The Renminbi’s Inexorable Rise

Asiamoney, May 2014

There’s long been a consensus on the end-game for the renminbi: full convertibility, plentiful and unimpeded flows in and out of China, and eventually the status of a vital reserve currency. But just lately, something’s changed about this prediction: the pace of it.

In March, HSBC’s China economist Qu Hongbin said he thought that full renminbi convertibility may come earlier than expected – within the next two to three years. HSBC’s chief executive, Stuart Gulliver, said in late March he expects it to be fully convertible by 2017. And Linan Liu, Deutsche’s chief China economist, tells Asiamoney she now expects to see effective convertibility by 2016.

What’s changed? Firstly, China’s new leaders, who came into power early last year, have proven themselves to be committed to financial reform. That was already in evidence during their first months in power – there was capital market and interest rate liberalization, and the foundation of the Shanghai Free Trade Zone as a testing ground for further reform – but then in November, the Third Plenum showed a more daring pace of change. While the end of the one-child policy and labour camps grabbed the headlines, there was an enormous amount of financial market reform too, which boiled down to a single imperative: let the market play the decisive role on pricing, whether the outcome be good or bad.

Since the broad policy announcement, there have been steady changes, small but in the aggregate very significant. Interest rates have been freed up for foreign currency deposits. Within the Shanghai FTZ, restrictions on cross-border capital flows have been removed. And in particular, on March 17, the daily trading band for the spot rate between the renminbi and the dollar was widened to plus or minus 2% per day, from 1% previously. That’s not a free currency, by any means, but it’s twice as free as it was the day before.

The intention is clear and the pace bracing. And the RMB is actually closer to convertibility than one might think: Yi Gang, head of the State Administration of Foreign Exchange, has said that around 85% of China’s capital account is already convertible, and the current account has been wide open since 1996. HSBC’s Qu Hongbin writes that out of 40 items that appear in an IMF definition of capital flows and convertibility, only four are not convertible – mainly transactions in domestic money markets, funds and trust markets and trading derivative instruments – while 22 are partially convertible and 14 are to all intents and purposes open already.

So what, specifically, comes next? Firstly, that widening of the band: there’s more to come. “Widening the spot RMB-dollar trading band from plus or minus 1 to 2% is already an indication of China pursuing a more flexible exchange rate,” says Linan Liu, Greater China rates strategist at Deutsche bank. “In the next two years, you may see the central bank widening to plus or minus 3%, before moving to convertibility in 2016.”

The point of widening the band is to allow more volatility in the currency, both upwards and downwards. “Band widening indicates that the central bank wants to exit from frequent intervention,” Liu says. “If that’s the case, there is a higher probability of two-way swings.”

With the policy barely two weeks old at the time of writing, it’s far too early to tell if that’s going to work; the currency has already traded near the top of the new band, but nowhere near the bottom. Still, as Candy Ho, head of RMB business development at HSBC says, “the market’s reaction to the widening of the FX trading band was quite positive, in the sense that companies and investors are treating it as a signal that the RMB is reaching equilibrium levels, and also that the one-way street appreciation of the RMB will definitely be slowing down.” That’s positive, she says. “That sets a really good backdrop for China to implement further financial reforms.”

Such as? Next, there will likely be an expansion of the existing quota programmes, both inbound and outbound. Liu says: “This year we might see China introduce the QDII programme for individuals rather than for institutions, and at the same time try to open up the expansion of international markets through QFII.”

To take the first of those theories, QDII, the long-standing programme through which institutions in China have been permitted to invest internationally, may be shifted to ordinary investors. Why? One reason is that, no matter how wide the band, the direction of the RMB has consistently been upwards against the dollar, and part of the reason for this is that China has such exceptionally high reserves. It has a current account surplus and it continues to attract foreign direct investment. But money doesn’t flow out again, so the currency is pushed upwards. “To offset that, China needs to move to a more balanced level, which means allowing for more outflows,” says Liu. “The best way to do that is to expand the QDII program.”

But the problem is that until now, domestic investors have had a strong reason not to bother moving their money overseas: the relentless climb of their own currency. Dollar assets have been depreciating against renminbi ones, so there really does have to be a mighty investment case to justify putting money offshore from the mainland. True volatility in the currency, in both directions, would change that.

That might seem a chicken-and-egg sort of a problem, but perhaps currency weakness might come from another source: China’s own economy. “We-expect near-term CNY [the term for RMB onshore, as opposed to CNH in offshore capital markets] depreciation on weakness in economic activity and continued concerns about domestic financial sector risks,” says Hamish Pepper, FX strategist at Barclays Capital.

