Sign of the times: a Hong Kong shop advertises that it takes renminbi. Residents of the territory may buy up to US$2,500 worth a day but it is in trade that the use of the Chinese currency is first establishing itself outside the mainland

So new is the trade in offshore Chinese currency bonds that it has yet to gain a proper name. For want of anything else, it is often dubbed the “dim sum” market, in culinary recognition of its Hong Kong home base.

In spite of its infancy, interest in the market is growing quickly. Caterpillar, the US-based maker of earthmoving equipment, launched a Rmb1bn ($150m) bond issue last month, making it the second multinational to tap the market, following an August issue by McDonald’s, the fast-food chain.

What makes these bond issues important is that the offshore renminbi market is much more than just a new avenue for debt financing – it is one of the core components in a plan to internationalise the Chinese currency. The process will be a slow one, with more baby steps than giant leaps, and it is by no means assured that the renminbi – also known as the yuan – will forge a decisive international role. But it is one that could have a huge long-term impact on trade, the global financial system and even international politics.

If the plan works, the renminbi could become the main currency for doing business in Asia, the world’s most economically dynamic region, and in the long run it could become a significant part of the reserves of the world’s central banks. Indeed, some Chinese officials have already called for the renminbi to be included in the International Monetary Fund’s basket of main currencies.

A case for the basket

Some Beijing policymakers would like to see the renminbi included in the International Monetary Fund’s basket of main currencies – the so-called special drawing rights.

The Group of 20 industrial and developing nations, next year chaired by France, may discuss its addition. Joining a basket that includes the dollar, euro, yen and sterling would give China’s currency a big credibility boost.

The IMF itself said last month, however, that the renminbi was not ready to be part of the SDR because it does not yet pass the test of being “freely usable”.

The timing is also full of portents. The renminbi is starting to go global just as the future of the euro is looking increasingly uncertain. Eventually the shift could have an impact on the ability of the US to borrow overseas in its own currency. In China, some have taken to calling their currency the hongbi, or “redback”, to rival America’s greenback – a moniker that gives a flavour of the geopolitical undercurrents.

“We may be on the verge of a financial revolution of truly epic proportions,” says Qu Hongbin, China economist at HSBC, one of the banks pushing the renminbi to its corporate clients. “The world economy is, slowly but surely, moving from greenbacks to redbacks.”

In many ways, the surprise is how little the renminbi is currently used outside China’s borders. China is now the second-largest economy in the world, the largest exporter of manufactured goods and holder of the largest volume of foreign exchange reserves. Yet the amount of the currency held overseas is negligible – the result of China’s strict capital controls and restrictions on currency trade.

“If aliens landed on earth today, they would look at the current global monetary system and think it is very weird and unreasonable,” Li Daokui, who sits on the monetary policy committee of the People’s Bank of China, told a forum in Beijing last month.

Yet the financial crisis has changed attitudes in Beijing and bolstered support for China to seek a greater international role for its currency. Officials argue that the crisis came about because the international monetary system allows the US to run unsustainable current account deficits. As a result, over the past year Beijing has put in place some of the conditions for the renminbi to go global.

The first step has been to encourage international trade to be conducted in renminbi. That process accelerated in June, when China expanded its year-old renminbi trade settlement scheme to every country in the world and to 20 Chinese provinces and municipalities, allowing imports and exports to be invoiced and settled in renminbi.

Even if the use of the currency is to be limited to trade, companies and banks still need to be able to hold and invest renminbi offshore – which started to become possible in some scale from July when the authorities allowed renminbi-denominated financial markets to spring to life in Hong Kong. A month later, a select group of investors, including foreign central banks, were given limited access to China’s onshore bond market. Malaysia is believed to have become the first central bank to hold mainland renminbi assets in its reserves.

The effect has been dramatic. The People’s Bank says trade settled in renminbi totalled Rmb340bn between June and November – from zero just a year and a half ago. The pace has stunned senior western bankers who know the region. Renminbi deposits in Hong Kong banks surged 45 per cent in October to Rmb217bn – another reflection of the use of the Chinese currency in trade.

For Chinese companies, the attractions of settling cross-border trade in their own currency are clear. Avoiding the dollar allows them to cut transaction costs and minimise foreign exchange risks – a huge benefit in a world at risk of a global currency war.

Sinochem, China’s biggest trading company, is one of the pioneers. The group’s offshore trading division in Singapore this year received renminbi as payment for sales of petrochemicals, rubber and fertiliser, after what it says were requests to do so from Chinese companies as well as units of Sinochem on the mainland. “This allows us to build a stronger bond with our customers,” says Song Song, finance manager at Sinochem International (Overseas), who expects the trend to continue.

Indeed, an increasing number of western multinationals – including McDonald’s from the US, Ikea and Nokia in the Nordic region and Germany’s Metro – are also experimenting with using the renminbi in trade deals. “For our corporate clients, US dollars and euros are no longer the de facto currencies of trade,” says Shivkumar Seerapu, Asia head of trade finance at Deutsche Bank.

Deutsche, Citigroup and JPMorgan Chase are among banks rapidly building the infrastructure needed to process renminbi transactions across the world. Standard Chartered and its rival HSBC are meanwhile already well placed to capitalise on the internationalisation of the renminbi because they have strong positions in Hong Kong, the designated offshore centre for the Chinese currency. Makers of products “from garments to gas cylinders” have started using the renminbi, says Neil Daswani, head of transaction banking for North Asia at Standard Chartered.

