Yuan use must be extended to entire industry chain to avoid similar issues as yen

China's central bank has recently announced major initiatives on internationalizing its currency, the yuan.

First it permitted direct transactions between the yuan and the pound sterling, and authorized China Construction Bank to be a clearing bank for yuan business in London.

It also authorized Bank of China to become the yuan clearing bank in Frankfurt. The yuan clearing bank network now extends to the world's major offshore markets. Direct transactions can be conducted with the Japanese yen, the Australian dollar, the New Zealand dollar, the British pound and other major international currencies.

Even in official documents, which used to be coy on the matter, the term yuan internationalization is now being used. In April the Hong Kong Securities and Futures Commission unveiled a pilot program called Shanghai-Hong Kong Stock Connect, which is welcome for a variety of reasons.

First, promoting internationalization of the yuan helps make Hong Kong an offshore yuan business Center.

The announcement marked the first time since 2009 that the Chinese government had officially used the term yuan internationalization, instead of the usual "cross-border use of the yuan". This change in wording underlines the determination of Chinese decision-makers to push yuan internationalization.

For the government, the ultimate goal is to promote the yuan as a global currency, or even replace the US dollar as hard currency. The aim is also to keep the dollar from depreciating, something that could lead to foreign exchange reserves shrinking. Another motive is to help China remain independent in international politics and not be integrated into Pax Americana.

Internationalizing the yuan is a path Chinese decision-makers must stick to, and this year we have seen the benefits. In addition to the establishment of yuan clearing banks, changes in the international political situation are conducive to promoting yuan internationalization.

Due to the Crimean crisis, Russia has faced sanctions from the United States and the European Union, so it is jumping on the de-dollarization bandwagon and has reached a comprehensive strategic partnership with China.

As the initial steps in internationalization are achieved, the next steps become particularly important. While the yuan expands in overseas markets, the Chinese government needs to pay more attention to the reform and development of the domestic market and strengthen the foundation of yuan internationalization.

The contraction of US market influence since the global crisis has left some gaps in the international distribution of capital, which provides space for internationalization of the yuan. Recently, Premier Li Keqiang said that China is a guardian of the international economic and financial system, which is another manifestation of the yuan's possibilities.

The Middle East, Africa, Central Asia and Southeast Asia will gain particular attention from China, because they have energy resources. China needs to use the yuan to cover the whole industry chain, thus avoiding the same failures associated with the internationalization of the Japanese yen. Japan imports raw materials and exports high-added value products, and these rely on overseas markets.

One reason for the failure of yen internationalization has been Japan's export-oriented economic and trade structure. Its industrial chain upstream (commodities) and downstream (end consumer) are overseas.

When transactions are in dollars, fluctuation in the yen exchange rate seriously affects the value of the yen as an international currency. In contrast, even though the US dollar has been depreciating for a long time, and the US launched quantitative easing after the financial crisis, the international role of the dollar has not been challenged because the US has used dollars to cover the whole industry chain.

Compared with the rapid expansion of overseas markets, the internationalization of the yuan domestically has been very slow.

Capital account convertibility and setting up a yuan bond market can be said to be building blocks on the road to yuan internationalization. Without those in place, the foundations of internationalization are weak. Two of the fundamentals in pricing the yuan are marketizing interest rates and coming up with a mechanism for establishing exchange rates.

Capital account convertibility will ensure the availability of the yuan. Both factors complement each other, and China needs to employ sound risk control measures to reduce short-term speculative capital in and out, which would unsettle the yuan exchange rate.

While making it convenient for overseas investors to obtain the yuan, China must keep yuan pricing power firmly in the hands of the central bank and the domestic market. In this regard, the pilot Shanghai free trade zone is highly significant. It is expected to become the next global yuan pricing center and establish a unified yuan clearing house.

The yuan bond market is critical to the yuan market as a whole and the capacity to accommodate sufficient cross-border capital and highly heterogeneous investment and financing needs.

The bond market, now fragmented, is limiting financial innovation. Shenzhen Ping An Bank's recent asset securitization program controversy reflects the market's vulnerability. In this regard, the regulators have set out no clear timetable. Setting up a yuan bond market may be the last step in reform for internationalization of the yuan.

The author is a researcher with Anbound Consulting, a think tank for public policy. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 07/25/2014 page11)