Will yuan become the new default?

As the U.S. tries to disentangle itself from its economic woes, China has slowly started to weave a web around the global currency system. At the core of it is the “redback”—not the Australian spider, but a catchphrase for the renminbi that is fast gaining currency in international finance circles.

While China over the last decade has become a dominant player in the global economy, its monetary policy has also been designed to suppress the renminbi. But following recent reforms, the renminbi has started to acquire some international characteristics, says Philip Poole, global head of macro and investment strategy, HSBC Global Asset Management, in a recent commentary.

“Things are now changing and the currency is internationalizing at pace with the ultimate ambition to make the renminbi a global reserve currency for investment, trade and settlement purposes,” says Poole.

He attributes this push partially to China feeling trapped in its reliance on the U.S. dollar as the principal unit of exchange for its exports and the store of value for the lion’s share of its accumulated foreign exchange reserves holdings.

The internationalization of the renminbi comes at a time when the world is becoming keen to acquire new reserve assets. Investors from retail clients to central banks and sovereign wealth funds are looking to diversify away from the greenback, which many believe is being debased as a result of quantitative easing.

Chinese policy makers have also suggested the International Monetary Fund’s Special Drawing Rights (SDR) as a potential alternative reserve currency, with the renminbi being part of that.

“China has no aversion to the dollar per se, but to potential dollar weakness and particularly its implications for accumulated external savings, much of them held in U.S. Treasurys and other dollar-denominated assets,” says Poole. “The authorities in China fear that dollar weakness could lead to substantial losses in the local currency value of these dollar assets.”

The shift away from the dollar’s global dominance will be gradual, given that China owns so many dollars that it can’t sell them without driving the price down against itself.

However, that has not deterred China from being “at the forefront of the reserve currency debate, actively looking for possibilities to diversify away from the dollar.”

“China is on track to become the world’s largest economy and exporter and historical parallels imply a role for the renminbi as an important reserve currency at some point in the future,” says Poole.

Changes in the approach to the currency have afforded the current foreign exchange regime greater flexibility and the gradual pace of it has allowed authorities to be better prepared to let the currency appreciate.

Poole points out that on the regulatory front, change seems to have gathered pace. “China has set up currency swaps with many other countries including in Latin America and Asia and renminbi bond issuance in Hong Kong [dubbed ‘Dim Sum’ bonds] is growing as a first step towards creating a deep investable bond market for the Redback,” he says.

In the final analysis, Chinese policymakers are keen to internationalize, keeping the offshore renminbi market central to the strategy, the process is already well underway.

“This will open up new investment opportunities in what we believe is likely to remain one of the world’s most rapidly growing, dynamic economies,” says Poole. “In particular, Dim Sum bonds are likely to continue to prove interesting to international investors that cannot directly access renminbi-denominated bonds in the Chinese domestic market and issuers are also likely to be keen to leverage this growing market for funding.”