Demand has been strongest from Hong Kong, he adds, but has also come from Singapore, Malaysia, South Korea, Japan, the Middle East and the UK. According to economists and trade finance experts, the use of the renminbi in trade is likely to take off first in Asia and then between China and other developing countries.

HONG KONG

A dual currency city where China’s coinage is king

For those who think that nothing can displace the greenback as the world’s reserve currency, Hong Kong comes as a shock. The former British colony, now a “special administrative region” of China, is already a special financial region as well – at least informally.

Officially, the Hong Kong dollar is pegged to the US dollar. Unofficially, though, Hong Kong is already a dual currency city. If most of its residents had their way, their currency would be linked to the renminbi instead.

Landlords ask prospective tenants to consider paying their rent in the Chinese currency. Property buyers come increasingly from across the border. Not only are they paying cash for their luxury flats, they are paying that cash in renminbi.

Just about everyone in Hong Kong believes the long-term trend of the Chinese currency is up and that of the dollar is down. Since there is currently not much interest to be earned on bank deposits in Hong Kong or US dollars, there is little incentive to hold either.

Indeed, part of the attraction for expatriates in becoming permanent residents of Hong Kong is that status allows them to buy up to US$2,500 worth of renminbi a day. Economists at Goldman Sachs expect that within five years, renminbi deposits in Hong Kong could amount to as much as Rmb2,000bn ($300bn).

Just about every week, the list of companies issuing renminbi bonds in Hong Kong grows longer, with the territory’s own banks to the fore.

Some residents are pooling their funds to buy into those issues, since they are often so oversubscribed that most retail investors cannot get their hands on nearly as much renminbi bonds as they want. Swiss banks are meanwhile offering renminbi bond funds domiciled in the Cayman Islands.

The increasingly internationalised renminbi is a development that the US Federal Reserve is beginning to monitor. That is not just because the peg to the dollar makes Ben Bernanke, Fed chairman, in effect the territory’s central bank governor and comptroller of Hong Kong’s monetary policy. Hong Kong “is the canary in the coal mine” for those who think that nothing will challenge the reserve status of the US dollar for many years, says one senior Fed official. “Despite capital controls in China, it is already happening.”

“It is the most exciting development,” adds Jim O’Neill, the economist and director of Goldman Sachs Asset Management. “They are experimenting in Hong Kong as a way to see what the price of their currency should be. The policy of internationalising the renminbi is just starting.” Henny Sender

Momentum is clearly gathering behind the renminbi internationalisation drive, yet it is still a highly unusual process and one that is not guaranteed success. In the past, market forces have driven the greater international role of a currency: but in the case of China, that development is being developed by bureaucratic plan. “The attempt to create an international and eventually fully convertible currency through a policy-driven process is unprecedented – nothing like this has ever been tried before, even partially,” says Paola Subacchi of the UK’s Chatham House think-tank in a recent paper. “Beijing is openly aware of the fact that there is no roadmap to guide this process.”

What makes the push even more unusual is that Beijing still intends to retain a raft of capital controls, to insulate its economy and to prevent the currency from becoming fully convertible for the time being, because of the leadership’s fears about the volatility of foreign exchange markets and the impact of open capital flows on the country’s still underdeveloped financial system. As Ms Subacchi says, “past experience shows that convertibility and opening of the capital account have always preceded the international use of a currency, rather than the other way round”.

Instead, China is trying to use Hong Kong as a laboratory, where it can encourage international companies and investors to hold and trade renminbi-denominated products. The dim sum bonds are one part of that plan.

Meanwhile, to boost the foreign availability of renminbi, Beijing has over the past two years signed currency swap agreements with central banks in eight countries – Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Singapore and South Korea – totalling a little over Rmb800bn. The Hong Kong Monetary Authority, the city’s de facto central bank, last month drew down Rmb10bn of its Rmb200bn swap line, opening a new way for commercial banks in the city to obtain renminbi for their corporate clients to use in trade deals. Hong Kong banks can also obtain renminbi via mainland banks and the local branch of Bank of China, subject to quotas.

Chinese officials admit, however, that while the offshore market in Hong Kong can help lay the groundwork for greater international use of the currency in trade, the renminbi cannot become a reserve currency until there is much greater access to the mainland bond markets and the renminbi is easier to trade on the foreign exchange market.

Given China’s caution about liberalising its financial system, all of this suggests a process where the renminbi takes a greater international role over a period measured in decades rather than years, meaning it will be a long time before reserve managers are really considering shifting substantial holdings of dollars into renminbi.

“There’s not a lot of point buying renminbi in Hong Kong if you can’t ultimately buy assets in China,” says John Greenwood, Invesco chief economist and architect of Hong Kong’s exchange rate mechanism. “[But Chinese policymakers] have got to be careful that they don’t make a hole in the dam that allows a huge flood in all directions – either inwards or outwards. China has a long way to go before its domestic capital markets can be opened up to foreign inflows without it being hugely destabilising.”

Yet one of the big questions posed by the Chinese plan is whether the authorities will really be able to keep such a tight rein on the process. HSBC estimates that within three to five years at least half of China’s trade flows with other developing economies will be conducted in renminbi – about $2,000bn – making it one of the three top global trading currencies. With such a huge volume circulating outside the country, it could become much harder to prevent unwanted capital from entering.

By encouraging the use of the renminbi, Beijing is also creating a constituency of investors, companies and central banks that will be lobbying for ever greater access to the currency and to Chinese markets.

Indeed, one reason global financial institutions are so excited about the internationalisation process is that they expect it to punch new channels through the wall of controls that protect the domestic financial system. By pushing for greater use of its currency, China could open up more quickly than many in Beijing might think.