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Here’s What China Is Secretly Planning for the Yuan

Stefen Chow | Bloomberg | Getty Images

Earth shattering monetary stimulus from the Bank of Japan, a threat to the safety of European deposits (courtesy of the Cyprus bailout), weeks of fretting over U.S. spending cuts - 2013 has given financial market participants an awful lot to digest so far.

This probably explains why perhaps the most significant story of them all seems to have passed most people by - China, and the increasing role its currency is having in the world.

Few would dispute China's end goal of having its currency, the yuan, become a genuine world reserve currency. Who wouldn't want cheap access to world capital markets that reserve currency status brings? Not to mention cheaper transaction costs on international trade.

Indeed most spectators also understand China's political motives in achieving reserve currency status for the yuan (more voting rights at IMF, World Bank etc). However, what does seem to be lost on the financial world right now is how quickly they are getting there.

Before we assess the steps China is taking to achieve this end, let's get reacquainted with the world of foreign currency reserves.

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According to IMF data there is currently approximately $11 trillion of foreign exchange reserves sitting in the coffers of the world's central banks. $6 trillion of this is referred to as "allocated reserves" where the currency composition is known. Most of the remaining $4-5 trillion "unallocated reserves" are owned by China who choose not to divulge the currency composition of their foreign loot.

We know roughly 62 percent of "allocated reserves" are held in U.S. dollars, 23 percent in euros, 4 percent in yen, 4 percent in sterling with the Swiss franc, the Aussie and Canadian dollars making up the tiny remaining balance.

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The most striking aspect of these allocations is how uncorrelated they are to one distribution of international trade and two to distribution of world gross domestic product (GDP).

Most recent International trade data show the largest volume of trade of goods are distributed as follows - European Union 12.3 percent, U.S. 11.3 percent, China 11.3 percent, Japan 5 percent, U.K. 3.3 percent and South Korea 3.3 percent

As regards with world GDP, the order of distribution is not un-similar - E.U. 23 percent, U.S. 21 percent, China 10 percent, Japan 8 percent and U.K. 3.3 percent.

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Those reserve allocations just don't seem right do they?

Of course this issue is far from new - long have central bankers, politicians and economists mooted a fairer and more representative reserve currency system, with SDR (the IMF's Special Drawing Rights) often mentioned.

Well now it seems China's time has come.

Growth in global foreign currency reserves has exploded - the $11 trillion in central bank coffers today is over three times what it was 10 years ago. The dawn of monetary debasement via the printing press has rocked confidence in all the major currencies. Even gold no longer cuts it. The world is crying out for a new store of value - and the Chinese know it.

The Chinese yuan is not freely traded on the open market and its capital markets are far from fully open - so how is the yuan getting into the hands of those desperate to diversify reserves into this currency which offers fundamentally better value?

Stealth - that's how.

As with all matters of strategic importance, China is following a well-planned and controlled path in pushing the yuan to the forefront of the currency world. The authorities in Beijing have been very prescriptive in setting up swap lines between their own central bank (the People's Bank of China) and central banks of their trading partners (swap lines are direct channels between central banks to exchange currency). It is via these swaps line that yuan flows out of China and into the hands foreign corporates, financial institutions and households.

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Consider Mr Tan in Singapore who wishes to have some of his savings in yuan rather than 100 percent in his native currency the Singapore Dollar. He walks into his local bank branch, converts some of his savings into yuan and leaves it in a newly opened account earning a better interest rate that he was getting on his Singapore dollars.

His local bank branch is able to acquire the yuan on his behalf from the Singapore central bank – which in turn was able to acquire it from the Chinese Central bank via the swap line. This process has seen the yuan deposit base outside of China grow substantially, particularly in Hong Kong, Singapore and Taiwan.

Away from retail banking, the offshore yuan deposit base has also seen strong growth via accounts held by corporates. Consider the export company in Singapore trading with mainland China - they may choose to accept payment in yuan and keep it in an account set up in Singapore. Why convert it back to any other currency when the yuan offers better fundamental valuation and a better interest rate on deposits?

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Recent data tell us this process is rapidly accelerating - and of course Singapore is just one country among many where yuan is being held as a store of value within its borders. The first such swap lines were set up in 2008 but many have been added last year and we expect many more to be added, with the U.K. and France imminent.

So where do central bank reserves fit into all this?

The world's central banks' appetite to diversify reserves into the "under-valued" yuan is clearly there. Only a few weeks ago the Reserve Bank of Australia announced it plans to diversify 5 percent of its reserves into yuan - and that's just the start. Many of the smaller central banks in Asia have already been seen buying yuan through banks. As more bilateral swap lines are set up and China moves further down their path of capital market liberalization, central banks' appetite to own this currency will unfold.

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If we assume reserve allocation comes into line with China's share of international trade and GDP (approximately 10-11 percent) then about $700 billion worth of yuan will be purchased by central banks alone!

We hear the arguments that China's capital markets have a long way to go before being able to accommodate such a quantum of reserves - but let's not kid ourselves, the process is well underway and further down the path than many think.

China is getting its yuan into the hands of many entities in many countries. Controlled, prescriptive, pervasive and stealthy are all valid descriptions of this process - but it is happening nonetheless.

Based in Singapore, Stuart Oakley runs the global Asian forex cash trading business at Nomura. He has worked in financial markets since 1995 and has spent most of his career trading Emerging Market currencies and interest rates, previously at Barclays Capital and Credit Suisse in London.