Expanding the near-convertibility of the yuan

WORLD NEWS: "Beijing Aims to Expand Foreign Trade in Yuan," by Denis McMahon, Wall Street Journal, 11-12 April 2009.

China continues to expand the ability of both players within its economy and foreign trade partners to use the yuan in a manner closer to a convertible currency.

The latest announcement is that China designated five of its biggest trading cities to take part in this new program of foreign trade in which entire transactions are conducted in yuan instead of dollars or something else.

China's central bank has also set up billions of currency swaps with South Korea and others (so little yuan is held abroad, that China needs to prime the pump).

China is the world's third largest economy, the article points out, but little of its money travels beyond its borders (the essence of unconvertibility being that people outside your country can't hold onto your currency and thus indirectly influence its exchange value by the volume of their usage; real convertibility would be the option to directly trade currencies [my best attempt off the top of my allergy-addled head to describe this--please correct, anybody]).

Some key bits:

The government maintains strict rules that make it difficult for companies to exchange yuan for foreign currencies--and which help authorities maintain control over the yuan's exchange rate.

The new steps will loosen that system but only within careful parameters. The moves could lead to further opening of China's capital markets, creating the need for yuan derivatives and investment options outside of the country. Eventually, the measures could help make the yuan a more important currency globally and reduce the use of the dollar by one of the world's biggest trading nations.

Using the yuan to settle trade deals would help Chinese companies reduce the risks of exchange-rate fluctuations. Many Chinese exporters lost money last year because the dollar's value fell after they signed orders but before they were paid.

The moves, so far, won't impact U.S.-China trade much at all, but rather will be concentrated in trade with regional partners.

Overall, this is a careful but good move. The more China moves in this direction, the more it'll open its economy to forces that will challenge the government to create more balancing mechanisms/markets across the economy, and that's the right direction in terms of expanding economic freedom. So long as few abroad hold any yuan, Beijing can strictly control its value, but as more yuan circulate, that'll get tougher.

Naturally, Hong Kong is expected to lead the way in this experiment.

The next big step, unlikely any time soon after the financial crisis, would be to do the same in investment markets. For now, China finds that prospect too scary even as it'll eventually need to take this step.