MOST people are aware that China's economy has grown very fast for a really long time, so readers wouldn't be too surprised to learn that, officially, it works out to 10 percent a year since 1978.

They might be a little more surprised, however, to learn that GDP (or anything) doubles at that rate every seven years, meaning that China's economy is 28 times bigger today than it was back in 1978.

Thirty-five years of compound growth have made China the world's second-largest economy, after the US. Even more remarkably, China is now the largest trading nation in the world. Last year, its exports and imports totaled US$3.87 trillion - US$1 billion more than the total trade of the United States.

At DBS, we have been talking about the shift in economic gravity from West to East for the past seven or eight years. It is, without doubt, the biggest structural change underway in the global economy today.

These tectonic shifts in the world's real economy have not been accompanied by similar changes on the financial side. China may now be the biggest trading nation in the world, but nobody uses its currency, the yuan, to do the deals. In mid-2011, less than 1 percent of the world's trade was conducted in yuan.

China aims to change this lopsided situation. In the past two or three years, it has embarked on a path to make the yuan an "internationalized" global currency - one as important to the world's financial markets as China's production, demand and trade have become.

Like any globalized currency - of which the US dollar and euro are really the only two examples - an internationalized yuan would be used to denominate and settle international trade, to borrow and lend in both onshore and offshore markets, to serve as a benchmark for other currencies and to function as a foreign reserve currency held by central banks outside China.

That's a short and simple list, but it implies huge changes for China's economy and the way it does business today.

For starters, China's markets would have to be open to foreigners no less than America's and Europe's are today. Its interest rates would have to go up and down according to market forces, instead of government command. And China would have to create the rules and institutions to govern these markets before investors would feel comfortable holding yuan.

None of this would come easily. What economists call "opening the capital account" opens a whole can of worms for managing the economy. Anyone in Asia during the financial crisis of 1996-98 would be forgiven for wondering why on earth would any country want to go and do something so silly as open its capital account? Foreign money comes rushing in. The currency loses competitiveness. Exporters fail. A bubble grows in this sector or that. Inevitably, it pops. The foreign capital rushes out. The currency collapses. Interest rates shoot to the moon. The economy collapses.

And all that's just in the first year!

China has experienced 35 years of relatively stable 10 percent GDP growth. It's 28 times bigger today than it was in 1978. Why risk this kind of success for a globalized yuan and an open capital account?



There are several reasons why it makes sense for China to take the plunge. But first let?s dispense with nonsense reasons one usually hears for internationalizing the yuan.

Non-reason 1: To save on forex transaction costs

If China denominated its foreign trade in yuan, the argument goes, it would save a lot of money on foreign exchange costs. Poppycock! These days the bid-offer spread on foreign exchange transactions is miniscule. For the yuan, for example, the difference between buying and selling costs since January 2008 has averaged 1.3 basis points. That?s nothing.



Non-reason 2:

To save on hedging costs

The cost of locking in an exchange rate in the forward market is simply the difference between local and foreign interest rates. For example, if the local yuan-denominated interest rate is 3 percent and the foreign US-denominated interest rate is 2 percent, then a Chinese importer would need to pay his bank 1 percent to guarantee the price of dollars one year hence. More likely, the importer will take delivery in two months, so the cost of the insurance would be two-twelfth of 1 percent, or 17 basis points.

For every Chinese importer paying 17 basis points to guarantee the yuan price of a dollar doesn?t go up, there is a Chinese exporter getting paid 17 basis points to guarantee the number of yuan he receives for a dollar doesn?t go down. From a national point of view, the cost of hedging is zero. Plainly, hedging costs can?t be driving the internationalization of the yuan either.



Non-reason 3: To borrow at a cheaper rate

If China had a currency that everyone wanted to hold, the idea goes, it could borrow more cheaply in international markets. More cheaply than what exactly?

And more to the point, China doesn?t borrow in international markets. It lends, big time! Over the past 15 years, China has run trade and current account surpluses equivalent to 6 percent of GDP on average ? big enough to have most of the world?s developed nations hopping mad about it. Added up, its lending comes to some US$2.3 trillion since 1997.

Non-reason 4: The free lunch of òseigniorageó

An internationalized yuan is supposed to confer upon China all the privileges and entitlements that countries enjoy when other countries òhave toó buy and hold their currencies, of which lower interest rates are but one example. Seigniorage would, in the extreme, allow China to run large current account deficits and pay for them simply by printing yuan.

That would be nice, surely. But for the past 15 years China has been giving things away ? running large current account surpluses due to yuan?s low value against US dollar. If you?re like many in the West, your biggest fear is that China will still be trying to give things away for free when your kids have kids. In any event, it?s hard to argue that any country running a current account surplus ? sending abroad more than it takes in ? is scouting around for a free lunch.

Non-reason 5: Protecting international assets

Since 1997, China has run current account surpluses amounting to some US$2.3 trillion. It holds US$3.3 trillion worth of foreign-exchange reserves. The argument goes, that if China?s trade and net international assets were denominated in yuan instead of, say, US dollars, then it would be protected from a hypothetical crash in the value of the dollar.

