L2B explains the FT: China seeks to make the renminbi a global currency
27 June 2014
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The FT has reported on George Osborne’s push to place London at the centre of the fast-growing renminbi trade. But what does that actually mean? Lawyer 2B looks at the paradox of China’s push to build a global currency.
What does it mean to be a global currency?
In essence, it is a currency that is commonly used outside its home country by people with no connection to that country. The US dollar is the most popular currency to use when two parties anywhere in the world enter into a transaction and that makes it a global currency: an Indian company buying something from a Chinese company is more likely to pay for the goods in US dollars than in Indian Rupees or Chinese Renminbi (RMB). Conversely, the Indian Rupee is not accepted as a payment method anywhere outside India.
Global currencies are also referred to as Reserve Currencies because countries are prepared to keep their cash reserves in that currency.
So what makes a global currency?
Perhaps more than anything else the answer is convertibility and confidence.
For a currency to be truly global it needs to be fully convertible and at present the RMB is not: there are limits on the amount of RMB that can be sent outside China and exchanged for other currencies and entities currently do this under licence from the Chinese government.
The Chinese government is taking steps to reduce exchange controls and doing so may also assist in increasing confidence. By transacting in US dollars the Indian and Chinese businessmen are saying that they trust the US dollar to hold its value (both to purchase raw materials and relative to other currencies) more than they do Indian Rupees or RMB (neither of which is fully convertible) or any other freely convertible currency such as sterling.
As confidence in, and the convertibility of, a currency grows more people are prepared and able to accept it and the cycle continues until the currency is so popular it can be considered to be global.
Why does China want its currency to be global?
At present China uses the US dollar as its principal global currency (or Reserve Currency) but it has no control over it: that’s what was eating up Luo Ping of the China Banking Regulatory Commission when, in 2009, he told a New York audience that he hated them.
At the time the US government had just agreed to print $1tn to $2tn worth of new US dollars as part of its response to the financial crisis. Increasing the number of dollars in circulation resulting in each one becoming a little less valuable was bad news for China as it meant that its US dollars were worth less. The American government had unsurprisingly put the interests of Americans who faced financial turmoil at home ahead of foreign users of its currency and China started to lose confidence in the US dollar.
By promoting the RMB from a regional currency into a global currency China can trade in a currency that it has more control over. Of course, from a political standpoint cutting the cord of US dollar dependence with America is also an attractive proposition.
But as we have seen, to make RMB truly global it must be easy for everyone (not just the Chinese) to use. Part of this process is clearly a move away from exchange controls to ensure the RMB is freely exchangeable. In addition, payments in RMB wherever they are made must be capable of being reliably and quickly cleared. It is for this reason that the Chinese government has officially sanctioned China Construction Bank to provide an RMB clearing service from London.
So what is ‘clearing’?
Imagine I bank with My Bank and you bank with Your Bank and I owe you £20. To pay you back I instruct My Bank to pay £20 into your account at Your Bank. The process that actually transfers that £20 from My Bank to Your Bank is the clearing process.
My Bank and Your Bank both have accounts at the central bank (in the UK this is the Bank of England)***. When I instruct My Bank to pay £20 to your account £20 is debited from My Bank’s account with the central bank and credited to Your Bank’s account with the central bank. Your Bank then updates your account details to show you have another £20 to spend. In this way I have repaid my debt to you but at no stage did any physical money change hands either between me and you or between My Bank and Your Bank.
Depending on the clearing system, debits and credits to the accounts at the central bank may happen in real time (referred to as real time gross settlement) or they may be saved up until the end of the day (referred to as net settlement because all the transfers due from My Bank to Your Bank are netted against the payments due from Your Bank to My Bank and only the balance gets transferred).
Clearing RMB in London has several advantages for users of RMB outside China. For example, clearing will be quicker as it will be done in the same or similar time zone rather than in China and companies (particularly UK companies) will be able to hold RMB accounts more easily as they can be opened in the UK. In short, it will make it easier to buy and sell things using RMB.
What’s the paradox?
The paradox is one of control. For a currency to be truly global users must have confidence in it. But as we have seen, excessive government intervention in the currency can weaken that confidence. China wants to establish the RMB as a global currency in part because it cannot control the value of the US dollar. But will China’s desire to retain control of the RMB (whether through a residual form of exchange control or on a more ad hoc basis) be the very thing at stops it becoming a truly global alternative to the US dollar?
Cyrus Pocha is a corporate associate at Freshfields Bruckhaus Deringer
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***Banks that hold accounts with the central bank are called clearing banks. Not all banks in the UK are clearing banks and banks that are not clearing banks will have an account with a clearing bank through which it clears its payments.