On April 9 the Australian and Chinese governments made an historic announcement: Australia was to become only the third country after the US and Japan whose currency could be direc tly traded with the Chinese renminbi.
The agreement, which was revealed while Australian prime minister Julia Gillard was visiting China, is big news for financial ties between the two countries. It will help cut transaction costs and smooth bilateral trade. It also gives Australia bragging rights, offering proof that it is important to the world’s second-biggest economy. And it marks a vital step towards greater financial integration with China, which is a major strategic aim for Australia.
But for all the potential, it’s best not to get carried away just yet. Analysts say that closer financial integration will take time. And it will depend on China inching towards greater financial liberalisation of its economy.
“[Direct currency trading] is one small step that demonstrates our institutions can talk together,” says James Laurenceson, a senior lecturer specialising in the Chinese economy at the University of Queensland’s School of Economics. “But the really big gains are going to come from changes determined within China itself, not from overseas countries like Australia.”
China has become one of Australia’s key trade partners in the past 10 years. It is Australia’s largest export destination with 26% of its exports going to China last year. Australia is also important to China: some 5% of total Chinese imports originate from Australia, including strategically important resources such as iron ore.
The robustness of the relationship was highlighted with another announcement in April that Australia and China will hold annual leadership discussions that will include the former’s prime minister, treasurer and foreign minister, and their respective Chinese counterparts.
Australia’s desire to form closer ties with China makes sense. Amid signs the mining boom is ending, Canberra wants to exploit other opportunities in what has been dubbed the ‘Asian Century’. It believes that it can turn trading ties with China into financial ties.
“A strong trading relationship provides the basis for a strong financial relationship,” Philip Lowe, the deputy governor of Australia’s central bank, the Reserve Bank of Australia (RBA), said in a recent address to the Australian Chamber of Commerce in Shanghai. “As history shows, finance follows trade. As trade linkages increase, firms require an increasing array of financial services. And a strong trading relationship helps businesses in both countries identify and develop investment opportunities in each other.”
Yet Australia’s current financial ties with China are “extremely limited”, Laurenceson notes, adding “and that’s being generous”.
According to the RBA, China’s stock of investment in Australia was just AUD20 billion (US$20.63 billion) at the end of 2011; it is also dominated by foreign direct investment, which is largely resources-related. The RBA’s Lowe, however, notes that there has been more than a fivefold increase since 2006, though it remains far below the US’s investment in Australia of more than AUD500 billion, which is dominated by portfolio investment.
Australia’s investment in China was also just AUD17 billion in 2011. Lowe says it is likely that the data understated the size of bilateral investment “as some funds are intermediated through financial centres including Hong Kong,” but he concedes that two-way investment flows are in their infancy.
Freeing up direct trading in the two nations’ currencies is a good first step, and it is a political victory for Gillard. But it also marks the first step on a potentially long journey.
Creating confidence
The main obstacle to greater investment and financial integration between Australia and China is the latter’s inbound and outbound capital controls.
“Until it’s freed up, I don’t think you’re going to see particularly close financial linkages,” Laurenceson says.
But Australian authorities, and particularly the RBA, have been moving to at least position the country to increase ties between the two in the event of China’s future financial liberalisation.
The RBA and the People’s Bank of China (PBoC) in March last year signed a swap agreement that allowed for the exchange of local currencies between the two central banks of up to AUD30 billion; it’s the fourth-largest renminbi (RMB) swap. Lowe says that if the swap were to be activated, the RBA intends to make RMB available to all authorised deposit-taking institutions (ADIs) in Australia through a standing facility.
“Its existence provides market participants with greater confidence regarding the availability of RMB liquidity in Australia, particularly during times of stressed market conditions,” Lowe said. “In turn this greater confidence should help build a solid platform for growth in the RMB market in Australia.”
On April 24 the RBA also announced that it would invest some of its foreign-currency reserves in China, marking the first time the central bank will directly invest into the sovereign bond market of any Asian country other than Japan. The RBA said it intends to hold around 5% of Australia’s AUD38 billion foreign-currency assets in China.
