Watch China's FX swaps, not just super-currency plan

BEIJING (Reuters) - On the chess board of currency politics, China has disclosed its endgame in a striking show of confidence ahead of this week’s Group of 20 summit in London.

Just as significant, it is already advancing its pawns.

Beijing’s ultimate goal is to replace the globally dominant dollar with a beefed-up Special Drawing Right, the International Monetary Fund’s in-house unit of account, which would become a “super-sovereign reserve currency”.

The plan, laid out a week ago by central bank governor Zhou Xiaochuan, is bold, thoughtful and visionary. It is also magnificently unrealistic.

The political intent of Zhou’s message could not be clearer: as the crisis of capitalism erodes U.S. influence, China is losing faith in the dollar and sees the time ripening for the yuan to assume its rightful role as a major world currency.

“It has the potential to lead to one of the most profound reforms of the global monetary system in the coming decades,” Jun Ma, Deutsche Bank’s chief China economist, said of Zhou’s blueprint.

However, with 5,000 years of history behind it, Beijing is ready for a long game. Zhou knew his trial balloon would immediately be shot down, save for backing from Russia. Hence his acknowledgement that creating a new international monetary order would require “extraordinary political vision and courage”.

Translation: Beijing realizes that a currency does not lose its global domination overnight. Even after the United States overtook Britain in economic size in the late 19th century, it took two world wars that drained Britain’s Treasury and its military might before the dollar supplanted sterling. The American grandmaster will not surrender his title lightly.

“It’s not a feasible or workable monetary measure,” Zhong Wei, an economics professor at Beijing Normal University, said of Zhou’s proposal.

Rather, he said, the central bank chief was simply rueing the unfairness of today’s global financial order.

“The paper should be read as a complaint from Chinese officials -- and that’s all,” Zhong said.


Perhaps. But Zhou’s essay takes on a different complexion if read in the context of a flurry of moves by China in the usually dull arena of trade finance.

A retail investor looks down in front of a screen showing stock information at a brokerage house in Wuhan, Hubei province, March 30, 2009. REUTERS/Stringer

Since mid-December, China has sealed currency swap accords totaling 650 billion yuan ($95 billion) with the central banks of South Korea, Malaysia, Indonesia, Hong Kong, Belarus and, in a deal announced on Monday, Argentina.

These are pawns that are not being moved at random, and financial diplomats say more agreements are in the pipeline.

The proximate purpose is to grease the wheels of trade, which have been gummed up by the global credit crunch. Importers in the six countries will be able to pay for Chinese goods in yuan instead of in dollars, the principal export-import currency.

But the potential repercussions for global currency politics are more far-reaching: if Asia got accustomed to the practice, the yuan could evolve into a regional currency, giving Beijing the status and influence that goes with it.

A former senior international monetary official said the pacts were in keeping with what he said was China’s greater assertiveness in global forums over the past two years or so.

“They want to play a stronger role, and these small steps such as giving bilateral swaps to Indonesia, Malaysia and Korea are a lot more important than the SDR proposal,” said the official, who declined to be named as the issues are sensitive.

Getting comfortable with the internationalization of the yuan for trade should, in turn and in time, make Beijing more willing to move toward capital account convertibility -- a precondition for the yuan to become part of a revamped SDR.

Now, there is no sign China wants to speed up the opening of its capital account -- even though the yuan, if it could be bought and sold for non-trade purposes, would be more attractive for central banks as an alternative reserve asset to the dollar.

But, as some economists see it, pricing and settling trade in yuan will inevitably lead to greater use of the Chinese currency offshore for financial and investment purposes.

“The swaps should be seen as a political statement with the intention of turning the yuan into a regional reserve currency,” said Ben Simpfendorfer with Royal Bank of Scotland in Hong Kong.


Take the scheme, due to be launched soon, that will allow trade between Hong Kong and the mainland province of Guangdong to be settled in yuan rather than in U.S. or Hong Kong dollars.

The 200 billion yuan swap that Beijing signed with Hong Kong in January will provide an initial pool of Chinese currency needed for paying export and import invoices in yuan.

But imagine if the experiment takes off: banks would eventually need access to the mainland interbank market for funding, according to a financial diplomat in Beijing.

And should banks in Hong Kong -- and other centers -- be allowed to adjust their positions with each other? If so, an offshore interbank market in yuan would sprout.

“We must understand that it is an inevitable trend that an overseas yuan investment market will grow after foreign trade settlement in yuan becomes widely accepted,” Ye Xiang, a co-founder of VisionGain Capital, a Hong Kong investment management firm, wrote in Caijing magazine.

Hong Kong is already a test bed for liberalization of the yuan. In the past few years Beijing has permitted the issuance of yuan-denominated bonds in the city, as well as the establishment of Chinese currency accounts for Hong Kong residents.

Many pieces will need to be moved around the board before China is in a position to force a draw with the dollar, let alone declare checkmate. But Beijing, thinking strategically, is unlikely to be too perturbed if Zhou’s gambit founders in London.

“Whether or not the reserve currency question progresses beyond an intellectual debate, it is clear that China has decided the time is ripe to become proactive in the debate,” Stephen Green and David Mann, economists at Standard Chartered Bank, said in a report.

“The crisis which started in the West is helping to accelerate the ascendancy of economic superpowers in the East.”

($1=6.831 yuan)

Additional reporting by Zhou Xin; Editing by Mathew Veedon