China to Test Freer Yuan in Financial Zone

BI: China is Experimenting with a Truly International Currency
China Offshore: Central Bank Allows Chinese Businesses to Settle Trade Using the Rmb
FT: China to Create Special Currency Test Zone
Reuters: China to Experiment with Freer Yuan

On June 28, 2012, China announced plans to create a special financial test zone. The financial test zone is to be located in the city of Shenzhen on mainland China and will allow China to determine how easily Chinese currency can convert into gold and other foreign currencies. This new measure will allow Hong Kong banks to lend renminbi, the official currency of China, directly to companies on mainland China, particularly in the new economic zone of Shenzhen.

The currency experiment aims to increase the flow of the Yuan (the primary unit of the renminbi), between Hong Kong and mainland China. Prior to the announcement, Hong Kong banks could only lend to Chinese clients in Hong Kong, and if the Chinese clients wanted to bring that money into China, they needed approval from the foreign exchange regulator. The Chinese foreign exchange regulator limits the amount of renminbi that can leave and enter mainland China. The Chinese government also has regulations in place to ensure the renminbi cannot travel without restriction across the border for pure financial transactions, like loans. The currency experiment in Shenzhen allows renminbi held by bank lenders overseas to flow back to China because banks in Hong Kong can lend to Chinese clients in Hong Kong, but with the currency experiment, they can also lend to those on mainland China.

China’s currency experiment could prove important to the eventual undoing of capital controls in the country as well as increase the Yuan’s presence overseas. Capital controls are mechanisms the Chinese government uses to regulate the flow of Yuan in and out of the country. For instance, the Chinese government limits the amount of Yuan companies can take out of mainland China for trading and lending as well as the amount they can bring back in. The experiment follows a series of other steps taken by the Chinese government to make the renminbi a more globalized currency that could eventually compete with the U.S. dollar in global markets. A global currency refers to a currency in which the vast majority of international transactions like sales and trades take place, (e.g., the U.S. dollar and the Euro). China’s drive for financial reform includes the goal of making the Yuan convertible to foreign currencies as early as 2015.

Over the past two years, large amounts of Chinese currency have moved abroad for the first time because Chinese companies could settle their international trade in renminbi, rather than first exchanging renminbi to dollars prior to doing business with foreign companies. The allowance of settling international trade in renminbi meant the Chinese Central Bank allowed all businesses that trade with China to use the renminbi in their trade exchanges and in business transactions, such as sales, with each other. Thus, a Chinese company can now pay a European company in renminbi, allowing the outflow of Chinese currency to foreign hands. The Chinese government has also allowed foreign investing institutions a limited but growing selection of investment options for their renminbi holdings, which includes Hong Kong’s dim sum bond market. Hong Kong’s dim sum bond market is a market that sells bonds denominated, or valued, in Chinese Yuan.

Shenzhen, designated as the country’s first special economic zone in 1980, helped to bring foreign investment and free trade to China. This economic zone was the first city that experimented with China’s broader economic reforms that were later rolled out across the country and helped China on its way to becoming the world’s second-largest economy. If the Chinese government follows through with its announced plans in globalizing the Yuan, Chinese currency could be more easily convertible to foreign currencies very soon.