China is exerting its influence on African markets， starting with rapidly expanding bilateral trade， gradually extending to capital flows， both in the form of foreign direct investment (FDI) and infrastructure financing. This provides an opportunity for the Chinese yuan(CNY) to play a more significant role in African markets. Paying for goods and services in the CNY may be an important first step.

CNY trade settlement is taking place in Africa

With the cross-border trade settlement scheme in Hong Kong and the new CNH market， CNY trade settlement is already taking place on the African continent. The first CNY trade settlement transaction in Africa debuted in South Africa in January 2010. Since then， banks in other African countries such as Kenya， Uganda and Zambia have joined the market and started offering CNY trade settlement services in their respective markets. Although the market is still at an exploratory stage and the transaction flows remain negligible， mainly limited to small and medium-sized enterprises (SMEs)， this new market has already aroused interest among business communities in Africa.

In December 2010， the Central Bank of Nigeria (CBN) released a circular， announcing that the CNY would join 13 other currencies， including the US dollar (USD)， the euro (EUR)， British pound (GBP) and Japanese yen(JPY)， to become one of the tradable currencies in Nigeria’s International Foreign Exchange Market (IFEM) starting from 1 January 2011. The CNY is also regarded as a trade-settlement currency， so Nigerian corporates are now allowed to purchase USD with trade documents invoiced in the CNY. This means that Nigerian banks that have access to the CNH market in Hong Kong are able to quote the Nigerian naira (NGN) directly against the CNH. Corporates in Nigeria will also be able to buy the CNH from Nigerian banks， including Standard Chartered， for trade-settlement purposes， making Nigeria the first African country with a managed currency to allow this.

Why Africa?

Close trade links with China

While the trade figure may suggest a positive outlook， in reality， the growth potential of CNY trade settlement may be undermined by the unbalanced nature of China-Africa trade itself – consistently more than 90% of China’s total imports from Africa are primary products. In 2009， 64% was fuel trade and 24% was ores and metals. Historically， the USD has been the dominant pricing currency in the international commodity markets， especially for oil and metal trades， which are less likely to shift to being denominated in the CNY in the near future. When commodities are excluded， Africa runs a huge trade deficit with China， amounting to USD 55.4bn in 2010.

China-Africa trades are currently settled in a third currency

Currently， the USD and EUR are the major international trade settlement currencies in African economies. Using a third currency for trade settlement subjects both ends to additional foreignexchange risk and transaction costs. In the case of China-Africa trade， given the increasing significance of China’s trade across African countries， the CNY should be able to act as the common trade settlement currencies in Africa and help eliminate FX risks.

The majority of African currencies are traded offshore

Prior to the CBN’s announcement allowing the CNY to become tradeable in Nigeria’s domestic FX market， most major African currencies， as shown on Table 1， had already been traded offshore; i.e. two-way cross-rate quotes are feasible with the freely traded offshore CNH， allowing corporates in those African countries to have access to CNH liquidity. The decision by the CBN to include the CNY in its list of tradable currencies is a benchmark move in African markets， not only because it opens up the access to the CNH in Nigeria， but also， it provides a model for other African countries with a managed currency regime (such as Angola and Ethiopia)， to mull the feasibility of access to the CNH in their markets.

Africa’s CNH market

The development of Africa’s CNH market depends greatly on the dynamics of the market players. Looking at the trade components and the trade settlement arrangement， the key market players below will determine the scale and growth prospects of Africa’s CNH market. Although rapid growth may not be realised in the very near term， medium-term prospects are still considered favourable.

African central banks

Although many African markets have liberalised their current accounts， capital-account restrictions persist in some markets. Unlike Chinese FX controls， which aim to curb CNY appreciation pressure， many African central banks impose FX regulations in a bid to prevent their currencies’ depreciation. Therefore， African central banks’ willingness to liberalise their FX markets will be an important factor in determining the pace of CNY development in Africa.

Table 1 shows that， after Nigeria’s recent advancement， the majority of African markets with significant trade volumes with China are ready to use the CNY as a trade settlement currency —CNH nostro account arrangement is allowed and CNY-denominated trade documents are eligible for FX purchase.

CNH liquidity providers

Hong Kong is currently the only designated offshore CNY financial centre to help facilitate the internationalisation of the CNY. Any CNY trade settlement transactions in other markets beyond Hong Kong entail a nostro account arrangement with one of the participating banks in Hong Kong. Therefore， CNH liquidity providers are limited to the following two types:

? Banks in Africa which have a nostro account arrangement with participating banks in Hong Kong

? International banks which have a presence in African markets and， are at the same time participating banks in Hong Kong， such as Standard Chartered Bank

With the number of both types of CNH liquidity providers currently limited， rapid expansion of CNY offshore trading in Africa may not materialise just yet. However， given the market potential， much more scale is likely in the future.

CNH users for trade settlement purposes

Since commodity trades are unlikely to be settled in the CNY in the near future， what is left of China-Africa trade is largely one-sided， with Africa importing manufactured goods from China. Therefore， the most plausible users of the CNY for trade settlements are the exporters of manufactured goods in China and their counterparts in Africa. Both sides will have different incentives to settle trade in the CNY:

Exporters in China — They have a natural desire to settle trades in the CNY to eliminate FX risk and minimise transaction costs. Currently， exporters in China can either receive their export proceeds in Hong Kong by opening a CNH account， or register to become a Mainland Designated Enterprise(MDEs)， entitled to make use of the cross-border trade settlement quota through Hong Kong to receive proceeds in China. This arrangement may limit rapid expansion in CNY trade settlement for general China-Africa trade at the present stage.

