What does the Chinese giveaway add up to?

China is loosening controls over its currency. And London is set to become a trading hub for the yuan. But will anyone in the UK benefit beyond currency traders? Ben Chu examines what it all means.

The 1997 transfer of sovereignty over Hong Kong from London to Beijing was dubbed "the great Chinese takeaway". But are the economic benefits now flowing in the other direction? George Osborne certainly thinks so. On a trip to the Far East yesterday, the Chancellor hailed an agreement with the Hong Kong Monetary Authority to make the City of London a hub for the trade of the Chinese currency as excellent news for the British economy.

"I believe we can make Britain the home of Asian investment and Asian finance in the West," Mr Osborne told his audience in the Asian Financial Forum. But what exactly does the currency agreement mean? And is it really the economic boost for Britain that the Chancellor claims?

To answer those questions, a history lesson is useful. When China opened itself up to international trade in the 1980s under the leadership of Deng Xiaoping, the authorities in Beijing kept a firm control over the national currency, the renminbi (RMB), which is also known as the yuan. A Chinese firm exporting goods to the West had to accept US dollars as payment. It then had to exchange those dollars with the Chinese central bank for RMB. There was firm control of currency flows in the other direction too. A Chinese firm that wanted to buy imports from the West had to pay in dollars, which it had first swapped for local currency at the central bank. These controls meant that Beijing prevented RMB from leaving the country.

But in recent years China has begun to allow some foreign firms to pay for Chinese goods in RMB, instead of having to settle in dollars. There has been liberalisation the other way too. A number of Chinese firms can now pay for their imports in RMB. The share of global trade settled in yuan reached 3 per cent last year. A recent report from Chatham House forecasts that by the end of the decade 20 per cent of global trade deals will be conducted in the Chinese currency. Foreign businesses are also sometimes allowed to hold RMB outside of China. In 2011, there was RMB219bn ($33bn) in bank accounts in Hong Kong. Chatham House expects that number to increased 27-fold by 2020. Some large companies have also begun to issue bonds which pay their regular coupons out in RMB.

So where does London fit in to this liberalisation? Until now, Hong Kong has been the only part of the world outside mainland China where the Beijing authorities have allowed the RMB to accumulate in deposits and to be traded. Now London, the world's largest foreign exchange centre, is to be permitted a slice of that action too.

The City is certainly excited about the agreement struck by the Chancellor. "It's a massive benefit for all the major banks" says James Hickman of currency exchange firm Caxton FX. "It's more volume, more revenue. It's all pluses." Mr Hickman is also in no doubt that firms will be eager to get their hands on RMB to conduct their trade with China. "There's huge pent-up demand for the yuan, not just from UK businesses, but businesses globally" he says. Banks say they are preparing to hire more currency traders on the back of the Chinese currency liberalisation. And City lawyers anticipate new flows of businesses which will come from the need for someone to look over the fine print on new RMB bond contracts.

So how big could this get? Could the RMB ultimately become a global reserve currency, used by central banks and savers around the world? Could a Chinese "redback" challenge the supremacy of the American greenback? Some are in no doubt that this is the direction we are headed as China's place in global trade networks becomes ever more entrenched and the the country's economy catches up in size with the US.

"Will the RMB become a global reserve currency? There's no question about it," says Mr Hickman. "The RMB, the dollar and the euro will all be jockeying for position." But not everyone is so sure. Some point out that the dollar's status as the global reserve currency is based on decades of political stability in the US – something that China has yet to demonstrate. "Progress towards the 'yuan tomorrow' is unlikely to be as smooth or swift as many have predicted" says Benjamin Cohen, Professor of International Economics at the University of California, Santa Barbara.

Simon Derrick, chief currency strategist of BNY Mellon, says that nothing will shift overnight. "It takes a long time for people to become comfortable enough to put large chunks of their foreign exchange reserves in your local markets" he says. "Those markets have to be very liquid and China doesn't necessarily fulfil all the requirements yet". Much will depend on how confident investors and businesses are in China's economic future and the stability of the state. At the moment confidence is high. But things might change if China experiences a financial crisis or a hard economic landing after years of breakneck expansion.

It is also remains to be seen how Beijing will adapt to a loss of tight control over its currency. There are benefits from liberalisation. Trade and cross-border investment is made cheaper and easier.

But it also means that a currency can be pushed up or down by speculators and flows of "hot money", as Japan and Switzerland have found to their cost in recent years. China has long had a policy of holding down the value of the yuan in order to boost its domestic export sector. That will be much more difficult after currency liberalisation.

Finally, will the currency deal be good for anyone in the UK beyond a relatively small number of currency traders? The bolstering of the City's status as a trading hub is obviously not going to help to shift the UK economy away from its dependence on financial services. Yet if RMB liberalisation represents a step by China down the road to becoming a full, and responsible, member of global trade and financial networks, the British economy, not just the City of London, should benefit.

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