For the past several months, China has been making headlines across the world. And not for the usual reasons.

In September 2016, China hosted the G20 for the first time. Argentine President Mauricio Macri, Brazilian President Michel Temer, and Mexican President Enrique Peña Nieto joined world leaders to travel to Hangzhou for this historic gathering. Peruvian President Pedro Pablo Kuczynski followed up with a trip to Beijing as his first official foreign destination. China seeks to celebrate its economic muscle again in October 2016. The renminbi becomes the fifth global currency—joining the United States, European Union, Japanese, and United Kingdom banknotes—to be accepted by the International Monetary Fund as an international reserve asset.

The renminbi is clearly on the rise. But why is a Latin America center devoting its intellectual firepower to what at first appears to be an issue for the world’s financial centers? The answer is simple: Internationalization of the renminbi may fundamentally reshape trade and finance with emerging markets around the world, with a particular impact in Latin America.

Although there is a temptation to set aside the discussion as too technical or even too political, opening up investment and trade to take place in China’s own currency may push even more commerce to the East.

China is already one of Latin America’s top three trading partners and the number one export destination for Brazil, Chile, Peru, and Argentina. In the past five years, China’s investment in the region has reached almost $11 billion annually. With the renminbi as a global currency, this reality may eclipse previous trends as more businesses trade directly in the renminbi and Chinese-originated investment opens up to new players who prefer RMB-denominated transactions.

This could be a unique opportunity for Latin America to further diversify its trade and investment partners. But policymakers should recognize the pitfalls that come with a currency around which many questions swirls in global financial markets.

Is Latin America ready? This report focuses on the regional ramifications of a globalized renminbi, but clearly, there are implications for the United States as well. The potential of a further boost in China-focused investment and commerce, with transactions in the renminbi rather than the dollar, has the potential to come at the expense of US commerce. More easily accessible Chinese money must be weighed against the certainty and strong historical fundamentals of the US currency. Clearly, even those outside Latin America should pay close attention.

This report is important for those seeking an accessible primer on China’s motivation for internationalizing the renminbi and how Latin America fits into the equation. It clearly lays out the path for how this new reality can become an asset for the region, and also the bumps that may exist along the way.

The China–Latin America relationship has already proven to be highly complex. Our first two reports on this topic—“China’s Evolving Role in Latin America” (September 2015) and “Industrial Development in Latin America” (August 2016)—point out the benefits and drawbacks of closer engagement. This publication tackles a topic that is often left to the back pages of financial sections, but should really be front-page news. We are grateful to the many US, Latin American, and Chinese institutions that participated in a May 2016 New York City roundtable, whose comments and insights on the topic helped inform our work.

This report could not come at a more timely moment. Though there is limited insight on the regional implications of an internationalized renminbi, the time to chart the way forward is now. These are uncharted waters, making it even more critical to ensure that this new reality further fosters Latin America’s economic ascent.

We extend a special thanks to HSBC for the generous support for this initiative, without which this report would not have been possible.

In the past four decades, beginning with Deng Xiaoping’s gradual opening in 1978, China has reemerged as one of the world’s most important economies. Its economic, geopolitical, and financial rise is underscored by key milestones: joining the World Trade Organization (WTO) in 2001; surpassing the United States, Germany and Japan to become the world’s most significant exporting nation;¹ and becoming one of the world’s top three global sources of outward foreign direct investment (FDI).² In 2015, China became a net foreign investor, sending more FDI out than it took in.³ China is well on its way to overtaking the United States as the world’s largest economy in absolute gross domestic product terms, and has already done so on purchasing power parity measures.⁴

Its economic and financial importance in Latin America echoes trends on the global stage. China is now among the three most significant trading partners for the region, eclipsing the European Union (EU) in 2012. Brazil, Chile, Peru, and Argentina count China as their top export destination, as well as a major source of imports. Chinese investment has also surged, with Brazil topping the list as the region’s leading destination for Chinese FDI.

