China takes baby step to reduce dependence on dollar

As China grapples with a downturn that has threatened the value of its investments in the American dollar, it is taking baby steps to conduct trade in its own currency – most recently, by allowing five cities to settle certain international transactions in renminbi instead of dollars.

Though limited in scope, the pilot project marks one of China's biggest moves yet to reduce its dependence on the greenback – and raise the renminbi's international profile in the long run.

It comes as top US and Chinese officials wrap up a two-day summit in Washington Tuesday to discuss economic cooperation, including a bigger role for China in global financial bodies.

In recent months, top Chinese officials have publicly voiced concern about the staying power of the dollar, though Beijing is not offering its own currency as an alternative any time soon.

"Chinese officialdom is serious about trying to increase the international use of the renminbi over time," though "they understand it will take decades to make their currency attractive" enough, says Barry Eichengreen, an economist at the University of California, Berkeley.

First steps toward trading in renminbi

The new project allows some importers and exporters in Shanghai, Guangzhou, Shenzhen, Dongguan, and Zhuhai – cities at the heart of China's export world – to settle cross-border deals in China's currency. It would also allow renminbi trade with Hong Kong and Macau, and possibly later with Southeast Asian countries. Some of the first deals included an electric-equipment manufacturer and a textile exporter.

If widely traded in the long run, the renminbi would become stronger. That would please American officials, who have long pressed China to raise the renminbi's value. That would help offset its large trade surplus with the US – though Chinese officials are wary of eating into already slim profit margins for Chinese factories.

No currency will rival the dollar in the near future: The British pound remained the top international currency long after the US had emerged as the world's largest economy.

Still, some economists say, China's rising economic might means the dollar will eventually share the stage with the renminbi.

"It's one small manifestation of a larger change in the world," says Professor Eichengreen. "We live in a more multipolar place, and no one country and no one currency will dominate like the US did in the brief period at the end of the 20th century."

Airing concerns about the dollar

The project follows months of Chinese officials making unusually direct comments about the dollar. In March, Prime Minister Wen Jiabao expressed concern over the safety of Chinese assets held in the form of hundreds of billions of dollars of investments in US Treasuries. A few weeks later, China's central bank called for a replacement to the US dollar as the international reserve currency.

For now, China is sticking to its dollar-backing guns. It's increased its holdings of foreign reserves – especially US treasuries – at record rates. In May, China added $38 billion in US treasuries, bringing its total holdings to over $800 billion, the Treasury Department reported Thursday.

Reworking the economy

Because of its heavy dependence on export sales, the Chinese are unlikely to move quickly beyond small gestures like the trade settlement zones for the time being, says Eichengreen.

The Chinese economy, he adds, will have to undergo fundamental transformation to solidify its position on the world economic stage.

And because China's financial system remains less than fully open, other countries will be wary of shifting to renminbi, says Linda Lim, a professor at the University of Michigan Business School in Ann Arbor, Mich.

"They need a more deeply liquid and diversified capital market, they still need to reform their financial sector, and have more transparency in accounting," adds Professor Lim.

Eichengreen says establishing the renminbi's global clout is good in the long term.

"Is it something for America to worry about?" he asks. "I don't think there is anything wrong with the dollar sharing its status as a leading international currency with the euro and 20 to 30 years from now with the renminbi. It might actually be good for us to help us concentrate the mind and encourage fiscal discipline."