I have been following what China has been doing with its currency since the head of China’s central bank proposed replacing the dollar with an international reserve currency at April's G20 meeting. Today the chairman of China's second largest bank, China Construction Bank, said that he is exploring offering renminbi-denominated trade finance credit that could make the Chinese currency more widely used internationally. More...
Since December, China has signed currency swap agreements with seven of its trading partners including Argentina, Belarus, Brazil, Hong Kong, Indonesia, Malaysia and South Korea which enables these countries to pay for Chinese exports in yuan rather than dollars. This means that 95 billion, in what would normally be dollars, will now be transacted in 650 billion yuan over three years.
China, Argentina's second largest trading partner, entered into a bi-lateral 70 billion yuan ($10.2 billion) currency swap agreement that enabled Argentina to place orders for Chinese imports in yuan and not dollars. They followed with a 100 billion yuan ($14.6 billion) currency swap agreement with Indonesia and a 20 billion yuan ($2.9 billion) agreement with Belarus. Most recently, they closed an agreement with Brazil.
All this activity is making the U.S. general public increasingly fearful that these swap agreements are a step toward making the yuan a convertible currency that will replace the dollar as the world's reserve currency. But the general public doesn't understand the essence of currency swaps and convertible currencies.
First, China’s currency can’t be exchanged on foreign exchange markets for other currencies because the Chinese government has deemed it non-convertible. Unlike the dollar, yen, or euro, this limits the yuan's use in international trade transactions. So China has opted, in the near-term, to enter into these bi-lateral currency swap agreements.
A currency swap between countries is basically a foreign exchange agreement where one currency is traded for another for a negotiated period of time. In essence, the swap is like a loan where one country gives its currency to another in return for an equal amount of the other country's currency at a later date. For example, the U.S. Federal Reserve has been executing currency swaps for years in conjunction with IMF loan programs to support developing nations which might require immediate financial assistance.
Beijing's big concern is the $2 trillion in dollar assets they have accumulated over the years through exports to the U.S. in addition to the huge quanitity of U.S. treasuries they have purchased. China is looking long-term to reduce its reliance on the dollar and thereby its risk. At this point in time, currency swap agreements offer their best option.