About a month ago, I wrote a post summarizing the steps the Chinese government has already taken on its march to join the US dollar as a world reserve currency. That is to say, Beijing wants the renminbi to be used not only as a reference currency in the worldwide trade in goods and services, but also to be held as a store of value in the coffers of the world’s private and government central banks. Almost no one believes that’s Beijing’s final destination, however. The ultimate goal, I think, is to supplant the dollar, rather than supplement it.
For a while now, China has been encouraging companies involved in international trade to construct and settle their transactions in renminbi instead of (mostly) dollars. To this end, it has been allowing more of its currency to seep out of the mainland and be held legally in foreign banks, notably in Hong Kong. In addition, it has been supplying currency to foreign central banks who want to provide renminbi to firms that make up their countries’ side of the deals. One catch, though: the money can get out of China very easily. Getting it back in is another matter.
Last week, though, according to the Financial Times, Beijing took another step. It is now encouraging Chinese companies that are setting up businesses or making acquisitions abroad to do their business in renminbi, as well. Such deals have to be approved by Beijing, just as any foreign currency purchase would be. Same catch, though: easy to get the money out, but once the cash leaves the mainland, there’s no guarantee it can get back in.
Of course, interest rates are low, so the opportunity cost of holding renminbi in short-term deposits isn’t high. And if you think the Chinese currency is undervalued, you may be willing to bet on having it appreciate. So you might say it’s kind of like gold, only without the physical storage difficulties.
There are two conclusions that I think we can draw from this development:
–the targets are unlikely to be publicly traded companies in the US or Europe. I can’t imagine pension funds or index funds voting in favor of deals that would land them with hundreds of millions of dollars worth of renminbi that they would have to dispose of. I don’t this is that big a change in strategy, since Washington and the EU have made it pretty clear they’ll throw up all sorts of (mostly bogus) political obstacles to almost any deal where the buyer is Chinese.
–If this initiative is successful, China is going to be piling up lots more dollars. China was involved in a tenth of the global merger and acquisition activity last year. The Economist predicts, I think, that this is just the tip of the iceberg. My take on this thrust, plus the foreign aid to Latin America and Africa, and the offers to buy the government bonds of ailing European countries like Greece, is that a good part of China’s motivation has been to try to divest itself of as much of its gigantic hoard of US Treasury bonds before the profligate ways of Washington cause them to lose value. In fact, the cover of the Economist issue (November 13, 2010) that I linked to above has the Chinese buyer offering a wad of American cash.
Suddenly, however, the emphasis has changed from shrinking the central bank’s pile of greenbacks to draining the domestic economy in China of part of its supply of “redbacks,” as some have begun to call the renminbi.
Why? My guess is that Beijing has worked out that it can’t reduce the risk of holding tons of dollars by just spending them as fast as it can. More just keeps on coming in. And it may well lose as much on bad acquisitions as it would on depreciation of the dollar. The only real solution to its currency risk is to push harder to get more renminbi circulating outside the mainland and see what happens.
Step one will be to see if there are any sellers willing to take Chinese currency.
Investment implications? This is more something to keep an eye on than to worry actively about. An increased willingness of China to hold onto dollars would arguably be good for the US currency, at least for a while, and would imply that interest rates might stay a bit lower than they would otherwise. But let’s see how big the offshore renminbi market gets before doing anything else.