China’s rise in the global economy is reflected by changes in the international significance of its currency, the renminbi (RMB). This is not surprising. Currency internationalization is a natural step in the evolution of a leading economy. The international use of the dollar, for example, grew out of the United States’s rapid economic emergence at the beginning of the 20th century, although it became the world’s leading currency only in the aftermath of World War II. Likewise, the international significance of the Japanese yen grew out of the country’s rapid economic ascent in the 1970s and 1980s.⁵

With the October 2016 inclusion of the RMB in the International Monetary Fund’s Special Drawing Right (SDR) basket of major international currencies, joining the US dollar, the euro, the Japanese yen, and the British pound sterling, China is now among a select group of countries whose currency is recognized as an international reserve asset. It adds credibility to a currency still observed with some skepticism in many parts of the world.

While China is now firmly established as a leading driver in the global economy, the ramifications of the renminbi’s internationalization are still evolving, especially for emerging markets such as those of Latin America. To the extent that Chinese authorities undertake additional domestic reforms—in areas including the capital account, financial market, and exchange rate policies—this may give other economies, including Latin American countries, more confidence to use the RMB for trade and finance transactions.⁶

If history repeats itself, it will just be a matter of time until China’s currency is widely used internationally. But the story is not that simple. The Chinese economy continues to be characterized by a high degree of government involvement, including with its exchange rate. This gives pause to the many governments and private businesses who question the possible implications for market behavior.

How relevant are these policies to Latin American countries? With major economic relationships with China, most of the region’s largest economies are likely to see both more businesses trading directly in the RMB and more Chinese-originated FDI using the RMB. To encourage this and manage possible liquidity issues, China has already signed currency swap agreements with countries such as Brazil, Argentina, and Chile. What do these agreements actually mean and what are the risks for businesses that traditionally have depended on trading and investing in dollars? What measures could Latin American countries and businesses take—individually and collectively—to adapt to China’s changing economic landscape and the opportunities and risks that come with greater use of the RMB?

From an economic standpoint, China’s process of RMB internationalization is intended to support the diversification of its trade and investment relationships, and encourage continued domestic economic restructuring. Enhanced competitiveness and a more innovation-friendly financial ecosystem are major objectives in China’s economic reform strategy. Top international goals under this framework include trade with and investment in emerging markets worldwide, as well as achieving greater economic and financial balance between its developed and emerging market relationships.

The process of restructuring addresses both changing demographics in China as well as concerns about the middle-income trap. Both of these are important changes from China’s pre-2008 economic model, which was based largely on exports, particularly to the United States and the EU, and was underpinned by WTO accession in 2001.

RMB internationalization is intended to both reduce risks associated with an overreliance on the dollar and provide outlets for China’s domestic savings and investments. The combination of these twin objectives is intended to support economic restructuring and competitiveness, in addition to reducing currency risks. It aims to serve as a bulwark against the many potential financial crisis indicators that have characterized China’s economic and financial system over the last several years: rapid credit growth, dramatic changes in property prices, and currency and financial market volatility.

Major challenges lie ahead for China, and thus for the rest of the world. In particular, the financial and currency market volatility that began in spring 2015 highlights the risks of China’s ongoing process of financial liberalization and currency internationalization. New doubts have been cast around China’s resulting interventions in its stock markets, its expenditures and outflows of foreign exchange reserves, and uncertainties over its exchange rate.

In the wake of the United Kingdom’s June 2016 decision to leave the EU, the value of the RMB declined, a stark contrast to the yen and the dollar. This reversal marks a different trajectory for the RMB from what happened during the 1997 Asian financial crisis and the 2008 global financial crisis—both periods in which the currency strengthened as a safe haven.

