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UPDATED: January 27, 2011 NO. 5 FEBRUARY 3, 2011
Yuan Sets Sail
Wide use of the yuan in direct investment overseas marks a step toward a fully convertible currency

WELCOME INVESTMENT: Employees at a scotch tape plant in Kyrgyzstan tend to tape products. The company has investment from Chinese investors (SHA DATI)

But since China adopts foreign exchange controls and the yuan is not fully convertible on the current account, foreign entrepreneurs, after getting a large sum of yuan but unable to exchange it to their own country's currency or the U.S. dollar, might be less willing to use the Chinese currency.

Since the Chinese Government now allows yuan settlement in ODI, it means China is ready to make breakthroughs in liberalizing its capital account.

The latest progress is that starting in 2011, U.S. citizens can buy the yuan worth up to $4,000 a day per person at the Bank of China's New York Branch.

A research report published by the Agricultural Bank of China also pointed out the yuan settlement in ODI further stimulated the yuan's convertibility under the capital account.

In the wake of the financial crisis, some of China's trading partners have started using the yuan as a settlement currency to avoid currency risks from sharp fluctuations in the U.S. dollar and the euro. The international community needs to diversify the risks of relying too much on the U.S. dollar so that the yuan will gradually become a choice for settlement, said the report. Meanwhile, the expected yuan appreciation creates an advantageous condition for its internationalization.

Guo said the yuan's internationalization is conducive to the development of the Chinese economy—it opens the way for the yuan to flow into overseas markets and increases the yuan supply in the international market to ease inflation and excess liquidity on the domestic market.

Major concerns

Allowing the yuan to be used directly in overseas investments is bound to increase the stocks of yuan in those markets. Therefore, the yuan's flowing back into China becomes a problem.

As for China, building a yuan return flow mechanism is a necessary step in realizing the free convertibility of the Chinese currency. Meanwhile, it is necessary to increase the scale of the yuan's circulation and use to make it fully convertible under the current account and make overseas institutions or individuals willing to hold the yuan.

As a matter of fact, with yuan settlement implemented in foreign trade, China has been confronting the return flow problem. A report released by the auditing firm Deloitte at the Asian Financial Forum held in Hong Kong on January 17 said the low yield in overseas markets led the yuan to flow back to the Chinese mainland market.

Zhang Jianjun, head of the Shenzhen Branch of the People's Bank of China, said Shenzhen and several other inland cities have facilitated overseas yuan investment in the form of foreign direct investment (FDI) on the Chinese mainland, but the amount involved in the 20-30 transactions has been small. For now, relevant departments are working on regulation guiding the yuan return flows.

Wang Yong, a professor at the central bank's training institution in Zhengzhou, Henan Province, said apart from the problem of the yuan's return flow, there are three important issues that need immediate attention.

First, along with the progress of the yuan settlement in both cross-border trade and ODI, overseas enterprises may lack yuan funds and investment channels.

Second, China should immediately readjust the supervision method of cross-border capital movements. When dealing with ODI businesses, Chinese banks must be vigilant against money laundering and terrorist financing.

Third, after the yuan is used to cross-border trade settlement, overseas yuan debt will be formed. When the debt reaches a certain scale, the yuan will be held in a large amount by overseas investors. The sum of money will flow in and out along with the yield fluctuations in domestic and foreign currency markets. Reasonably managing capital supply will become a challenge to the central bank's policymaking skills.

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