At the same time, China’s own domestic banking and capital markets need to evolve, and a number of measures are already either in evidence or expected on the mainland. Ho expects the liberalization of interest rates in China “in the next one to two years,” starting with the liberalization of deposit rates (which is already underway). A cap on deposit rates is also expected to be lifted.

“But before that happens, we need to see deposit insurance introduced to the market,” says Ho. “Deposits involve large populations: there are 1.3 billion citizens in China, and most of them will have deposits sitting with the bank.” Liu agrees: she also expects a deposit insurance scheme is likely on its way and expects a higher ceiling on deposit rates in the banking sector. “Domestic interest rate liberalization is an integral part of RMB liberalization,” she says.

Alongside deposit and interest rate reform must come an evolution of the home-grown debt markets. “We believe that the domestic capital market will play a bigger role in terms of asset allocation,” Liu says. “A lot of corporates in China are still relying a lot on bank lending, and hence there hasn’t been much development of a corporate bond market. By far the biggest issuance domestically is government bonds, followed by financial institutions. This needs to change.”

It needs to change not just to make sure that there are diverse funding sources for China’s corporations, but because once the door of convertibility is open, there’s no going back, and the consequences for unprepared domestic institutions could be drastic. “It’s important to see that the pace of RMB internationalization is also a function of domestic interest rate reforms, because opening up the market must imply more competition,” Liu says. “A freer exchange rate and interest rate mechanism may force banks to adjust their funding costs and pricing mechanisms on the asset side of the balance sheet. That’s going to take time.”

Gradually, though, the markets should move towards a greater appreciation of risk, a more nuanced pricing of credit, and along the way a better understanding of using the market as a hedging tool. The recent defaults that have been permitted to happen in China’s bond markets for companies like Shanghai Chaori Solar Energy and Haixin Steel have been painted by some (stand up Bank of America Merrill Lynch) as China’s Bear Stearns moment, which seems excessive, but they do represent an important milestone: a message that the state won’t step in every time a debt-issuing company gets into trouble, and that from now on, the market knows best.

On the policy side, by 2016 Liu expects to see significant expansion of quota for individuals and corporates to convert RMB into foreign currency; most capital account items being permitted; FDI policy, already relaxed, to be open; and wider access to domestic capital markets by foreign investors, with relatively free too-way flows for both corporates and investors. That’s still not quite full convertibility, though, which she doesn’t expect to see until 2020.

Then there’s the offshore RMB side.  The topic of choice here is not so much the expansion of the dim sum market in scale and sophistication, which has been going on for years, but the development of further offshore markets. In March, for example, Standard Chartered added New York to its Renminbi Globalisation Index, which might not sound much, but it does represent a recognition that an attempt to monitor offshore RMB must embrace multiple centres. Stanchart’s index now covers five locations: Hong Kong of course, but also Singapore, London, Taipei and now New York. “Our recent trip to the US confirmed growing acceptance of the renminbi and its offshore market among our clients, and the numbers support this,” the bank wrote on March 7. Weighted average RMB-denominated cross-border SWIFT payments through the US grew 422% year on year in January by the bank’s numbers; cross-border RMB payment volume in the US is about the same as Taiwan’s, and as Singapore’s a year ago. “Investors are increasingly attracted by the offshore renminbi’s stability relative to other emerging market currencies,” says Kelvin Lau, strategist at Standard Chartered.

London is the centre that has made the greatest effort to present itself as an RMB hub in the last 12 months, with UK Chancellor George Osborne announcing a range of new measures during a trip to Beijing in October, including relaxed requirements for Chinese banks setting up in the city and an apparent quid-pro-quo of a RMB80 billion quota for UK financial institutions to invest in Chinese securities. Already, London accounts for more than 30% of RMB-denominated SWIFT payments to China and Hong Kong, says Lau at Standard Chartered, more than twice Singapore’s share; payments have risen more than tenfold since January 2012. Osborne has said London wants to appoint an RMB clearing bank, which would help it to capture regional flows and boost deposits. But London may not have Europe to itself: Frankfurt, in particular, and Luxembourg have voiced intentions to make themselves RMB hubs. In December the Frankfurt Stock Exchange’s operator, Deutsche Boerse, signed an MOU with the Bank of China for a preferred partnership to explore initiatives including promoting offshore RMB in Europe. Luxembourg is looking for clearing and settlement bank status alongside a R-QFII quota (allowing institutional investment into mainland Chinese securities).

