Yuan poised to pressure the dollar

China's economy is growing rapidly and as it does so its currency is playing an increasingly powerful role on the world stage but can it threaten the dollar's position?

More global businesses are settling their debts in the yuan and offshore funds are investing in it but analysts say the US dollar will remain the first-choice global currency for some time.

China's currency is poised for a bigger role on the global stage as its economy continues to grow at breakneck pace.

More global businesses, including those in the UAE, are settling their debts in the yuan and offshore investors are sinking funds into the currency. But analysts say the redback still has a long way to go before it can knock the greenback off its perch as the first-choice global currency. Excessive red tape is one of the key problems.

So what is the outlook for the yuan? The National looks at the currency's future and how it may affect the Gulf.

How soon will the yuan become an international currency to compete with the US dollar?

China may have emerged as the world's second-biggest economy in recent years but so far its currency's global status has not reflected the nation's surging dominance. Slowly but surely, however, use of the yuan is increasing in a trend likely to lead to a radical altering of the global monetary system.

China has taken major steps to promote the yuan as a trade and investment currency. But for the yuan to compete with heavyweights such as the dollar and the euro, policymakers have to transform it into a reserve currency for central banks as well as retail investors.

For that to happen, restrictions over its convertibility need to be lifted, say economists. In effect that means making it easier to exchange the yuan into gold or other currencies.

"At the very least it could take five years for the yuan to become fully convertible," says Mark McFarland, an emerging markets economist at Emirates NBD. "A lot depends on the openness of the financial markets in China and the willingness of the international financial community to trade in the currency."

China's bid to turn the yuan into an international currency is helped by the problems with the US dollar. The current global reserve currency has lost its sparkle since the economic financial crisis, and ballooning deficits in the US.

Economists point out investor concerns about the US reaching its sovereign debt ceiling and uncertainty about the end of the country's financial stimulus measures have accelerated the dollar's longer-term slide.

Many are predicting the end of the dollar's dominance in the coming years. By 2025, the most likely scenario for the international monetary system is a multi-currency framework centred on the dollar, the euro and the yuan, a World Bank report released last week predicted.

So what is what holding back the yuan from becoming a global currency?

Businesses, governments or individuals wanting to exchange dollars into euros or yen into Swiss francs are able to do so freely. In contrast, trading and investing with the yuan can be more troublesome.

"Restrictions on currency convertibility are one avenue in which the attractiveness of the [yuan] as an international currency is constrained," Justin Yifu Lin, the chief economist at the World Bank, wrote in a report released last week.

At the moment, the yuan can be converted into other currencies for payments of goods and services but capital inflows and outflows are subject to tough restrictions. Yuan held by foreigners or by Chinese residents can be exchanged but up to a limit of US$200,000 (Dh734,610). Anything above that amount and the sort of red tape holding back the currency from becoming fully convertible becomes a problem. A stumbling block for investors or businesses wanting to buy the currency is that restrictions mean they cannot freely acquire Chinese assets in exchange for their own currency. Foreign firms often have to ask their Chinese trading partner to open a yuan account for them in China with which to pay for goods or services. This then has to be approved by China's financial authorities.

What factors have been driving the yuan?

With China forecast to overtake the US as the world's biggest economy within the next few decades, more investors are keen to share in the success of the Asian powerhouse. That means holding yuan assets.

China's currency has already climbed almost 5 per cent since it was de-pegged from the dollar in June last year. The government is under pressure from the US to loosen controls to allow the appreciation to speed up.

China has made progress towards achieving its goal of boosting the yuan's use in global trade. Shifts in the pattern of trade from developed to emerging markets have benefited China as more nations move from trading in dollars to the yuan. By 2015, international business worth about $2 trillion - more than half of China's trade - will be settled in the yuan, HSBC forecasts.

Regional traders are playing their part in the growing use of the yuan. According to HSBC's latest Trade Confidence Index, as much as 13 per cent of traders from the region said they would use the yuan to settle deals in the next six months.

"Foreign exporters will gain a margin in the [yuan] at no additional transaction cost," says Donna Kwok, a China economist at HSBC. Signs are emerging of regional importers using the currency, too, as they come under pressure from Chinese manufacturers to pay for goods in the currency. Paying for goods in the yuan now can allow traders to hedge against the risk of future exchange rate fluctuations.

Moves to start positioning the yuan as an investment currency have also been successful. That process began in July last year with the creation of an offshore inter-bank market for the yuan in Hong Kong. It allowed foreign investors to issue so-called dim sum bonds, investment vehicles priced in offshore yuan.

What are the chances of the GCC swapping its currency pegs from the US dollar to the yuan?

With oil still priced in US dollars any move to abandon GCC pegs to the greenback in favour of the yuan is unlikely, say analysts. Before that could happen the yuan would have to be established as a reserve currency. A more likely scenario could be a gradual move towards a currency basket, heavily weighted in dollars but also including the yuan and other important currencies such as the euro.

"As China becomes a more important trading partner with the GCC, the currency's role will increase," says Mahmood al Aradi, the senior executive vice president of financial markets at National Bank of Abu Dhabi. China is expected to become the GCC's most important economic partner by 2020, according to the findings of an Economist Intelligence Unit report published this month. Oil consumption in Asia is predicted to grow by 4.4 per cent in the next five years, while demand for the commodity from US and other western economies was expected to plateau, the report revealed.