? And what impact will the development of yuan settlement exert on China’s monetary policy?

In general, accounting and settlement are not separate: A currency used for accounting is the same currency used for settlement.

Basically, there are two types of international commercial activities: trade and investment. Internationalizing the yuan means that both international trading and international investments are accounted for and settled in yuan. This has two implications. For one thing, trade and investment involving China are accounted for and settled in yuan. But this is also the case for trade and investment that does not involve China.

At this time, the role and status of the yuan are similar to those of the dollar and euro; it is becoming an international reserve currency, although the process will take more time. Thus, what matters right now is the first implication; namely, that trade and investments involving China are accounted for and settled in yuan.

Multiple Values

Foreign trade accounting and settlement in yuan involves overseas agent banks as well as overseas exporters and importers. First, overseas agent banks open interactive accounts at domestic commercial banks to obtain financing in yuan. Overseas importers and exporters accept yuan accounting and settlement, and then open yuan accounts at overseas agent banks. Since they probably would not have deposits in yuan, agent banks offer credit to them in yuan. After yuan settlement becomes more popular, the process should fill an initial need for the yuan that fluctuates according to the amount of trade.

As for using the yuan for settlement, a country or region with a long-term trade deficit with China will see that reflected, from a macroeconomic perspective, in the increased amount of yuan indebtedness to China and an increase in China’s yuan credit. A country or region should pay off the debt to China, increase exports to China, or reduce imports from China. In other words, each should repay debt to China in an accepted reserve currency.

Likewise, when one country or region enjoys a long-term trade surplus with China, it owns yuan credit against China. Prior to the yuan becoming a major reserve currency, a country or region perhaps would not want to hold a large sum of yuan credit and would ask China to pay back debt with another reserve currency.

Yuan settlement in international trade has significant meaning for China’s monetary policy. When the Chinese economy enjoys a rather large surplus, and the yuan is anticipated on a good prosperity, any surplus will not be converted into other currencies. A surplus in the form of yuan currency will either be exchanged for foreign exchange reserves, or increase the amount of yuan circulating domestically in China.

Similarly, when the Chinese economy has a rather large trade deficit, and the yuan is not being used as a major reserve currency, a creditor country will ask for repayment in another reserve currency. This will reduce the need for yuan on overseas markets and thus decrease the amount of currency circulating in China.

Thus, international trade settlement in yuan is helpful for balancing bank saving and consumption in the world economy, surpluses and deficits, and the world economy and financial stability in the long-run.

Offshore Markets

Comparatively, yuan accounting and settlement for international investment is relatively difficult. Before issuing financial instruments denominated in yuan, investors must have savings accounts in yuan. For instance, the China Development Bank and Bank of China only can issue yuan bonds in Hong Kong to individuals. This is because only individuals have yuan bank accounts and bank savings. Institutional investors do not have yuan deposits, making a larger scale of international investments denominated in yuan difficult.

After using yuan for international trade settlement for awhile, importers and exporters with surplus yuan positions may have interest in buying yuan-denominated financial instruments. At such time, it would be relatively easier to promote yuan-denominated investment instruments.

Another situation arises when Chinese banks lend to overseas investors to buy yuan financial instruments. This type of business, however, is rather risky and should not be encouraged in the short run.

Overseas yuan investment market growth is significant for China’s monetary policy. At times when our domestic economy is heating up, and overseas investors are looking toward the Chinese economy and yuan appreciation rather positively, foreign “hot money” will not flow into China directly if overseas investors buy yuan-denominated financial instruments. Likewise, when overseas investors are not looking at the Chinese economy positively, yuan-denominated financial instruments will be dumped, and the yuan will be under more pressure to depreciate.

Use of the yuan for international trade settlements is associated with current accounts. As long as a capital account does not interfere with current account, risk control is good. Especially when the yuan-denominated investment market has yet to be developed, overseas yuan needs are basically associated with trade. And it is easy to keep track of money flowing from domestic banks.

Development of an overseas, yuan-denominated investment market may relax control of capital accounts or, at least, we can say the growth of the yuan-denominated investment market is based on a more relaxed capital account.

When foreign investors take a negative view of China’s economy, they only need to dump yuan-denominated assets to cash out, which will result in yuan depreciation. The central bank must sell reserve currency and buy yuan to stabilize the yuan. This will result in an indirect outflow of assets. Likewise, if foreign investors look at China’s economy positively, they will keep buying yuan-denominated assets. Then the central bank must keep selling yuan in exchange for foreign currency to prevent the yuan’s appreciation. As a result, international assets indirectly flow into China.

To summarize, international trade settled in yuan offers ease of operation as well as low, manageable risks. But international investments settled in yuan should be approached with more caution.

We must understand that it is an inevitable trend that the overseas yuan investment market will grow after foreign trade settlements in yuan become widely accepted. For example, when overseas agent banks all have some yuan positions, should we allow interbank yuan exchanges? If we do, overseas a yuan interbank market will be developed. Also, we should let companies engaged in imports and exports adjust their yuan positions via banks to allow development of the overseas yuan monetary market. Gradually, a yuan investment market will take shape.

Key issues for China’s central bank and regulators as they adjust the development pace for the yuan market are the operational and risk control abilities of overseas Chinese financial institutions. If Chinese financial institutions can promote the development of an overseas yuan market, risks will be controlled. This internationalized process for the yuan depends on the pace of internationalization among Chinese financial institutions.

Ye Xiang is chairman of Hong Kong-based Vision Gain Capital, and formerly served as an official at the Hong Kong Monetary Authority, and the Hong Kong Securities and Futures Commission.

Full Article in Chinese：http://magazine.caijing.com.cn/2009-03-15/110120997.html