Source: Reuters.com                    Date: 08 July, 2010

Each journey of a thousand miles begins with a single step. Yet for the trek of turning the yuan into a global currency, China is only just lacing up its boots. According to this skeptical line of thinking, it will take Beijing a generation to make the yuan a fully convertible currency that can rub shoulders with the dollar and the euro. But a more tantalizing interpretation of events is that China is proceeding quite nicely in expanding the use of the yuan beyond its borders, underlining its determination to eventually wield more influence in global financial affairs.

What has got optimists excited is the extension on June 17 of a pilot program permitting imports and exports to be settled in yuan, also known as the renminbi, rather than in dollars or other foreign currencies. The scheme was widened to firms in 20 Chinese provinces, not just five southern cities, and to counterparties in all countries, not just in Hong Kong, Macau and Southeast Asia. The experiment got off to a slow start last July but has picked up as procedures have bedded down. Total trade settled in yuan doubled between the end of March and the end of May to 44.6 billion yuan.

That remains a drop in the ocean. But if China stands by the promise it made on June 19 to make the yuan more flexible, the attraction for domestic companies of avoiding foreign exchange risks by invoicing in their home currency can only grow. As for exporters to China, the consensus that the yuan is headed higher is a big incentive to hold renminbi. "We expect more than half of China's total trade flows, primarily bilateral trade with emerging markets, to be settled in renminbi in the next three to five years," Mr. Qu Hongbin, chief China economist at HSBC in Hong Kong, concluded in a report.

It gets more intriguing. Companies outside China will be wary of holding yuan unless they have somewhere to invest it. Putting the money on deposit in Hong Kong, the main conduit for yuan settlement, yields a pittance.

On cue, plans are afoot to broaden the range of renminbi investments available in the territory. A toll-road company has announced the first non-financial renminbi corporate bond issue in Hong Kong. Yuan-denominated insurance policies are expected soon, and the authorities are drawing up plans to let brokerages take yuan deposits and invest them in the mainland capital markets.

As always with financial liberalization in China, the pace will be sensible, not stunning. And not to be forgotten, China has it will make it easier for domestic firms to move money overseas for purposes unrelated to trade or investment.

This gets to the nub of the political motives at work. Resentful of the "exorbitant privilege" the United States enjoys in issuing the leading reserve currency, China would prefer to build up claims on the rest of the world in yuan -- raising its profile in the process -- rather than in a dollar it distrusts.

The IMF is committed to shifting at least 5 percent of its voting powers to its emerging market members, and Managing Director Dominique Strauss-Kahn would like to add new currencies to the SDR basket -- starting with the yuan. If cross-border trade in yuan booms and market forces are gradually allowed to set the yuan's value, China will presumably grow more comfortable with the idea of convertibility. Bringing the yuan into the SDR would be more feasible.

"These are baby steps, not big steps," said an analyst, about Beijing's initiatives. "But they are all steps in the direction of making the renminbi into a more international currency that is commensurate with China's global role, opening up the capital account and moving toward convertibility."