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Korea and China have been deepening their economic integration lately. On December 20, 2015, the Korea-China free trade agreement (FTA) will enter into effect, see our analysis on the FTA here. In October, outside the FTA, Korea and China agreed on two notable items: 1) the establishment of a direct Korean Won-Chinese Yuan trading market in Shanghai and 2) the Korean government’s issuance of yuan denominated sovereign bonds in the Chinese bond market. These not only promote China’s agenda for internationalization of the renminbi as well as helping the yuan’s inclusion into the SDR basket by boosting yuan transactions in international market, it also supports Korea’s goal to launch the Korean won’s internationalization[1] and to become a major offshore yuan trading hub in Asia.
The direct trading of won-yuan in Shanghai signifies an important moment in Korea’s international launch of the won. More specifically, the Korean won can now be traded with the Chinese yuan directly among non-residents without the use of the US dollar, lowering transaction costs, and helping domestic enterprises reduce foreign exchange risk. Currently, the exchange of Korean won among non-residents has been restricted under the Foreign Exchange Transaction Regulation. This is mainly due to concerns about sudden capital outflows (Kim and Suh, 2009). But, because of a large trade surplus with China, supporters of financial openness successfully argued that trade settlement in won would benefit Korean exporters and importers and reduce their foreign exchange risks (Hyun, 2014). For a successful launch of the Korean won’s internationalization, not only does Korea need domestic reform, but it also needs to benefit from increased demand for won in Shanghai.[2]
Korea also agreed to sell yuan denominated bond from the Chinese interbank bond market. Before, Korea had only issued US dollar and euro bonds, so the issuance of onshore yuan bonds is significant. This measure is a response to the growing importance of the renminbi, and of its efforts to open its bond market. Now that the yuan’s inclusion in its Special Drawing Rights (SDR) basket has been approved, Korea’s issuance of panda bonds will help Korea diversify its foreign currency holdings, and increase the supply of Chinese yuan to Korean corporations planning to invest in China. It will also encourage Korean financial institutions to enter the Chinese bond market to expand their business. Recently, Korea obtained the approval of People’s Bank of China (PBoC) to issue 3 billion yuan ($463 million) of panda bonds. That amount is relatively small[3], but it is large enough for Korea to play an important role as a trading hub for the yuan.
The Korea-China FTA can herald a new era for Korea-China relations. Both countries expect that the free trade agreement will boost demand for trade settlement in won and yuan. In 2016, the old method of using the US dollar as a reference for won-yuan exchange will be replaced with a direct exchange rate for won-yuan transaction. If this financial agreement is successfully implemented, China will be the first foreign market where the Korean won is used for trade settlement. Korea will also be the one of earliest sovereign nations to issue yuan denominated bonds outside of Chinese territory. Therefore, the Korea-China financial accord could be a vehicle to help achieve each country’s major economic goals. More importantly, it also reveals that Korea and China have increased mutual trust for each other and are intent on deepening bilateral economic ties in trade and investment, including the financial markets.
Notes
[1] In this blogpost, Korean won’s internationalization is defined as the transaction of won in the Chinese market, rather than world.
[2] As a testing bed, Seoul launched direct trading of the won and yuan in December 2014. According to a report from the Bank of Korea (Korean), transaction costs dropped by 30 percent, and the volume of Korean trade settlement in yuan increased fourfold from $240 million to $930 million over a year.
[3] China approved the issuance of 6 billion yuan (approximately $957 million) of panda bonds for Canada.