Beyond the important economic and financial factors underpinning RMB internationalization, there is also a major political component. Widespread global use of a currency is symbolic of a country’s growing power. China seeks both greater recognition of its economic significance and a more active role in international economic affairs. SDR inclusion was a major step. China also has its eye on the United States and what will come of its pivot to Asia. In some ways, Chinese involvement in Latin America is an attempt to counterbalance growing US ties with many countries in Asia.

In the aftermath of the 2008 global financial crisis, the Chinese government initiated a series of policies that would later define RMB internationalization. These policies aimed at developing three main markets for RMB international use: trade settlement; crossborder investment; and crossborder financial transactions (see Figure 1). The goal is for countries around the world to be able to trade, receive FDI, and invest in RMB-denominated products (including bonds and stocks).

liberalize foreign exchange rate and capital controls

The first step in RMB internationalization occurred in mid-2009 when the People’s Bank of China (China’s central bank) launched a pilot program for crossborder trade transactions. For the first time, companies inside and outside of China could engage in commercial transactions (imports and exports) using the RMB rather than the dollar.

But this also posed a challenge. China sought to promote the international use of its currency but without an established market. Unlike the dollar, which is underpinned by the world’s deepest and most liquid capital markets and has a dominant status in a variety of international transactions, RMB markets were neither large nor liquid and the currency was not widely held outside of China. This created a problem. How could companies trade in RMB without either an offshore market beyond China or access to a developed domestic RMB market?

China’s solution: develop a series of global currency swap agreements—an idea loosely based on its experience in the wake of the 1997 Asian financial crisis.⁷ These agreements between central banks, which exchange local currencies for direct access to RMB liquidity, helped increase confidence in and access to RMB in international markets. Another result is that the RMB can then be offered as an alternative to the dollar, making China an alternative to the International Monetary Fund for countries facing liquidity constraints.

Since 2009, China has signed 33 currency swap agreements with different countries and regions, totaling $500 billion; the latest is a May 2015 agreement with Chile.⁸ Together with the bilateral swap agreements with Brazil and Argentina, the total for those signed with Latin America reaches $49 billion (see Figure 2).

But a mechanism was also needed to carry out RMB transactions among a wider pool of participants. For this purpose, China agreed to a series of clearinghouse agreements, which allow a designated bank (a Chinese bank on the RMB side, with a local or international bank as counterparty) to act as a financial intermediary—a middleman between two parties—in local currency operations involving RMB. Chile is home to one of the sixteen global clearinghouses that China established. Through these agreements, middleman banks facilitate a company’s imports and exports by helping to save in transaction costs, translate all operation-related documents, and assist in operations with intermediary banks in another country.⁹ The China International Payment System (CIPS) also was launched—a mechanism to draw these various clearing arrangements into a global network, similar to the way SWIFT works for the dollar.

China also began to liberalize its capital account, launching a series of programs allowing foreign investors to conduct operations in RMB-denominated products. Of particular importance was the creation of the RMB Qualified Foreign Institutional Investor (RQFII) scheme, which gives investors from select countries and jurisdictions access to China’s domestic markets. Through it, a quota system determines how much each investor—a public or private-sector financial institution—is allowed to invest in the Chinese financial market. As of June 2016, China had provided program licenses to eighteen countries, plus Hong Kong, with a total quota ceiling of almost RMB1.5 trillion ($225 billion). The most recent RMB250 billion ($37 billion) agreement, with the United States, is the second largest after Hong Kong. In Latin America, so far only Chile has received such a license, with a quota of RMB50 billion ($7.5 billion).

Still, lingering obstacles to currency internationalization efforts, as well as allegations of currency manipulation, are continuing to create concerns around China’s foreign exchange rate controls. Before 2005, China’s exchange rate was tied closely to the dollar. It was generally viewed as undervalued, providing an exchange rate advantage for Chinese exports.

In reaction to US concerns, for several years prior to the 2008 global financial crisis China steadily allowed its currency to appreciate against the dollar and its exchange rate to more closely reflect a basket of currencies. But as China’s economy slowed, its currency once again became more closely tied to the dollar. This time it depreciated as the dollar appreciated.

