By James Laurenceson

Julia Gillard has left for China, her second trip to the Middle Kingdom as Prime Minister. As befits China’s status as Australia’s most important trading partner, the trip has attracted widespread media attention and speculation abounds regarding what policy announcements might be at hand.

One in particular has aroused interest: a currency deal that would allow the Australian dollar to be traded directly against the Chinese currency, the renminbi (RMB). Such a development has been hailed as a move that would slash costs for thousands of businesses.

Before discussing the implications of such a move, it is important to be clear about what exactly is being proposed.

Historically, China has only allowed the renminbi (RMB) to be traded directly against the US dollar. That is, there exists a foreign exchange market where the renminbi and US dollar are bought and sold, and the price at which they are traded represents the RMB/$US exchange rate. The current rate is 6.201832.

This rate moves up and down in response to changing demand and supply conditions in the market. For example, if foreign investors became more bullish about China, this would lead to an increase in demand for renminbi, causing the above number to fall. Of course, we also know that one of the main forces impacting on demand and supply conditions in this particular market is the Chinese government’s penchant for intervention, such as increasing the demand for US dollar in order to slow any such appreciation in the Chinese currency.

Yet despite China only allowing the renminbi to be traded directly against the US dollar, it is still possible to find quotes for an RMB/$AUD rate. The current rate is 6.48454. How can a RMB/$AUD rate be quoted in the absence of a market where the two currencies are traded?

The answer is that the RMB/$AUD rate is arrived at indirectly. In the $USD/$AUD market, the current rate is 1.045585. This means that $AUD1 buys $USD1.045585, and $USD1.045585 buys RMB6.484542 (1.045585*6.201832). Therefore, the quoted RMB/$AUD rate is that $AUD1 buys RMB6.48454.

What is now being proposed is the creation of a new foreign exchange market where the renminbi and Australian dollar can be traded directly in the same way that the renminbi and US dollar have long since done. The price in this market will then represent the RMB/$AUD exchange rate.

Such a move would continue the trend begun last year, whereby China allowed the renminbi to begin trading directly against the Japanese Yen.

For Australia, there are two main advantages in having the renminbi and Australian dollar trade directly against each other.

Firstly, trading in foreign exchange markets is not costless. Having a RMB/$AUD market means that only one trade needs to be executed, as opposed to two the moment. This is mainly where the cost savings being touted for Australian businesses lie.

Secondly, the presence of an RMB/$AUD market means that the RMB/$A rate can, at least in theory, better reflect developments in the two countries, irrespective of what is happening in the US. For example, for a variety of reasons, the Chinese government has shown an unwillingness to let the RMB/$USD rate fluctuate significantly. What this has meant is that any fluctuations in $USD/$AUD rate have also resulted in fluctuations in the RMB/$AUD rate, because it is calculated indirectly.

For China, the establishment of a RMB/$AUD market brings other benefits, such as furthering the internationalisation of the renminbi.

While the establishment of an RMB/$AUD market is a positive step in view of the large volume of trade between China and Australia, excitement ought to be tempered for a number of reasons.

Firstly, the status quo is not particularly onerous for businesses because the RMB/$USD and $USD/$AUD markets are highly liquid. Fluctuations in the $US/$AUD rate can also be readily hedged against. In contrast, liquidity will be an issue for the new RMB/$AUD market, at least initially. This is where currency swap agreements such as the one signed last year between the Reserve Bank of Australia and the People’s Bank of China may turn out to be important, because they can be drawn up to provide additional liquidity if needed.

Secondly, the renminbi is already convertible for trade transactions and, as economists such as HSBC’s Qu Hongbin have noted, is readily available to businesses for such purposes.

Finally, we should also be clear about what the expected currency deal does not mean.

It does not mean that the renminbi will become convertible for Australian investors. China’s capital controls will remain, such as those that prevent Australian investors from using renminbi to freely purchase shares on China’s stock exchanges in Shanghai and Shenzhen.

It also does not necessarily mean that the RMB/$AUD rate will float freely. Chinese government intervention in the RMB/$USD market is well known, and there have also been reports that fluctuations in the RMB/Yen rate are the subject of restrictions.

Click on the links below to read other articles from this week’s newsletter

This Coal Stock is Up 422% – How To Play The Coal Sector       

5 Aussie Stocks Catching The Asian Internet Wave

18 Share Tips – 8 April 2013

Attention stock bulls: beware a toppy market

Trading: Losing To Win

Financial Planning Strategies For Parents

Top 10 shorted stocks

Stock on a roll: ASX rolling 52-week highs

Stock on the slide: ASX rolling 52-week lows


James Laurenceson does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.

This article was originally published at The Conversation. Read the original article.