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Asia-PacificJanuary 3 2012

Renminbi's global status: a case of when, not if?

There seems to be something of an inevitability about the renminbi's rise to reserve currency and global dominance. However, there are mutterings that this ascents will be curtailed by China's development model, corporate governance and financial system.
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Renminbi's global status: a case of when, not if?

The tug-of-war between China bulls and bears has sharply divided financial markets in recent years, with the debate adopting an ever more partisan tone as the country takes centre stage in the global economy. A vulnerable China, plagued by opaque local debt burdens and a real-estate bubble, is frequently pitted against the image of a self-confident superpower that is rapidly assuming the mantle of global economic leadership.

In recent months, the latter portrait has dominated, as the fiscal funk in the West shows no sign of abating, thus boosting perceptions of China’s relative economic strength. What is more, Beijing seems to be engineering a soft economic landing – for now.

In September 2011, Arvind Subramanian, a fellow at the Washington, DC-based Peterson Institute, articulated the case for the Sino-enthusiasts with the release of 'Eclipse: Living in the Shadow of China's Economic Dominance'. In this manifesto for a Chinese-led world order, Mr Subramanian argued the renminbi could dethrone the dollar as the principal global reserve currency within a decade.

That is quite an accolade for a currency that remains heavily guarded in its onshore market and represents just 0.4% of turnover in the global foreign exchange market and 0.1% of international debt securities. What is more, bullish predictions of the renminbi’s ascent sit awkwardly with China’s hitherto tight grip on its capital account and the historic time lag between economic dominance and currency ascendance – 70 years in the case of the US versus the UK. But Mr Subramanian, a former International Monetary Fund (IMF) economist, argues that the renminbi’s rise is a logical outcome of China’s strengthening economic fundamentals.

In short, China has a $7000bn economy, in nominal terms, that could outsize the US’s $15,000bn economy in a matter of years if it continues with its breakneck growth rates. China’s growing economic clout, the argument goes, should logically boost its financial muscle, namely in the foreign exchange market – provided it embarks on currency reforms. Promisingly, China’s heavily managed and ad hoc approach to currency internationalisation – a strategy without historical precedent –continued in earnest last year, highlighting how Beijing is now ideologically wedded to currency reforms, Mr Subramanian’s book argues.

In sum, the fact that the Chinese currency punches below its weight in global trade and capital markets is a historical anomaly and economic logic dictates a correction is long overdue, bulls contend.

Rebalancing China’s growth

The shifting sands in the global economy and the subsequent need to rebalance China’s economy have also added impetus to currency globalisation efforts. Put simply, the Asian dragon needs to retool its outdated growth model away from financial repression and cheap exports, fuelled by an undervalued exchange rate.

The current financial system is characterised by a low (and heavily managed) interest rate environment that effectively punishes net savers and leads to perpetual bouts of capital misallocation. By contrast, a free-floating and globally traded renminbi would help Chinese policy-makers craft a new growth model based on stronger domestic consumption, a more efficient financial system and capital mobility.

This argument is gaining currency with consensus opinion now betting on the redback’s ascent. To wit, a Bloomberg survey conducted in May 2011 of 1263 market players revealed that a majority reckon the renminbi will be fully convertible by 2016 – compared with Beijing’s 2015 target – and half of those polled believe the redback will become a reserve currency within 10 years.

Adding to the growing a sense of inevitability about the renminbi’s rise, corporate bond issuance in the Chinese currency outpaced euro-denominated corporate bond sales for the first time in the third quarter of 2011, with $31.1bn-equivalent of deals, according to Dealogic. Granted, these figures reflect the uncertainties around the eurozone crisis as much as the growth of the Chinese capital market, but its symbolism is still seductive for Sino bulls: markets have faith in the currency as a store of value, one of three commonly cited functions of money, along with a medium of exchange and as a unit of account.