In an effort to allow greater market determination of the exchange rate, China substantially altered the preexisting system in August 2015. This brought an extremely volatile market reaction, with global implications. Since then, exchange rate policy has been inconsistent, raising significant concerns around the world. In particular, China has come under pressure for its failure to communicate exchange rate policy directions and for a lack of clarity in the mechanism itself.

▲ Mexico's Central Bank (pictured) - like its regional counterparts - will be tasked with developing a strategy that adjusts to RMB internationalization.

Over the past decade, use of RMB as a trade currency has increased dramatically. Trade in RMB already represents 26 percent of China’s trade with the world; it grew an average of 46 percent per year over the last five years.¹⁰ But when Hong Kong’s share of China’s total trade is eliminated, global trade denominated in RMB falls to just 12 percent.¹¹ Service trade in RMB—an area of particular importance to Latin American countries—has experienced only a modest boost, perhaps reflecting the fact that China is not a major service exporter. Overall, although the RMB is the fifth most important payment currency in the world, it only accounts for less than 3 percent of global payments for crossborder trade and financial transactions.¹²

However, the use of the RMB as an investment currency has grown rapidly. Outward direct investment (ODI) increased dramatically over the past two years. In 2014, RMB as an investment currency accounted for 25 percent of China’s ODI, up from only 5 percent in 2012¹³ Still, there is not much evidence that China is using RMB for its investments across Latin America. Chinese FDI in the region tends to be directed to cost-intensive natural resource projects, such as mining activities in Peru or constructing a hydropower plant in Ecuador. Given these projects’ importance to the local economies, countries tend to rely on the more stable and liquid dollar as the currency of choice.

Financial operations is an area where China has yet to develop policies attractive to both domestic and foreign interests. Foreign institutions actually decreased their RMB assets over the past couple of years (see Figure 3). This decision can be explained by a shift in market sentiment, questioning the future possibilities of RMB appreciation. Latin American countries are not isolated from the impacts of changes in RMB value; a relative RMB appreciation makes it more expensive for Chinese importers to buy commodities from the region.

At the same time, loans and bond markets experienced disappointing growth over the past two years. This is likely due to the regulatory constraints that worry foreign institutions. There is still a lack of regulatory understanding about whether a company is able to bring the RMB to the offshore market. A knowledge gap is also common among Chinese investors about the issuers and their businesses.

An internationalized RMB can be a new opportunity for Latin American countries to diversify their sources of finance—perhaps in the same way that trading relationships have expanded with the rise of China. For example, countries and companies can issue RMB-denominated debt, which—depending on prevailing interest rates—may lower their financing costs. This is particularly true for countries with constrained access to the G3 (dollar, euro, yen) markets, with Venezuela serving as the leading current example.

A central aspect of China’s RMB internationalization strategy is increasing RMB use for trade and trade finance. Trade in a local currency offers significant cost savings: It avoids the transaction costs that result from using a third currency, such as the dollar. Although China–Latin America trade has decelerated in the past two years, the outlook points to robust commerce, just at a new normal. RMB-denominated trade could provide huge cost savings and a competitive advantage going forward,¹⁴ since China offers a discount to all foreign companies that settle in RMB.¹⁵

At the same time, in 2015 China and Latin America announced their intention to increase trade to $500 billion per year within the next ten years, slightly less than double current volumes. RMB use may facilitate that growth. Given strong trading links to China, three of the top six economies in the region—Brazil, Argentina, and Chile—will likely lead the charge to put mechanisms in place that allow for greater RMB-denominated operations.

