China should make more reforms on reserves, trade and currency to promote the yuan globally

When Japanese Prime Minister Yoshihiko Noda, was in China late last month it was confirmed that the world's third-largest economy had approached Beijing to buy Chinese government bonds.

A statement on the website of the People's Bank of China, the central bank, said "matters related to Japan's applications to buy Chinese government bonds are being processed". The statement was issued after Noda met Chinese Premier Wen Jiabao in Beijing on Dec 25.

The size of the proposed deal was not spelt out, but there were reports that it could be $10 billion (7.8 billion euros). Whatever the size, the deal is significant to China, Japan and Asia as a whole, and is a big boost to China's ambition to internationalize its currency.

Japan is the first developed country to show an interest in making the yuan bonds part of its foreign reserves. So the purchase, still not complete, is a strong endorsement of China's currency. It is also a big milestone in China's efforts to globalize its currency, a unit that cannot be freely converted.

Japan is also the world's second-largest foreign exchange reserve holder. Its selection of the yuan as a reserve currency could have a "bell cow" effect. More economies, especially those in Asia, may follow suit to buy yuan assets.

For Japan, the move is a step forward in its efforts to diversify its foreign reserves, which are mostly in US dollars.

For Asia, hit hard during the 1997 financial crisis partly because of the heavy reliance on the US dollar, the deal is an experiment for its economies in buying each other's government bonds to reduce the damage wrought by an unstable and depreciating greenback. Among the $6 trillion of foreign exchange reserves held by Asian economies, more than 70 percent of them are in US dollar assets.

In fact, East Asian countries have been pressing ahead with the process of cutting the reliance on the US dollar after the Asian crisis. The Japanese yen used to be the most common choice. Now the yuan seems to be another to supplement the US dollar in regional trade and as foreign reserve, especially in Asia.

But it would be premature of China to celebrate, because the country cannot afford foreign governments buying a lot of its government bonds.

To explain this, we need to understand what would happen if foreigners spent freely on Chinese bonds.

Mostly notably, it would result in an increase in foreign exchange reserves for China, which is bad for a country that already holds excessive foreign assets.

If a foreign government wants to buy Chinese government debts, it has to pay in yuan. One way for a government to accumulate yuan notes is through a currency swap agreement signed with China. Under such an arrangement a foreign government would exchange a certain amount of yuan, China buying the equivalent amount of the currency in question.

China has arrangements with many countries, most of them being its neighbors, including Japan and South Korea. The scale of the swaps is expanding as regional economies are keen to promote the use of their currencies to mitigate the impact of the financial crisis and an unstable US dollar.

That means the more foreign governments buy Chinese bonds using the yuan notes obtained through the swap, the bigger China's foreign exchange reserves will grow.

The other way to obtain yuan notes is by doing trade with China. The task is easy because the country has enthusiastically encouraged the yuan to be used as a settlement currency in trade. But the truth is that the yuan is mostly used when China imports foreign goods. Foreign currencies, the US dollar in most cases, are used when foreigners pay for Chinese products.

Since China exports more than it imports - a trend that cannot be rectified in the short term - foreign money that flows into China will greatly exceed the amount of yuan that flows out of the country. That will also add to China's foreign exchange reserves.

In addition, if China allows foreign governments and overseas individual investors to buy its government bonds freely, as the US does with its treasuries, China will have to deal with a growing yuan-denominated liquidity that circulates not only in China but also worldwide.

Managing that growing amount is beyond China's capacity, at least for now. To be sure, the country has not been mature enough to steer its domestic market, let alone the global market. The frequent swing of its monetary and fiscal policies, which sometimes goes beyond what economic conditions dictate, is evidence of its immaturity.

In addition, the fact that China's foreign exchange system and the interest rate formation mechanism are not liberalized impedes the future of the yuan as a global currency.

So far, China has done well in promoting the use of the yuan overseas, but it has been slow in reforming its currency and interest rate systems. Now the yuan is attractive to foreigners mostly because it brings short-term interest gains amid expectations that it will continue to appreciate. The yuan's lure has became all the more stronger as the US has kept its interest rate low and repeatedly adopted quantitative easing policies to lower the value of the greenback.

Simply put, the yuan is welcome because it offers speculative gains for investors for the time being. That is a bad sign for a currency that is supposed to ultimately become a global currency.

To maintain the yuan's lure in the long run, China must quicken its pace to allow the currency to be freely converted, let the market decide the interest rates and open the channel for the yuan parked overseas to flow back to China more freely. By doing so, foreign investors could invest their yuan notes in both Chinese and overseas markets to seek long-term gains.

If those reforms are not made or are implemented too late, the lure of the yuan will diminish in case the global economy bounces back to give support to the value of other currencies such as the US dollar. After all, nobody is willing to hold a currency that cannot bring good returns.

In that sense, China really cannot afford the world to rush in to buy its government bonds. It has to solve some fundamental problems - including too large a foreign exchange reserve, rising trade surplus and rigid currency regime - before its currency can be made international.

The author is a financial analyst in Shanghai. The views expressed do not necessarily reflect those of China Daily.