Over the weekend, millions of Chinese exchanged red envelopes filled with cash to celebrate the advent of the Year of the Snake. Oddly, most of those envelopes contained a currency that lumbers in the shadows of international markets, the yuan. The world's biggest exporter and second-largest economy still lacks a currency that can be used freely around the globe. China wants this to change, but how and when?
These are questions of intense interest to investors, speculators, and corporate managers around the globe. Right now, the yuan's value moves within a band enforced by the People's Bank of China, and there are restrictions on how it can be used by foreigners. A convertible yuan would trade without limits on currency markets, becoming more liquid, permitting bigger transactions, and responding more quickly to changes in the demand for Chinese assets and products. Convertibility would also pave the way for the yuan's use as a reserve currency by central banks and sovereign wealth funds, and perhaps even as the standard currency for pricing some commodities, such as copper.
These things would benefit China. When other countries use your currency for their reserves, they link their economic fortunes to yours. The stability of your currency is of material interest to them, and they can even help to defend your currency against speculative attacks or other unwanted fluctuations. And when your currency is used in trade, the private sector needs to hold more of it, lowering the cost of financing.
Naturally, China's present regime for the yuan also has some benefits. People who do business with China can count on a fairly narrow range for exchange rates, so it's easier to make long-term contracts. Convertibility would erase this implicit guarantee, but it would simultaneously solve the problem of volatility by opening the door to much greater hedging. Multinational companies could trade yuan and related derivatives by the billion to balance their risks. So far, China has taken only baby steps in this direction, with the first yuan futures hitting the markets just last September.
Typically, a country in China's situation might move to convertibility once it felt comfortable opening its financial markets and relying on domestic demand to drive the economy. But China has a complication: Hong Kong. The city-state became part of the People's Republic in 1997, but it maintains its own economic system and its own currency, the Hong Kong dollar (HKD). With a population of just 7 million, its exports amount to a quarter of the total for the rest of China.
Just as convertibility is a long-term goal, so is reincorporation of Hong Kong into the Chinese economy. Today this process would be like a snake swallowing an ostrich egg. Yet China is changing rapidly, both in terms of financial sophistication and the openness of its markets. With time, Hong Kong will be less different from the rest of China, and thus the separation will seem less necessary. If the yuan is to become convertible, it will likely be as part of a long-term plan for economic convergence.