Importers in Africa — Using the CNY as a trade settlement currency still subjects them to FX risk， especially w hen the CNY is appreciating. However， some of this risk can probably be offset by the benefit derived from better negotiation with Chinese exporters in terms of invoiced amounts， while Chinese exporters enjoy the benefits of receiving export proceeds in the CNY. The widening product ranges in CNH markets could help Africa’s importers hedge their underlying FX risk.

The trade flows may require more thought， as they may cause offshore CNH to flow back into the onshore market， which goes against the intent of the Chinese government to encourage CNY outflows. However， we believe this will be of little concern to the People’s Bank of China (PBoC) at present: first because the proportion of African trade in terms of China’s total trade is still small (less than 5% in 2009); second， the Chinese government is currently likely to encourage more trades settled in the CNY in order to increase its use in international markets.

Potential market depth

We expect China’s imports settled in the CNY to expand to more than 8% in 2011 and 12% in 2012， reaching 22% by 2015. Assuming that CNY trade settlement for Africa will keep pace with this global average， while taking into consideration the FX controls and development of banking infrastructure， we expect CNY trade settlement volume in Africa to reach at least USD 15bn by 2015 — 8% of total Sub-Saharan Africa’s China-Africa trade and 2% of CNY trade-settlement volume.

CNY trade settlement in Africa may contrast with other regions， where China’s imports are more likely to be settled in the CNY than its exports， given expectations of CNY appreciation. China’s exports to Africa will account for more than 80% of total China-Africa trade settled in the CNY and its imports will take the remaining 20%， mainly owing to the dominance of commodities in China’s imports from Africa.

In terms of regional distribution， South Africa will be the key market for CNY trade-settlement business， accounting for 44% of total market share， followed by Nigeria with 19%. This is driven by economic size， which generates strong demand for capital goods from China. Angola， which is China’s top trading partner in Africa， is only expected to take 5% of the total CNY trade settlement market， because its trade with China is dominated by oil.

Africa can be a possible market for CNY regionalisation

In the long run， the potential use of the CNY in Africa is not only limited to trade settlement of general exports. Two additional uses are possible:

The CNY as a commodity-pricing currency — For various historical reasons， the USD has long been the major commodity-pricing currency. However， China’s increasing importance in global commodity trade makes possible a gradual shift of pricing commodities into the CNY. As the report suggests， commodities not linked to benchmarks traded on international exchanges are likely to be the first to move away from the USD， such as iron ore， metallurgical coal and steel. This type of trade has already happened between China and Africa: the firstever CNY trade settlement in Africa was an intra-company import of steel from South Africa by a Chinese stateowned steel company.

Base metals are likely to be next， especially those commodity trades dominated by China， such as copper. A higher level of CNY convertibility is necessary to achieve this. Should this shift in the commodity-pricing currency take place， it will give a strong boost to CNY circulation in Africa， especially in the major ore and metal exporting markets， such as South Africa and Zambia.

The CNY as a denomination currency of capital flow — Another potential way that the CNY could play a bigger role in Africa is to act as the denomination currency of capital flows， such as FDI and foreign aid. We think this could be realised in the near future. Since January 2011， the Chinese government has allowed Chinese corpo- rates to invest abroad in the CNY. Also， at the third BRICS Summit (comprising Brazil， Russia， India， China and new joiner South Africa) in April 2011， the five countries signed an agreement to use their own currencies to issue credit or grants to each other. These possible developments are in line with China’s intention to increase CNY circulation in the international markets. At the same time， it constitutes the significant potential of the CNY in Africa. Africa is the third-largest beneficiary of China’s FDI after Asia and Latin America， with FDI stock reaching USD 9.3bn in 2009. China has also provided Africa with foreign aid in form of grants， interest-free loans and concessional loans， especially for infrastructure financing. According to the White Paper on China Foreign Aid Policy released by the Chinese government in May 2011， nearly 46% of total China foreign aid in 2009 was channelled to Africa. The CNY could be a powerful tool as China exerts its economic influence in Africa from trade flow to capital flow.

CNY reserve-ification could first take place in Africa

Commodity export proceeds and foreign aid are the key funding sources of foreign-exchange reserves for many African countries — Angola and Nigeria build their reserves through oil export proceeds， while Uganda and Tanzania still rely on foreign grants to keep a balance-of-payments surplus. Receiving these two capital flows in the CNY will drive a need for African countries to keep part of their reserves in CNY-denominated assets. In June 2010， the CBN’s Director of Reserves Management Department， Lamido Yuguda， mentioned that the CBN is considering holding a part of its reserves in the CNY to preserve the value of the nation’s external reserves， although this may not be the case yet. As the CNY internationalisation process continues， with more opening-up of China’s capital account and a higher degree of CNY convertibility (currently a key constraint)， Africa has the potential use the CNY to build up its reserves to ultimately achieve CNY ‘reserve-ification’.