“The recent announcement made by the RBA to invest up to 5% of its foreign-exchange reserve in China is a massive step forward for deeper financial ties between the two countries,” says Candy Ho, HSBC’s head of RMB business development for Asia Pacific, in its global markets division.
Lowe thinks that the decision reflects the broader economic relationship between Australia and China and “increasing financial ties”. He made it clear that longer-term strategic positioning drove the decision.
“It provides greater diversification of our investments and will help with our understanding of the Chinese financial markets,” he said in his Shanghai speech. “Over the long run, and particularly as capital-account liberalisation occurs in China, the RMB is likely to become one of the major reserve currencies of the region.”
Technical traction
The agreement to allow direct trading between the RMB and the Australian dollar in the onshore market is seen as another important step towards facilitating financial integration, though many of the benefits are technical.
David Olsson, a partner at King & Wood Mallesons and chairman of the Australian Chamber of Commerce’s China financial services working group, says: “[Direct currency trading] is a genuine win-win situation for Australian and Chinese exporters and importers.”
The immediate opportunity direct exchange creates is the minimisation of transaction costs and settlement risks for Chinese and Australian traders, Olsson says. He adds that Australian exporters should also be able to obtain better pricing through shortened transaction times as some intermediary foreign-exchange documentation and administrative tasks are reduced.
An obvious winner will be Australian small and medium enterprises, which receive RMB for their manufactured exports.
“With a published daily exchange rate the exporter is now able to sell some of the RMB to an Australian importer who imports goods from China and the remaining RMB can be swapped back into Australian dollars, in each case without having to do a swap into US dollars,” Olsson says. “By using RMB as the underlying trade currency, the Australian exporter also has the potential to gain better pricing and access to a wider customer base.”
HSBC’s Ho says there will be notable cost advantages for Australian companies and individuals doing business with China, with Chinese trade partners willing to offer savings to international businesses that trade in RMB. She adds that recent HSBC research of Chinese corporates found that 41% of surveyed Chinese companies are willing to offer price discounts of up to 3% for settling trade in RMB. Another 9% said they are willing to offer even greater discounts.
ANZ and Westpac’s opportunity
The new rules look set to particularly benefit two Australian banks, ANZ and Westpac, which have been granted ‘market maker’ licences. Westpac has been present in China for more than 40 years and has extensive RMB capability there, along with FX operations in Shanghai and Beijing.
Graeme Edie, managing director of foreign exchange trading at Westpac Institutional Bank, says that the licence will allow Westpac to help customers work seamlessly across the two countries. For mainland-based customers, it can also facilitate direct trading between the renminbi and the Australian dollar on the China Foreign Exchange Trading System (CFETS).
Edie says the agreement will save exporters money on transaction costs, but in the longer term it will also give them more opportunity to invest in a range of renminbi-denominated products as China opens up its financial system.
“Exporters who are paying in yuan [another term for the Chinese currency], for instance, would have the option of investing in dim sum bonds – RMB-denominated debt products traded in Hong Kong,” he says.
The agreement should help encourage trading volumes to grow further, Edie adds, especially in the small- to medium-sized businesses that may be unwilling or unable to contract in foreign currency.
“This could benefit Australia’s exporters and importers, as it provides access to a broader Chinese customer base, which may not have been accessible previously.”
Keeping a level head
UQ’s Laurenceson, however, believes the technical benefits of Australian companies trading in the renminbi shouldn’t be overstated.
He says there will be cost savings for businesses, but it is uncertain how many are going to start transacting in renminbi. US dollar transactions are low risk because the currency is very liquid and easy to hedge, which is not the case right now with the Chinese currency.
“There are some very good reasons to be trading in US dollars anyway,” he adds, noting that a lot of trading in Asia is invoiced in US dollars even though direct conversion is available.
Laurenceson argues that the main advantage of the direct currency trading agreement is its “strategic direction-setting benefit” – in other words the positive sign it offers of closer ties between the two countries.
“It’s good to see our institutions [Australia’s and China’s] co-operating and getting deals done,” he says. But Laurenceson also notes that the direct trading agreement “was quite an easy thing to get done. There’s no cost to either party”.
