TRADE
Cross-Border RMB Trade Settlement
November 11, 2009
Chris Lewis, Head of Trade and Supply Chain, Greater China at HSBC

In July 2009, the People's Bank of China (PBOC) released the final details of a pilot scheme that allows trade between the Chinese mainland and Hong Kong, Macau and certain countries of the Association of Southeast Asian Nations to be settled in renminbi (RMB).

While the initial pilot is relatively modest in scope, there are expectations that it will be extended in due course to include other countries.

In the short term it seems probable that the initiative will replace the use of U.S. dollars and euros in some existing trade transactions. However, in the medium to long term there are hopes that it will lead to significant new trade activity as new participants are attracted by the advantages of RMB settlement.

An announcement in April 2009 revealed that the pilot project would operate between five designated mainland cities (Shanghai, and four cities in Guangdong-Guangzhou,Shenzhen, Zhuhai and Dongguan) and Hong Kong/Macau. The final announcement of the pilot scheme by the PBOC in early July actually extended the pilot to let these cities settle trade with countries of the Association of Southeast Asian Nations (ASEAN) in RMB. (It was originally anticipated that this would not happen until a later phase of the pilot.)

Details of the pilot program

Around 400 corporates will take part in the pilot program, according to PBOC.

Although the pilot program is modest, it is nevertheless a significant and very welcome step. Hong Kong and Macau have their own currencies, which are also both pegged to the U.S.. These linkages will give participants an indication of the likely response if the program is expanded to include direct USD trade between mainland companies and trading partners in countries outside the initial pilot.

Settlement of trade transactions in China will take place through Bank of China (Hong Kong), or mainland correspondent banks via a nostro account.

The pilot for Hong Kong/Macau extends internationalization of the RMB.

In the short term, this conservative approach may result in a fairly modest effect on trade flows. However, companies that have the need and can see the potential benefits, and will be willing to settle trade in RMB.

These benefits could drive a significant, albeit smallscale, currency switch, as importers and exporters come to appreciate the potential advantages for their businesses. Nevertheless some mainland companies may have to take a fairly cautious approach, as some of their customers may insist on continuing to be billed in USD or euros (EUR). While their suppliers may accept being paid in RMB, this will have little effect on its wider adoption if they prefer not to hold RMB and always hedge or translate back into their domestic currency.

Even where trading partners do adopt the RMB for settling their transactions, this is unlikely to drive a significant expansion in total trade with China in the early stages. In most cases, it will be a case of RMB being substituted for transactions currently being executed in USD or (to a lesser extent, EUR).

The implications for Hong Kong as a trade center also are interesting. Companies both within and beyond Asia may be encouraged by the pilot to establish entities in Hong Kong to execute trade business in RMB. Ultimately they may use Hong Kong as a hub from which to conduct back-to- back trade beyond the special administrative region.

Beyond short term

While the short-term effects of the RMB trade pilot seem likely to be relatively low key, the medium- to long-term picture is a different matter. If China extends the pilot , it is likely that domestically focused Chinese companies will be inclined to rethink their business strategy. They may previously have been deterred from international trade by the prospect of having to manage USD or EUR currency risk, but will be more inclined to expand into this area if they can settle and/or hedge easily in their domestic currency.

While the USD has a long history as the currency of trade, the sheer volume of non-US-related China trade now flowing makes the RMB an attractive alternative. At present, the European Union is still comfortably China's largest bilateral trading partner, with the U.S. second. However, China's trade with other nations-particularlythe other BRIC countries (Brazil, Russia and India)-hasgrown phenomenally in recent years. Therefore, from the perspective of trade between Chinese companies and their customers/suppliers outside the U.S., trading directly in RMB (as opposed to using the USD as an intermediary currency) makes sense.

If the RMB continues to become more accessible as a trade currency, further positive considerations kick in. Given the robust state of China's economy compared to the current condition of other major trade nations such as the U.S., it seems reasonable to assume that the RMB would be similarly robust as a currency. If that assumption proves valid, then a growing number of China's trading partners would be content to hold RMB as an appreciating/strong currency, rather than always hedging out.

At present, the huge liquidity of USD spot and derivative markets make hedging reasonably cost-efficient, but there is still some frictional cost to using it as an intermediary currency. Assuming the availability of liquid RMB hedging and trade finance instruments (see "From the Bank Side" below) some non-US suppliers to Chinese companies may see further potential in adopting it for trade. Switching from billing their Chinese customers in USD to billing them in RMB may offer the opportunity to expand margins, while also reducing risks and hedging costs.

The bank perspective

While many of the fundamentals for greater trade adoption of RMB are positive, a critical factor will be the pricing and availability of suitable bank products. This depends on the efficiency of the methods available to banks to hedge and raise funds in RMB. On this point there has been some talk of allowing China-based subsidiaries of Hong Kong banks to raise RMB funds in Hong Kong. (HSBC has just completed such a fundraising exercise in Hong Kong and it is expected that other banks will shortly follow suit.) While there is a non-deliverable forwards market in RMB, growth and usage of other RMB derivatives has been limited.

If there is insufficient liquidity available in the interbank derivatives market for offsetting RMB risk, then pricing and availability to importers/exporters will be impacted and demand for RMB-denominated trade reduced. The key is how this can be facilitated and extended without giving rise to unwanted speculative activity. There are signs that the Chinese authorities are putting the appropriate derivatives infrastructure in place. For example, the PBOC made an announcement in March 2009 approving the consolidation of various derivatives master agreements into one uniform master agreement.

Conclusion

It is clear that greater levels of RMB-denominated trade could in the mid- to long-term prove highly positive for global trade volumes. While it may be premature to predict a significant decline in USD-denominated trade, it is certainly safe to assume that many trade participants will see the recent moves by the Chinese government and the PBOC as highly positive.

The key will be at what point new participants expand their domestic focus to a global one and/or existing trade participants ramp up their activity in response to the RMB opportunity. Predicting this tipping point with any degree of accuracy is impossible, but it is obvious that the range, availability and pricing of RMB trade finance and hedging provided by banks will have a huge influence on its timing.

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