RMB use also helps companies tap into the massive Chinese market and a consumer class greater than the United States and EU combined. A 2015 poll conducted among 150 companies found that lowering transaction costs and accessing new business opportunities are the top reasons why a foreign company engages in RMB operations.¹⁶

However, one potential outcome is an increase in the risk of Chinese investments in Latin America, since less trusted companies without access to international credit in dollars can to start invest. This adds extra layers of opacity when a Latin American company is considering an investment offer from a Chinese partner. A separate concern is the political tensions that come with a greater Chinese presence. These sorts of tensions have already arisen in Africa, a region where China is the preeminent foreign force today.

Still, RMB internationalization was seen initially as an attractive proposition with few drawbacks. Given China’s continued growth, the RMB was anticipated to appreciate against the dollar. Likewise, investments in China’s stock markets were regarded as an opportunity to participate in the fortunes of rapidly developing enterprises. Financially distressed Latin American countries, such as Argentina and Venezuela, saw China as not only a major new trading partner but as a new source of investment and finance, often with less demanding conditions attached—in terms of transparency, labor rights, etc.—than those from developed countries. This may yet prove to be the case.

But major concerns lie ahead. An increase in RMB use in China–Latin America economic and financial relations also creates risks. First, if Chinese companies invest in the region using RMB, what implications will arise from having assets valued in RMB? This could bring more Chinese investment but it also could lead to greater fears of over-dependence on Chinese trade, investment, and finance.

A number of important challenges exist. So far, the numbers do not to match China’s efforts to promote the RMB in Latin America. Today, less than 1 percent of the region’s trade with China is RMB-denominated, a sharp contrast to the previously mentioned 26 percent of China’s trade with the world.¹⁷ The reason is simple: China’s imports from Latin America consist mainly of commodities, where prices are determined by international markets and are already negotiated in dollars. Switching to RMB would require rewriting contracts already denominated in dollars.

At the same time, a lack of RMB liquidity is seen throughout the region. This is despite the visible increase in the number of Chinese banks present in Latin America to promote RMB products. Today, Chinese state-controlled banks have subsidiaries in eight of the largest countries.¹⁸

Still, Chinese banks that operate in Latin America do not have significant capitalization. For example, in Brazil, Bank of China and the Industrial and Commercial Bank of China have, respectively, $100 million and $200 million in capital allocated to their domestic subsidiaries.¹⁹ These are trivial amounts for two of the world’s largest banks, particularly in comparison to the scale of China-Brazil bilateral trade, which is uniquely composed of high volumes of commodity exports (traditionally priced in dollars).

▲ Argentine President Mauricio Macri meets with Chinese President Xi Jinping
during the G20 meeting in Hangzhou, China in September 2016

Likewise, the potential under existing swap and clearinghouse agreements is limited. Only Chile has a clearinghouse for RMB operations. The swap agreement with Argentina only became operational under emergency circumstances: a lack of international liquidity for the country’s currency in 2015. Without any other option, the Argentine government was able to swap pesos for RMB to access international markets and then swap RMB for dollars, boosting its domestic reserves. While this is the intended scope of the China-Argentina swap agreement (i.e., to alleviate the international liquidity crisis), this is clearly not the best use. The purpose should be to provide liquidity to ensure confidence in RMB transactions, thus engendering real economic activity, not prolonging calamitous policies.

After exhausting the $11 billion in funds in the agreement, the Cristina Fernández de Kirchner government sought to renew the agreement with the same face value. Negotiations have yet to conclude, but the new terms are likely to amount to less than half the previous agreement ($5 billion). This highlights the risk for China in using such swap agreements for political rather than economic purposes.

Private-sector financial operations also remain limited. Latin American asset management firms tend to have a position in Chinese companies in the offshore Hong Kong market. Despite an investment made by China Investment Corporation in Brazil’s BTG Pactual in 2010, a deal that was supposed to pave the way for financial cooperation between the countries, little has been done in this field.²⁰

Latin American firms also have yet to actively trade in the Chinese stock market. Much of this is attributed to the prevailing lack of trust in the fundamentals behind the Chinese stock market and the underlying institutional economic framework of the Chinese economy. After the Shanghai Stock Exchange’s 2015 boom and subsequent collapse, the Chinese government imposed a series of market control measures. Among them were the imposition of strict limits on asset sales and repatriation, which severely affected the confidence of foreign investors, including those from Latin America. Similar to many other foreign investors in Chinese equity markets, Hong Kong now looks to be a more reliable venue than direct investment in mainland markets.