When it comes to more complex issues, such as a free-trade agreement, “it becomes a lot harder to get deals done”.
In many ways this currency agreement is important to Australia not for its own sake, but for the broader strategic opportunities it creates as China moves towards greater financial liberalisation.
“The real benefit for Australia is not the fact that the currencies are directly exchangeable,” Olsson says. “Rather it is that the Australian dollar is now only one of three major currencies directly exchangeable with the RMB. That gives Australia a first-mover advantage to benefit from the introduction to the global economy of another significant currency – potentially with a financial market that will become as large and deep as that of Europe.”
HSBC’s Ho agrees the direct conversion of Australian dollar to renminbi onshore is a “symbolic and positive step forward” in supporting the growing demand for RMB in payments and settlement, investment and financing globally. “The direct conversion will eventually lead to greater RMB turnover and is a vital move towards building a liquid onshore RMB market,” she says.
China is liberalising its domestic financial markets, including partial liberalisation of interest rates and reforms to state-owned banks. Its willingness to develop the offshore RMB market is another encouraging step. But there’s a long way to go before it fully liberalises its capital account.
Laurenceson says for China to liberalise outbound and inbound portfolio flows it would require flexible exchange rates. “[Without that] the money supply is going up and down with inflows and outflows of capital,” he said.
But it’s unlikely to take place soon, and Australia will have no say in the exact timing. “They’re not going to go to a fully floating exchange rate at the request of the Australian government,” Laurenceson notes, somewhat wryly. “It will be driven by domestic concerns.”
Taking a long-term view
For all their hopes of an improved economic and financial relationship, Australian officials recognise that the liberalisation of capital flows into and out of China will take time.
In a recent address to the Australia-Hong Kong RMB Trade and Investment Dialogue, Martin Parkinson, secretary to the treasury in Australia, said that China has taken major strides by increasing the liquidity and status of its currency offshore, along with progress domestically towards a more liberalised financial sector. “However, there is much more to be done before China’s financial markets and economy are ready for full-scale capital account liberalisation,” he added.
Parkinson said that further financial liberalisation was of critical importance for Australia, but he also demanded “prudence on our part – a clear understanding of how we can participate in the process and a clear appreciation of how we can manage the risks, uncertainties and challenges which will inevitably arise along the way”.
Australia, after all, has been on a similar journey. Until the Australian dollar was floated in the early 1980s, Australia had experimented with different types of fixed exchange rates, complemented by a range of capital controls. “Financial liberalisation and capital-market reform are hard – something we saw clearly in Australia’s own experience,” noted Parkinson.
But the benefits of getting it right are big too, something that Australian policy makers are keen to point out to China.
“After we had tried everything else, in the early 1980s we switched to a floating exchange rate,” the RBA’s Lowe said in his Shanghai address. “The decision has, perhaps, been more important than any other single decision in promoting stability in the Australian economy.”
He added that it had also improved access to credit, boosted financial innovation and competition, and allowed Australia to participate more fully in the global economy. “I suspect that one day China will be able to make the same claims as it, too, continues with its own journey of financial reform.”
Facilitating financial integration
Beijing certainly has many options to facilitate further financial integration, to the benefit of Australia and other nations.
Olsson wants all Australian banks to be granted the necessary renminbi licences in China to let them become market makers for RMB/AUD daily pricing.
He also wants to see the rules for a pilot programme introduced that would allow qualified Australian fund managers to invest RMB funds directly into the Chinese market.
“The new RQFII [renminbi qualified foreign institutional investor] scheme allows Hong Kong residents to do this, but Australian institutions are now well placed to seek similar treatment,” Olsson says.
Ultimately of course, “the real benefit of the new agreements will only be unlocked when Australian firms can freely invest in major sectors of the Chinese market and easily buy and sell securities, fixed-income assets and corporate bonds,” he adds.
Australia is set to reap huge benefits if China frees up its financial markets. The direct trading agreement helps position the country to exploit them. But despite Australia’s opportunities and hopes, it will take time for China to liberalise. Patience will be key.
“We need to get past the notion that Australia can simply wake up one morning, realise that we want something and have it appear,” Parkinson said.