Opportunities and challenges

Moves to boost offshore trading of the renminbi in Hong Kong in recent months, dubbed the CNH market by traders, for many market participants highlights how Beijing is taking meaningful steps to cast the renminbi as a trade and investment currency.

“The infrastructure to develop the currency… is now being established with good speed, highlighting how the Chinese currency is following the well-trodden path of Japan’s move to internationalise the yen,” says Eddie Cheung, a foreign-exchange analyst at Standard Chartered.

If these predictions ring true, the growth of the offshore renminbi market in 2011 – after Beijing liberalised trade settlement in July 2010 – could rival the existential crisis of the euro in terms of historic significance.

Additionally, the speed of the growth in renminbi-denominated securities throws into sharp relief market confidence in its rise. The statistics speak for themselves: according to the IMF, as of the end of November 2011, outstanding issuance of so-called 'dim sum' bonds – traded in Hong Kong and denominated in renminbi, and seen as a crucial step in transforming the currency into an investable product – has reached about Rmb200bn; some 10% of mainland trade is now being settled in renminbi; and the Chinese currency makes up 10% of total Hong Kong deposits. These figures were negligible just two years ago.

The infrastructure to develop the currency… is now being established with good speed, highlighting how the Chinese currency is following the well-trodden path of Japan’s move to internationalise the yen

Eddie Cheung

“Demand for renminbi and its supply is more balanced now compared with a couple of years ago,” says Simon Flint, global head of foreign exchange research at Nomura.

And in August, Chinese vice-premier Li Keqiang outlined in greater detail the roadmap for a “firm but measured” pace of renminbi internationalisation. This included allowing non-financial companies to issue in renminbi offshore and establishing a pilot scheme to permit up to Rmb20bn of portfolio flows into the securities markets. The measures are aimed at – cautiously – increasing capital inflows to the mainland and boosting renminbi liquidity in Hong Kong.

In short then, Beijing is seeking to promote the renminbi for investment purposes from bonds, public equities and, more recently, direct investments, subject to regulatory approvals.

Trading places

But the speed at which the currency will achieve global dominion will be largely determined by its use in trade. To this end, in August, Beijing took further activist measures to boost its currency for trade purposes. These included further expanding renminbi trade settlement to the whole country from 20 provinces previously and permitting Hong Kong enterprises to use currency obtained overseas to finance foreign direct investments in the mainland.

What is more, the People’s Bank of China has signed a flurry of currency swap agreements with emerging market central banks in recent years. For example, in January last year, the Nigerian central bank added the renminbi to its basket of currencies permitted for trade settlement in the domestic foreign exchange market, becoming the first African country with a managed currency to allow this type of trade settlement activity.

Trade settlement services in the Chinese currency have also picked up elsewhere in the continent, leading Standard Bank, for example, to predict in August last year that at least 40%, or $100bn, of China’s trade with Africa will be denominated in renminbi by 2015. In addition, at least $10bn of Chinese investment into Africa will be denominated in renminbi over the same period, the bank predicts.

These bullish projections highlight how most analysts reckon the financial infrastructure has now been established to allow the “renminbi to become a truly global currency for trading purposes”, says Richard Brown, head of BNY Mellon Treasury Services for the Asia-Pacific region.

That prediction is based on an important caveat: foreign importers will not snub the currency for trade invoicing purposes given the prospect of an appreciating renminbi.  

That is by no means a one-way bet. Contrary to market expectations, the use of the currency for international trading purposes stalled in the third quarter of 2011, with the total volume of renminbi-settled deals falling 2% quarter-on-quarter to Rmb583bn, after the currency depreciated in the September sell-off. “The cyclical volatility is part of the global trading dynamic and in no way has dented support for internationalisation of the currency,” says Mr Cheung.

But for Michael Pettis, finance professor at Peking University, the sell-off highlights how much of the excitement about the currency and its potential use in global trade is wildly off the mark. Instead, market players have snapped up the currency “purely for arbitrage or speculative purposes rather than for transactional reasons” while few multinational companies have chosen to use the renminbi for trade settlement, he says.