Nevertheless, Panda bonds (bonds issued by foreign companies in the Chinese market) could be seen as an opportunity for Latin American firms to issue debt in the vast Chinese bond market with attractive current yields. This is due to interest rate differentials between the ten-year yields in China (around 3 percent) and those in Latin American countries (on average, above 5 percent). This interest rate differential could be positive for Latin American firms wanting to leverage operations, but with the caveat that China imposes capital controls on taking money out of the country. This makes Panda bonds useful for companies that plan to expand operations in China. It is also attractive for countries seeking to diversify their foreign exchange reserves, particularly as trade flows in RMB increase.

As much as Latin American countries tend not to engage in RMB-denominated operations, they cannot be isolated from the international spillovers of China’s monetary policies. Intense RMB volatility and devaluation from August 2015 to February 2016 caused global market turmoil, particularly given uncertainties regarding Chinese exchange rate policy direction and setting mechanisms. Contagion spread to the region’s financial markets, as well as other emerging markets around the world.

Latin American markets are seen internationally as highly dependent on Chinese demand, particularly for commodities. A period of decline in the value of the RMB has made commodities generally traded in dollars more expensive to Chinese local buyers, at the same time that Chinese consumers are dealing with a significant slowdown in their domestic economy. The result has been increased market and economic volatility in Latin America as uncertainties about the direction of China’s policy and the extent of its slowdown persist.

Perhaps most importantly, a profound cultural and informational gap also exists. A survey of over 150 executives from companies in the US, Europe, and the Asia-Pacific region shows that over 80 percent of business executives see a lack of understanding in how to conduct business in RMB as the greatest obstacle to RMB use in international transactions.²¹ Not all exporters know how to operate in RMB or how doing so benefits these operations.

Both China and Latin America need to come to terms with how to improve the partnership. Latin American exporters need to consider assuming more risk and engaging in operations to access China’s vast domestic market. Regional banks could also increase their activities in China, which would boost the confidence of Latin American exporters and mitigate cultural gaps. Currently, only Bank of Brazil has a subsidiary in the Chinese market. Hong Kong would be an ideal starting point for entering the Chinese market; it brings deep links to mainland China and has a central position in global RMB markets.

For their part, Chinese banks could do a better job of committing more resources to and understanding the Latin American business culture. For example, most Chinese banks in the region have no locals on their boards and avoid participation in local associations and media.

▲ The RMB is now an IMF-accepted reserve asset. Here, Managing Director Christine Lagarde (center) headlines a June 2016 press conference.

All in all, despite China’s massive investments in Latin America over the past decade, there is little evidence of substantial RMB use. A general reliance on the dollar still pervades. But recent reports suggest an increase in use in the past year, which could be a sign of things to come.²²

Greater RMB use will require providing answers to the lingering regional concerns that swirl around working with Chinese companies that invest in RMB. Those who receive payment in RMB do not have a clear idea of what to do with the currency and lack confidence in investing in Chinese assets. More risk-averse Latin American companies will not consider selling assets to risky Chinese firms. Still, with the recent opening of the domestic interbank bond market and increases in international liquidity, RMB use is likely to increase across the region.

RMB internationalization is clearly a central Chinese policy objective. However, before the RMB becomes widely used for trade, investment, finance, or reserves management in Latin America, it must win the confidence of financial market participants and policymakers. By taking the following three steps, the Chinese government could encourage greater RMB use in the region.

▲ The Chinese flag flies next to the Bank of England to mark the landmark bilateral currency swap agreement in June 2014.