(Nov 21, 2014)

Many of you may have read in the news that a particular country has established an offshore trading center for the Chinese currency the Renminbi. Recently, Singapore became South East Asia’s RMB trading hub and last week Toronto became North America’s.

But what does this mean?

Imagine you have an acquaintance in Brazil. You both wish to do business with each other and also buy things in the each other’s country. Wiring money is expensive and so is getting a loan in a foreign country. Therefore, you might agree to establish an arrangement whereby you will provide each other with credit so that you can spend money in each other’s countries. Any discrepancy between interest rates would need to be balanced. Whilst this is more convenient, you run the risk of buying a car for your Brazilian partner only to not have the favour returned later. It would be sensible to establish a maximum amount of credit.

This in short, has been the system used by sovereign countries to facilitate trade for many years – backed by only a token amount of physical cash. It requires two things; firstly the need to trade and secondly trust. China’s rapid growth since the 1990’s has made it a major force in world trade, importing raw materials and high end goods and exporting manufactured products. Yet there has traditionally been a mutual lack of trust and therefore no currency swap arrangements.

This began to change in 2004 when an extremely cautious China started to allow Yuan (RMB) to be used for personal accounts in Hong Kong and business accounts with some ASEAN countries in 2008. There are now 28 countries with Bilateral Swap Agreements with China and some 20 international banks that trade RMB. The combined value of these swap lines has also swelled to approximately $500 billion.

Why is this important?

RMB becoming used for trade finance is only stage one of three, according to SWIFT. The next two stages are for RMB to become used for investment and lastly for it to become a reserve currency. Clearly, it is impossible for small, unrelated countries such as Iceland and Peru to keep meaningful lines of credit available just in case they were needed. Instead, they would agree to settle debts in one of the four larger, more liquid reserve currencies: USD, EUR, GBP or JPY. Therefore, countries and financial institutions invest in these currencies safe in the knowledge that they will easily be used in the future.

Clearly, China will eventually have to become part of the reserve currency club sooner or later. It remains to be seen whether she can or wishes to, make the RMB the world reserve currency and displace the USD. It is helpful to bear in mind that according to SWIFT, whilst the value of RMB as a world payments currency has leapt from a tiny 0.63% in 2013 to 1.47% in 2014 it has also jumped from #13 in the world to #7. Other nations’ currencies must continue to give way. If any of the four incumbent reserve currencies are displaced by RMB rather than joined by it they will lose a great deal of their value and purchasing power.

The world and its monetary system is changing. It is important to know in which direction.