The Redback vs. The Greenback: A Global Financial Revolution Begins...

by Tony D'Altorio

The Redback vs. The Greenback: A Global Financial Revolution Begins...

by Tony D'Altorio, Investment U Research

Thursday, December 23, 2010

With a new year almost upon us, investors should take a closer look at the Chinese yuan.

Right now, no international bodies really use it. That's despite China being the second largest global economy, the largest exporter of manufactured goods and the largest holder of foreign exchange reserves.

In the past, China's restrictions on capital controls and currency trading made it easy to dismiss the yuan. But Beijing's attitude is changing now, and other countries are noticing.

Now, the currency is emerging strong as China slowly but surely internationalizes it. As 2011 progresses, it will have a huge impact on trade and global financial markets...

The yuan looks like it could become the main currency of business in the emerging world.

The Yuan's Baby Steps Towards Global Domination

China has already taken some small steps towards making the yuan a global currency.

In the past two years, it signed currency swap agreements with Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Singapore and South Korea. Combined, those deals - intended to boost availability - amounted to 800 billion yuan.

Beijing now strongly encourages international trade settlements to be conducted in yuans. Any country can participate, as can 20 Chinese provinces and municipalities.

In July, China allowed for yuan-denominated financial markets in Hong Kong. A month later, some investors - including central banks - got limited access to China's onshore bond market.

Malaysia's central bank was probably the first to hold such in its reserves. Its eagerness indicates potential demand for yuan assets in the larger continent... more than China will currently allow.

Yet just last month, China and Russia agreed to trade the yuan and ruble against each other in spot inter-bank markets. That will eventually allow them to settle their $40 billion in bilateral trade in their own currencies.

Combined, those small measures have worked wonders, considering that two years ago, there was zero trade settlement in yuan. Yet between June and November 2010, that figure rose to 340 billion ($51 billion).

Meanwhile, yuan deposits in Hong Kong banks surged 45% in October to 217 billion.

Avoiding the U.S. Dollar At All Costs

Chinese companies gain much from settling cross-border trade in their own currency. By avoiding the U.S. dollar, they cut transaction costs and minimize foreign exchange risks.

But more and more multinationals appear interested too. McDonald's (NYSE: MCD) and many European companies are experimenting with using China's currency in trade deals.

Meanwhile, both McDonald's and Caterpillar (NYSE: CAT) are the first multi-nationals to issue yuan-denominated bonds.

Shivkumar Seerapu, the Asia head of trade finance at Deutsche Bank notes, "For our corporate clients, U.S. dollars and euros are no longer the de fact currencies of trade." Recognizing this, global banks like Deutsche Bank (NYSE: DB), Citigroup (NYSE: C) and JPMorgan (NYSE: JPM) are rapidly making a way to process yuan transactions around the world.

Despite those efforts, HSBC Holdings ADR (NYSE: HBC) and Standard Chartered (PINK: SCBFF) already have an edge. Their strong positions in Hong Kong, the designated offshore center for the yuan, give them easy access to the currency.

Neil Daswani, head of transaction banking for North Asia at Standard Chartered, says Hong Kong has the strongest demand for the currency. But Singapore, Malaysia, South Korea, Japan and the Middle East also have notable appetites.

And HSBC gives it 3-5 years before at least half of China's trade with emerging economies will be conducted in yuan. Since that trade flow is currently valued at about $2 trillion, the yuan would easily fit into the top three global trading currencies.

China's Redback vs. America's Greenback

Because of its growing popularity, some people now call the yuan the "hongbi" or "redback." They see it becoming a true global rival to America's greenback.

Qu Hongbin, China economist at HSBC, is one of them: "We may be on the verge of a financial revolution of truly epic proportions. The world economy is, slowly but surely, moving from greenbacks to redbacks."

Yes, it must first escape the dense wall of capital controls that limit foreign inflows and outflows of funds. But as Asian trade settlements rely on it more, the currency will build up outside of China... giving Asian banks every incentive to lobby for increased access.

Eventually, China's currency will become fully convertible. And when it does, Adam Gilmour, co-head of foreign exchange sales for Asia at Citigroup, "expect[s] a significant amount of the world's reserves" to go into it.

For now, private investors have only two easy ways to profit on the new trend: the Market Vectors Chinese Renminbi/USD ETN (NYSE: CNY) and the WisdomTree Dreyfus Chinese Yuan ETF (NYSE: CYB). Though neither offers direct exposure to the yuan, they follow its movements through various derivatives.

But as yuan interest widens and Chinese restrictions fall, better prospects should appear.

Good investing,

Tony D'Altorio

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