More Yuan, Anyone?

Early this week the People’s Bank of China (PBoC) announced that domestic companies are now allowed to use the yuan for offshore investments. Apparently, approved mainland companies will be able to use the yuan to start a business or fund acquisitions abroad, which will provide another opportunity for the yuan to flow out of the country.

The recent change in rules is nothing new to the PBoC though, as it has been easing up on its regulations in 2010. Last year the PBoC also allowed the yuan to flow in and out of the domestic bond market, swapped currencies with emerging markets like they were baseball cards, and even allowed institutions to issue yuan-denominated securities in Hong Kong.

So why is China pushing for increased circulation of their currency, anyway?

It seems that they are really serious about their plans to internationalize the yuan in order to help Chinese companies hedge their currency risk. For them, using their domestic currency for transactions would allow them to protect their funds, especially when the global economy is unstable.

Is that it? Well, of course not. I’m sure you’ve heard of China’s not-so-secret plan to have the yuan snatch the reserve currency crown away from the U.S. dollar.

Faster and broader circulation of the yuan is the first step in achieving better convertibility and eventually globally-reserved currency status. As more and more companies and central banks use the yuan for their transactions, it can’t be long before it enjoys full liquidity and dominates currency flows.

It can’t be denied that China enjoys a more stable economic footing, and with its sheer size and massive growth potential, its domestic currency could easily trump the U.S. dollar.

You for real Forex Gump? You think China would really want that?

Why not?

There are actually quite a number of benefits to having your currency regarded as a reserve currency. First, it gives the issuing country a “liquidity discount”. Remember that one of the factors that go into the pricing of bonds is its liquidity premium. With more people holding yuan, this would effectively create a more liquid market as traders could more freely trade yuan-denominated bonds. This allows the Chinese government to issue bonds at lower yields, and help fund high-yielding projects.

Secondly, China would also benefit from more developed and efficient capital and financial markets. This would put them in a better, more competitive standpoint.

Third, if the yuan were to be a reserve currency, it would help China’s trade activities because it would be used more in international trade. This helps bring down both transactions costs and also lessen exchange rate uncertainty.

Of course, there are some drawbacks.

For one, China’s exports could take a hit, as the yuan’s value may rise by virtue of higher demand for the yuan and yuan-denominated assets. Also, having the yuan as a reserve currency would put the Chinese government under the spotlight. China has already been pressured and scrutinized for controlling the value of its currency. If it were to allow the yuan reserve currency status, China would have to be more flexible with their policies. The question is, can they play nice?

Not only would China be more restrained, but the U.S. will feel the aftershocks as well. The U.S. would no longer be able to freely rely on foreign nations buying up their debt. It would affect their budget and expenditure, as they will have to find a way to close the deficit. Most importantly, the U.S. could lose its tight grip as the being the economic and political powerhouse in the world.

None of this will happen overnight, but over time, we should see the implications should the Chinese push the yuan to the forefront.