But would it really? The landscape is littered with examples of lending to foreigners in one?s own currency that haven?t lowered the risk to the lender much, if at all. The reason is currency crises and credit crises tend to go together. You may lend money to a foreigner in your own currency thinking you?re protected from a crash in his. But if his currency hits the floor, his ability to pay you back in your currency does, too.

By definition, China?s forex reserves cannot be òrenminbized.ó They are what they are ? dollars, euros and yen.

Non-reason 6: To allow Chinese corporate to lend abroad in local-currency terms

In this scenario, a Chinese corporate, an insurance company perhaps, wishes to hold yuan assets to match its local liabilities but prefers to lend to, say, a US company instead of a domestic one. Now this reason ? diversifying credit risk ? is actually a good one for internationalizing the yuan. But it flips all the earlier ones on their heads. In the earlier scenarios, China feared a falling dollar and the ability of foreigners to pay their debts. In this scenario, foreigners are preferred to locals. Is anyone getting dizzy?

Let?s look at real reasons for internationalizing the yuan.

Reason 1: To avoid a credit crunch like that following the collapse of Lehman Brothers in September 2008

The collapse was the catalyst that triggered the biggest global recession in 80 years. Asia, of course, recovered a long time ago, but the downturn was still sharp and deep and most of it probably could have been avoided had an alternative to the US dollar existed for financing Asia?s trade.

To see this, one has to understand that Asia?s downturn wasn?t imported from the US or Europe in the normal textbook manner. When the global economy went down in 2008, it didn?t take a few months for the neighbors to feel unwell, and a few more months for their neighbors to feel unwell too. When Lehman Brothers collapsed, the whole world dropped at once ? instantly and simultaneously. Asia dropped just as fast if not faster than the US, not from a lack of real economy demand but from the financial sector shock. No credit, no trade, no activity. End of story.

Weak demand from the West was not the main problem Asia faced during the global financial crisis. Asia?s downturn was sharp and severe but it was caused mainly by a credit crunch in the financial sector ? a lack of US dollars to fund regional and international trade.

Avoiding a recurrence of this situation is the first thing China hopes to gain by internationalizing the yuan.

Real reason 2: Rising trade volumes

Asia is no longer too small to matter. It can now drive its own growth and help drive global growth like never before. This shift in economic gravity from West to East has been underway for many years.

Next year, Asia-10?s GDP will be every bit as large as that of the US. China alone will be 60 percent the size of the US. Even with slower growth in Asia and China in the years ahead, China will be 83 percent as large as the US by 2020 and the Asia-10 will be 32 percent larger.

What does this expansion path imply for imports going forward? Unless they fall as a percentage of GDP, which doesn?t appear likely, imports will grow roughly in line with GDP. And even though the rate of growth will be slower than in the past, the expansion in Asia?s imports will be stunning.

GDP ? US and Asia 10

(billion US dollars, 2012 prices and foreign exchange rates, US=100)



We reckon China's total two-way trade would grow to US$4 trillion by 2020, at today's prices and exchange rates. That is a lot of money. It becomes clearer why China wants to internationalize the yuan. If a globalized yuan doesn't exist, it has become necessary to invent one.

Real reason 3: Prestige and politics

Economics is key, but there?s no denying that prestige and politics play a role in the push to internationalize the yuan. How could they not? China is now the largest trading nation in the world. Against this backdrop, it would be surreal were China to still be denominating its trade in US dollars in 2020. It would be like having the biggest house on the street ? a mansion ? and calling a taxi for a ride to the ball. Mansion owners don?t take taxis to the ball. Not only does it look funny, what if there are no taxis available? What if one day China calls its foreign bank to arrange for some dollar trade credit and the bank says, òSorry, we?re no longer able to facilitate this transaction.ó What then?



No free lunch

Nothing worth having comes free. An internationalized yuan means the capital account has to be opened up and that can spell all kinds of trouble.

Why is this such a problem? Two reasons. First of all, capital flows can be volatile and difficult to control. Indeed, if the capital account is truly open, direct controls on flows are ruled out as a matter of course.

More generally, capital flows can greatly complicate the task of macro economic management.

Central bankers and economists, especially those from Asia, are well acquainted with the òtrilemmaó ? a problem identified by Nobel prize winner Robert Mundell in the early-1960s. The trilemma says that a country can?t have an open capital account, control over interest rates and control over the currency all at the same time. One may choose only two.

Going with an open the capital account means you surrender control of either interest rates or the currency.

If the economy is weak and the currency is falling, do you raise interest rates or lower them? There?s no easy answer. Conversely, if the economy is running too fast and you?d like to cool things down, raising interest rates may simply lead to capital inflow, which pushes rates back down and the economy back up.



In the end

At the end of the day, there are three good reasons for China to internationalize the yuan: to avoid short-term US dollar-based liquidity shortages like that which followed the collapse of Lehman Brothers; to finance its long-term structural growth in trade volumes (where it?s not clear that the US dollar is up to the task); and to ensure that its trade and investment flows continue uninterrupted should Western banks for whatever reason ever curtail access to dollar funding.

China?s leaders increasingly understand that these needs dominate the need to control every aspect of the macro economy.

China has, after all, been relinquishing control ever since 1978 when Deng Xiaoping?s black cat confronted central planning with the truth about catching mice. Internationalizing the yuan is merely the next step along the road, trilemma or no. If Singapore can live with it, the vastly larger China probably can too.