Closed economy

More profoundly, Beijing has taken baby steps in liberalising its capital account, a fact that slams the brakes on its bid to become a truly global reserve currency for private financial markets and central banks alike. Why? It is all down to China’s growth model, says Mr Pettis.

He argues that liberalising interest rates, the exchange rate regime and capital controls fly in the face of China’s economic model, characterised by “top-down monetary management, artificially low interest rates and a closed financial system”. A jump in interest rates would trigger a surge in corporate and public indebtedness, expose the indiscipline of state-backed borrowers, while an open monetary regime would ensure policy-makers would have less control over the banking system – the primary vehicle for stimulus policies.

Since banking sector reform precedes capital account liberalisation, “none of the basic conditions are in place for China to offer a truly global reserve currency since huge changes are needed to China’s development model, corporate governance and financial system”, he adds.

For these reasons, markets have been “fooled by the growth” of the offshore renminbi market and the Chinese bond mart since the supply of renminbi-denominated securities is a drop in the ocean compared with the capacity of China’s economy and the size of the US’s $32,300bn bond market, Mr Pettis says.

More generally, at present there are few mechanisms through which investors and borrowers can acquire renminbi. To achieve this, China could either run a large current account deficit – via an abrupt hike in consumption or by upping investment to gross domestic product ratios further – or kick open its domestic financial markets, Mr Pettis says. Both scenarios risk imperiling the banking system and economic growth. For these reasons, he reckons the renminbi will not even rival the Japanese yen or sterling as a truly global reserve currency within the next 10 years – in stark contrast to Mr Subramanian’s bet that the currency will reign supreme within a decade.

Delayed by the slowdown

Others occupy something of a middle ground in the debate about the renminbi’s march to a reserve currency status. Market pressures will “push the authorities to implement flexible monetary and capital account policies”, says Qinwei Wang, an economist at London-based research boutique Capital Economics.

The continued accumulation of offshore renminbi will bring pressure to open the domestic renminbi bond market, in part to ward off the threat that distortions in the CNH versus onshore spot market could create incentives for arbitrage activities, he says.

Moreover, Beijing understands its growth model based on an undervalued exchange rate is unsustainable and a convertible renminbi would help China correct imbalances. Although the path is littered with hurdles, it is a matter of when, not if, the renminbi becomes a truly global reserve currency, according to Mr Wang, formerly an economist at People’s Bank of China.

Policy-makers need a stable currency right now, rather than volatility. In fact, a slowdown in exports to Europe in the next two years will require Beijing to increase investment spending and monetary stimulus, hence, reinforcing the short-term attractiveness of its financial model

Qinwei Wang

Still, on the timing front, prospects have darkened. Although the eurozone crisis has perversely established a conducive environment for a more flexible exchange rate band (by reducing the risk that the mainland will be destabilised by a tide of speculative capital, says Jian Chang, a China economist based in Hong Kong) stability and financial protectionism are the name of the game now. “People globally are naturally questioning the efficacy of unfettered free markets,” says Nomura’s Mr Flint.

Mr Wang agrees: “Policy-makers need a stable currency right now, rather than volatility. In fact, a slowdown in exports to Europe in the next two years will require Beijing to increase investment spending and monetary stimulus, hence, reinforcing the short-term attractiveness of its financial model.”

The renminbi seems to be treading a well-worn path to becoming a global trade and investment currency – if from a very, very low base – but the journey to reserve asset status has, for all intents and purposes, barely begun, given iron-clad capital controls. And economists are sharply divided on whether there is a mechanistic relationship between economic supremacy and global currency dominion; after all there are only two historic precedents – sterling and the dollar. But what is certain is that the renminbi’s global ascent will require profound – and often misunderstood – changes to China’s growth model, and with it, shifts in global balance-of-payments trends.

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