16 January 2012 Last updated at 12:49 ET

Article written by Stephanie Flanders Economics editor

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Mr Osborne and China's long road to a global currency

 

After months of running back and forth to Brussels, you can see why the Chancellor would want to jump on a plane to Hong Kong. Next stop is Beijing - then I will catch up with him in Tokyo.

As Robert Peston has written, the "news" out of Hong Kong was that Mr Osborne is keen to get the city a big slice of the new booming offshore trade in the Chinese currency, the renminbi.

You can see why. For many, it's now only a matter of time before the Chinese currency displaces the dollar as the world's reserve currency - or at least becomes a major secondary reserve currency like, er, the euro or the yen.

But before the Chancellor or anyone else gets too excited, they might want to read Sebastian Mallaby and Olin Wethington's article in the latest issue of Foreign Affairs.

In their view: "Beijing's steps toward currency internationalisation reflect not a fully formed, coherent long-term strategy but rather an evolving process shaped by splits among China's policymakers over the scope and speed of financial reform.

"Far from confirming the inevitability of the yuan's rise, China's uncertain effort to internationalise its currency has exposed the profound struggles that lie behind the country's larger push to transform its economic model."

As they point out, it has usually taken a long time for currencies to emerge onto the world stage - and, in most cases, countries have actively resisted it.

The US overtook Britain as the largest economy in the 1870s, but the dollar didn't truly displace sterling as the world's anchor currency until the 1930s.

Sheer inertia, and tradition, played a part. But there was also the fact that, for most of the interwar period, the US didn't want the job.

US politicians didn't want higher demand for the dollar, as it would push up its value and make domestic producers uncompetitive.

They also wanted to keep control of their fairly closed and highly regulated national financial system. Becoming a major reserve currency was likely to get in the way of that, too.

In the 1970s, Germany and Japan resisted a larger role for the D-mark and the yen for similar reasons. And in the lead up to the 2008 crisis, China had exactly the same reasons for holding back on the internationalisation of the yuan.

With a heavily export-led development model, the feeling was that it was in China's interest to prop up the dollar system. They built up trillions in dollars in reserves to keep the Chinese currency under-valued, and maintained tight capital controls to keep domestic savers beholden to domestic (state-owned) banks.

But then came 2008, and a financial crisis and global recession that highlighted the dangers to China of relying on US export markets, and made the authorities worry they were going to lose their shirt on all their US assets.

Even as the crisis was still raging, in March 2009, Zhou Xiaochuan, the governor of the People's Bank of China started to talk about moving to a different kind of international currency system, with better alternatives to the dollar. Chinese officials all started to big up the role of the renminbi.

This was good news for reformists who had long wanted to see a more open financial system - and an economy less dependent on a weak currency and strong exports.

Before the crisis, when these reformers talked about a carving a bigger global role for the yuan, they were said to be caving in to US pressure to revalue. These days it is downright patriotic.

But, as Mallaby and Wethington write, even if reformers and others within the Chinese leadership could now unite around carving a bigger international role for the yuan, the commitment to internationalisation was pretty one-sided:

"In effect, the government wanted to have it both ways: booming exports, but reduced accumulation of dollars; continued funnelling of cheap loans to favoured companies at the expense of savers, but also more domestic consumption.

"Internationalisation of the yuan emerged as an official goal not because it resolved the long-running debate between reformers and mainstream opinion. Rather, it became policy precisely because it blurred that division, allowing people who disagreed to unite - at least in the short term."

What, you might well ask, does any of this have to do with George Osborne and his exciting plans for the city and the renminbi?

The reason it matters is that the very rapid development of trade in renminbi market is the direct result of this uneasy truce over the future direction of China's economy.

When you stop to think about it for a minute, it is actually very odd that the offshore renminbi market has developed as quickly as it has. Odd, not because there aren't a lot of people around the world clamouring to hold the Chinese currency - but because it has become before anything else.

Usually, the internationalisation of the currency is the endpoint of a long process. Countries gradually deepen and develop the domestic financial, then they start to open up to capital inflows and allow domestic investors to send money abroad. Letting the currency trade internationally is the last step.

But, as we've seen, the Chinese don't want any of those other steps, so they have done exactly the reverse.

The result is the booming RMB trade that Robert Peston describes in his blog, and Mr Osborne is understandably keen to push the city's way. Who wouldn't want a piece of it, when analysts are expecting yuan deposits in Hong Kong to quadruple in the next 12 months, to $340bn?

Except, that rapid growth is actually one of the unintended consequences of the authorities' decision to let Chinese regions conduct trade with Hong Kong in yuan, which is causing growing headaches for the authorities.

The key issue is that the new trade has created a wedge between the government-controlled, onshore exchange rate (CNY) and the offshore currency as it trades in Hong Kong, which is known as CNH.

Foreigners have bid up the CNH, giving Chinese importers an incentive to park their money in Hong Kong and use CNH to buy goods from abroad. But of course, the opposite is true of exporters, who have an incentive to use the weaker, government-controlled CNY.

One upshot is that growing mountain of yuan deposits in Hong Kong - because all this wonderful trade in renminbi is essentially one way. Importers send Chinese yuan out, but Chinese exporters don't use this market to bring the yuan back in.

The new money makes for good business in Hong Kong, and maybe the City of London as well, but it's a lousy deal for the People's Bank of China, because selling dollars to importers was the one way it used to offload the foreign currency it was forced to buy in the market, to keep the yuan from appreciating. With importers now getting their dollars in Hong Kong - at the better international rate - the People's Bank is getting landed with even more of them.

The upshot is that, far from taking China closer to a freely floating global currency - the offshore trade is actually take it further away, with the central bank intervening in the markets even more than before.

This won't necessarily end in disaster. After all, the Chinese have been unorthodox in their approach to most things. It hasn't blown up in their face yet.

But as with the rest of China's growth model, the imbalances created by its lopsided approach to internationalising the currency will eventually have to be resolved. On past form, they will not necessarily be resolved in favour of more free trading in yuan.

Bottom line? We should be wary of assuming that the offshore trade in renminbi out of Hong Kong is the first step on the road to the yuan as a major global currency, with the City taking a big piece of the action.

It might eventually end up there. But don't expect it to happen quickly - or smoothly.