Letter of credit financing gives the illusion of exaggerated yuan globalization

The yuan has surpassed the euro to become the second most commonly used currency in global trade finance, after the US dollar. Yuan usage in trade finance grew to 8.66 per cent in October from 1.89 per cent in January last year, according to the Society for Worldwide Interbank Financial Telecommunication (Swift).

The SWIFT only tracks about 20% of global trade. Swift has used a narrow definition. It has measured only the portion of global trade financed by the traditional means of letter of credit, which interposes a bank between buyer and seller to help guarantee payment and delivery. It is not surprising that Swift should use the narrow definition. Swift is a bank international payment service.

80 per cent of international trade is now conducted on open terms. Trade partners who have long done business with each other increasingly don’t see the need for a bank intermediary. They decide to trust each other and not pay for this costly extra level of security.

China’s foreign trade in yuan, however, is still dominated by letter of credit. Thus the only thing that the Swift ranking of global trade indicates is that exporters and importers who settle their accounts in yuan do not have that same high level of trust in each other that is enjoyed by most other traders

Letters of Credit are a popular investment tool among Chinese investors.

This activity involves using faked import orders to take out Letters of credit(LCs) at banks—which is essentially a form of borrowing. The rate on a six-month LC is about 2.5%, according to a note last summer by Anne Stevenson-Yang of J Capital Research in Beijing—much cheaper than that on a loan. The investor then cashes in the LC, investing in wealth management products (more on those here) and earning a much higher return than that 2.5% before having to pay up.

Banks are keen on the trade—and are therefore willing to lend at such low rates—because the LC doesn’t count as a loan and therefore doesn’t require a commensurate deposit.

Investors are also using LCs to bring cash from offshore trading centers like Hong Kong and Singapore onto the mainland.

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