An international currency is widely held outside the issuing country and used in transactions not just between nationals and non-nationals, but also between non-nationals. It is a unit of account for invoicing trade, denominating financial transactions and currency pegging. It is a medium of exchange for settlement of transactions, for foreign exchange intervention and central bank swaps. It is also a store of value used for currency substitution, cross-border investment and central bank reserves.

What will China gain from internationalising the yuan?

A challenge facing China’s policymakers is the capital preservation of its vast foreign exchange reserves, of which some 60 per cent are in US dollar-denominated assets. An internationalised yuan serving as a reserve currency could help China reduce its US dollar exposure. It could also help China reduce the implicit “seigniorage” charge it pays to the US, given the US dollar’s privileged status as the leading international reserve currency. Other benefits include reducing foreign exchange risk for Chinese businesses and improving funding efficiency of financial institutions.

What are the main impediments to internationalising the yuan?

The main impediments include inadequate breadth of the Chinese financial system and limited competition among its financial institutions. China’s capital markets to a large degree remain closed to foreign investors given the relatively small size of the Qualified Foreign Institutional Investor (QFII) and related schemes. It appears unlikely that the Chinese government will give up control of its capital account in the foreseeable future. While full currency convertibility and capital account liberalisation are not prerequisites for internationalisation, more liberalisation is needed for progress to be made.

How far is the yuan along the road to internationalisation?

China has been a significant fund supplier in bilateral swap agreements that use the yuan as their currency vehicle under the Ching Mai Initiative. This is a multilateral arrangement established in 2000 among the Association of South-East Asian nations (Asean) Plus Three countries to provide short-term liquidity to member central banks to counter currency speculation and avoid a repeat of the 1997 Asian financial crisis.

In 2004, more than 30 banks in Hong Kong started offering yuan deposit-taking, remittances and currency exchange services. In 2007, offshore yuan-denominated bonds, also known as “dimsum” bonds, were first issued in Hong Kong. In the autumn of 2012, yuan currency futures trading will start in Hong Kong.

Central banks including Malaysia, Nigeria, Chile, Thailand, Brazil and Venezuela, have started to include yuan in their reserve portfolios. Recently, the quota for the Hong Kong Monetary Authority to invest its reserves in China’s interbank market was doubled. Yuan internationalisation has progressed to encompass all dimensions from trade invoicing and settlement to investment products to central bank reserves.

How could the yuan be important to the GCC?

Due to strong oil prices, the GCC has managed to build huge financial reserves during the last decade. These financial reserves are mostly denominated in US dollars since most of the GCC currencies are pegged to it and that the price of oil is denominated in the currency. However, the GCC region should look into diversifying into other currencies.

Earlier the euro seemed to be a good alternative, but given the current crisis it has proved the opposite. Increasing trade flows between GCC and the East suggest that an important option may include the Chinese yuan. Also, China can look to engage the rich GCC region along with other Asian countries in its pursuit of its strategic interest to develop yuan as an international currency.

What are the challenges and the next steps?

Given the size of China’s economy and international trade, rapid increases in the international use of yuan in trade invoicing and settlement is almost assured though the volume is still minuscule compared with those of the other main world currencies and fees are still relatively high. However, the yuan’s allocation in central bank reserve portfolios remains insignificant.

One of the Chinese government’s objectives is building up the service infrastructure and yuan-denominated investment products offered via offshore yuan centres. China’s commitment to the development of Hong Kong as a key offshore yuan centre has been enshrined in China’s 12th Five-Year Plan. Offshore yuan centres, which include London and Singapore, play a critical role as a “firewall” prior to the full liberalisation of the capital markets, exchange rate and capital account in China.

Longer term, yuan internationalisation and China’s strategic interest in various Asean countries may strengthen economic ties and could shape a de facto yuan currency bloc among the Asean and Greater China countries. Optimistic analysts have predicted sizable use of the yuan in trade globally and full convertibility in about five years.

— Wendy Guo and Samuel Lum are with CFA Institute’s Asia Pacific Office and Domluke Da Silva is with CFA Emirates