Since the global financial crisis, China's economy has played an enormously important role as a driver of global growth. In 2010, it surpassed Japan's to become the second largest in the world and, last year, accounted for roughly a quarter of global GDP growth. Yet, among the currencies of the world's six largest economies, China's yuan is the only one that isn't widely accepted around the world and traded with ease.
China's authorities have been working hard to change that, invoking concerns from many that the yuan could soon supplant the dollar as the leading global reserve currency. To aid in this process, China has one crucial weapon at its disposal – the financial center of Hong Kong.
Over the past three years, the yuan's role in international trade and finance has grown significantly. This so-called process of "internationalizing" the yuan has accelerated dramatically, albeit from a very low base. Much of this progress owes to policy actions taken by China's authorities, who have taken numerous steps to promote the currency on the international stage. Indeed, as Harvard professor Jeffrey Frankel has pointed out, the Chinese government's rigorous use of policy to promote its currency's internationalization is historically unprecedented.
While the yuan is still far from internationalized and has a long way to go before assuming an important role as a global currency, progress thus far has been impressive. A large part of this success owes to China's crucial access to the special administrative region (SAR) of Hong Kong. In fact, the region, one of the premier international financial hubs, has proved extremely useful as an experimental resource in widening the international scope of China's currency.
Hong Kong rising
Currently, the yuan trades in two major markets -- the onshore, or CNY, market, and the offshore, or CNH, market in Hong Kong. Onshore trade is managed by China's central bank and occurs through the China Foreign Exchange Trade System. Offshore trade is carried out primarily on the Hong Kong Interbank market.
Unlike the onshore marketplace, which has to comply with capital account restrictions, the offshore market is burdened with fewer regulations and remains free of direct government intervention. As early as 2004, Hong Kong residents were allowed to open yuan-denominated deposit accounts. Since that time, a number of measures have been put in place to relax cross-border restrictions between Hong Kong and the Mainland. Currently, both cross-border trade transactions and bond issuances can be denominated in yuan.
Hong Kong's importance to China's yuan trade has increased dramatically in just the past couple of years. Since 2009, offshore yuan deposits in Hong Kong have soared from next to nothing to nearly 10% of total bank deposits. Similarly, yuan trade settlement leapt from just 2% of China's trade, to 9% last year. And, in the first quarter of 2011, Hong Kong financial institutions accounted for a whopping 86% of Chinese trade settled in yuan, up from 73% in 2010.
Dim sum bonds
Another major way that Hong Kong plays a role in promoting the yuan as an international currency is through yuan-denominated bond issuance. The issuance of these bonds, commonly referred to as dim sum bonds, has seen a rapid and dramatic rise in recent years. From 2007 to 2010, issuance nearly tripled, coming in at $6 billion in 2010.
Caterpillar (NYSE:CAT), McDonalds, Tesco, and several international banks are among the host of multinationals that have already experimented with issuing dim sum bonds. But, while the rising importance of the dim sum bond marketplace is a promising development in the yuan's journey to gaining a dominant position in trade and financial transactions within Asia, the market still remains minuscule on an international scale.
Though many had heralded the emergence of the dim sum bond market as a major turning point, recent data suggest a fledgling marketplace that has a long way to go. According to Fitch Ratings, dim sum bond issuance in Hong Kong has plunged 55% so far this year, compared to the same period last year.
Many, perhaps most, investors were buying these bonds hoping to profit from an appreciation in the value of the yuan. But, with a marked decline in China's economic growth, the yuan has appreciated only modestly against the dollar this year, making this prospect much less attractive.
Overall, the breadth of dim sum bond issuance remains narrow, with the majority still carried out by financial institutions, as opposed to corporations. Moreover, there is convincing evidence that a large share of cross-border yuan settlement is carried out with the intent to profit from exchange rate arbitrage opportunities that exist between onshore companies and their subsidiaries in Hong Kong. When these nuances are taken together, they imply that offshore yuan usage is still relatively small and has a very long way to go before it can rival the dollar or euro.
While Hong Kong has proved an invaluable resource for China's authorities as they seek to broaden the international usage of the yuan, it alone cannot combat the numerous challenges the currency faces on its path to reserve status. Importantly, for a currency to be viable as a global reserve currency, it must not only be widely used in international trade and finance, but the issuing country must also allow the free flow of capital into and out of its borders, which China does not.
Another major challenge for China will be strengthening its financial markets. To be sure, China has made tremendous strides in its equity markets over the past several years. Trading volume on major exchanges has risen by leaps and bounds, and several Chinese companies, including Renren (NYSE:RENN), Baidu (NASDAQ: BIDU), Dangdang (NYSE:DANG), and Yongye (NASDAQ: YONG), are actively traded on American exchanges.
But, despite progress on the equity side, the country's bond markets are still nascent with relatively low trading volumes. Immature and illiquid bond markets diminish the yuan's attractiveness to foreign central banks seeking to acquire reserves, because central banks allocate a high degree of importance to liquidity when deciding which currencies to accumulate. Indeed, the unrivaled liquidity of U.S. Treasuries is one of the main features that make them the most popular global reserve asset.
All in all, while the yuan is likely to play an increasingly important role within the international monetary system within the next few decades, it is unlikely to supplant the dollar's dominant position.
Fool contributor Arjun Sreekumar has no positions in the stocks mentioned above. The Motley Fool owns shares of Baidu. Motley Fool newsletter services recommend Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.