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Asia-PacificMarch 10 2011

Renminbi takes the slow road to domination

The battle over the valuation of the Chinese renminbi has often been characterised by vitriolic debate and has seen a titanic clash between Washington and Beijing about the right level for the currency and the speed of appreciation. But efforts to internationalise the renminbi are already taking effect.
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Seldom does one issue define an era, but in the battle between the Chinese renminbi and the US dollar there is enough drama and politics to suggest it might do so. As the economic giants grapple for dominance of global trade, currencies are increasingly the language by which their power is expressed.

The dynamic, however, is not straightforward, because both China and the US want ostensibly the same thing, which is a stronger renminbi. The difference lies in timing, with policy-makers in Washington, DC, pushing for immediate appreciation and Chinese officials preferring to take the slow road, aiming for full internationalisation of the Chinese currency over the next 10 to 20 years.

Amid talk of currency wars, trade sanctions and manipulation, the debate over the dollar-renminbi exchange rate has been conducted in an atmosphere that is at best febrile and worst aggressive. However, behind the headlines, China has been making steady progress on a process that even the most voluble of the Washington hawks recognises is fraught with danger.

Balancing act

China’s problem is that if it liberalises too quickly the currency’s rise will smother economic growth, increase unemployment and fan the flames of social unrest. If on the other hand it liberalises too slowly it is likely to hobble China’s progress toward rebalancing its export-driven economy, and to prolong its reliance on a depreciating dollar.

“China was one of a number of countries that was taken aback by the impact of what was, to a significant extent, a US-led crisis,” says Callum Henderson, global head of foreign exchange research at Standard Chartered in Singapore. “As a result it is looking to rebalance its economy away from exports and in favour of domestic demand, and part of that is reflected by internationalisation of the currency.”

At the forefront of the internationalisation effort is the development of the Chinese currency deliverable in Hong Kong, the so-called 'CNH market'. That was launched in 2009, when the Chinese government introduced renminbi-denominated trade settlement, a step toward building liquidity that was followed last year by the launch of local currency investment products and an off-shore renminbi bond market.

FX graph 5

Landmark move

In January this year, the Chinese central bank gave permission for Chinese businesses to make foreign investments using the renminbi, and exporters are expected soon to be allowed to park foreign currency earnings abroad. Meanwhile, the Bank of China has for the first time offered renminbi-denominated accounts at its branches in Los Angeles and New York.

In a significant challenge to dollar dominance, China late last year agreed with Russia and Malaysia to allow their currencies to trade against each other in spot inter-bank markets, a move that will facilitate cross-border settlement in the renminbi.

Efforts to promote internationalisation have already led to a rising renminbi, which appreciated 3.6% against the dollar in 2010, and is currently trading at a level of 6.57 against the dollar.

Still, with China reluctant to speed the pace of liberalisation, the renminbi remains a minor currency in global terms, with average daily turnover in the renminbi FX spot market reaching about $8bn, according to Bank for International Settlement (BIS) figures. That compares to $300bn in yen, $700bn in euros and $1200bn in dollars.

“Turnover tends to relate to the size of the economy so you would expect FX volumes on that basis to be in the region of $150bn a day,” says John Normand, global head of currency strategy at JPMorgan. “Turnover in the renminbi is grossly lagging the size of the Chinese economy and that highlights that liberalisation is a methodical and slow process.”

FX graph

Controlling capital flows

One of the biggest challenges facing China is how to control capital flows. Currently the Chinese government combines rigid restriction with an iron grip on internal money supply, managed through high bank reserve requirements and purchases of renminbi through so-called sterilisation bills.

China has a balance of payments surplus of some $200bn to $300bn, and buys an estimated $1bn a day from state and commercial banks in order to prevent those funds being used by exporters to buy renminbi. At the same time it prints renminbi which it credits to various bank reserve accounts. The central bank then raises short-term bills which it sells to the banks, effectively borrowing the money back and removing it from the system.

The efforts to control money supply are having some impact. Annual growth in China's broad M2 measure of money supply was 17.2% in January, compared with 19.7% a month earlier, according to official sources.

“If you add up reserve requirements and sterilisation bills, some 24% of bank assets are locked up,” says John Greenwood, chief economist at investment management company Invesco. “This is money that could be used to develop money markets and credit markets, which is a precursor for renminbi internationalisation.”

Without a properly developed money market, China has little chance of moving to a more liquid capital account, says Mr Greenwood, as an open-door policy without domestic infrastructure would likely prompt a rush for the exit. 

“I think China would like its currency to become more widely used internationally, but [Beijing is] very nervous about allowing it to be subject to large-scale capital flows inwards or outwards. The problem is that those two aims are fundamentally in conflict,” he says.

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