Meanwhile Taiwan is moving towards critical mass. By the end of January 2014, Taiwan’s renminbi deposits stood at RMB214.5 billion, according to Taiwan’s central bank, up more than 500% in a year. The Chinese currency now accounts for 31% of Taiwan’s foreign currency deposits, according to Standard Chartered; the figure was 6% in February 2013. “This is impressive,” notes Lau, “considering that renminbi deposits in Hong Kong account for only 24% of Hong Kong’s total foreign-currency deposits.” Stanchart expects the deposit figure to reach RMB300 billion by the end of the year. Singapore has perhaps lagged expectations a little, partly because Asean countries haven’t tended to use the RMB as a funding currency, but has nevertheless carved a niche as the Asean hub for the Chinese currency.

And it may not stop there. Lau notes that Canada is making a “proactive push” to become an RMB trading hub, as something of a commodity play, though he notes: “The first-mover advantage in tapping the impending rise of commodity-centric renminbi flows between China and Latin America is certainly New York’s to lose.”

Still, as HSBC’s Ho points out, “Each will have its own role to play. It’s not a zero-sum game: it’s not like the business of trading is taken away from Hong Kong and Singapore to London. Usage of the RMB in the international financial markets will continue to expand.”

“People are seeing the offshore RMB market as a whole from a bond market perspective, even if they have different names like dim sum or lion city bonds,” she adds.

This is the future: RMB being a part of every financial centre’s raison d’etre, with multiple cities worldwide finding their own niches for leadership.

While all of this plays out, the remninbi’s statistics accumulate relentlessly. According to Standard Chartered, the RMB is the eighth-most used currency for international SWIFT payments, accounting for 1.3% of international payments, which sounds insignificant, but is not far from overtaking the Swiss franc (2.1%) and is clearly only heading in one direction (indeed, Stanchart says that including domestic flows, it’s already overtaken the Swiss franc). HSBC reckons the RMB became the second-most used currency in global trade finance in December 2013, overtaking the euro. More than ten thousand financial institutions do business in RMB – the figure was 900 in June 2011 – and the RMB is now used to settle around 18% of China’s total trade compared to 3% in 2010. There are now currency swap agreements between China and at least 20 central banks from New Zealand to Argentina.

For the capital markets, there are two common questions: how big can they get, and when do the onshore and offshore markets integrate?

Liu says both markets will continue to expand in notional size, and makes some bold predictions: China’s domestic bond market will double by 2020, “not because of the government bond market, but because of the development of the credit market”; and the offshore RMB market will go from almost RMB 600 billion now to “maybe RMB5 trillion by 2020”.

Convergence is a trickier issue to pin down. So long as there is a quota system in place, “the two markets will be a little bit separate,” Ho says. “Not until China fully opens its capital account and allows international funds to move in and out of the market will the onshore and offshore capital markets integrate.” But even then, it won’t be straightforward. “One thing to remember is that the offshore market uses international law and the onshore market Chinese law. We will have to see whether there are some changes in the governing law in China before seeing how much true integration there is between the two markets.”

Then the final question is when, and to what degree, the RMB becomes a reserve currency. “There’s already evidence that foreign central banks and sovereign wealth funds are beginning to invest in RMB assets,” says Liu. “If they have access, they prefer the onshore market.” Foreign central banks can do this through two mechanisms: the China Interbank Bond Market and QFII.

Ho agrees. “There’s no official statistics on which central banks are holding RMB as reserves, but quite a number have publicly said they either invest or are planning to invest in China’s onshore bond market,” she says. A People’s Bank of China report, issued only in Chinese late last year, said that as of August 2 2013 there were already 84 foreign institutions approved under CIBM. We also know from State Administration of Foreign Exchange data that out of the 237 approved QFII investors, 15 are classified as sovereign wealth funds, with US$12 billion in assets between them, or 23% of the total quota on issue. Notably, some countries – and not obvious ones – are setting official targets for RMB reserves. In January 2014 the Central Bank of Nigeria said it would increase the RMB holding in the country’s FX reserves from 2% to 7%.

“Perhaps for the time being the absolute share of RMB assets in total reserves is still quite low, but once the RMB becomes fully convertible it will attract a lot more reserve money to the domestic onshore market,” Liu adds. “Then the RMB will become a major reserve currency.” Again, Ho agrees. “We are expecting RMB full convertibility two or three years down the road. Then you will see a significant pick-up in central banks holding RMB as a reserve.”

Until then, there’s clearly a ceiling. As HSBC’s Qu Hongbin points out, “it is very hard to see how the RMB can become a reserve currency if foreigners were to continue to count for only 1-2% of local bond holdings. This contrasts starkly with the situation of most major currencies and even a number of major emerging market ones.”

Economists tend not to try to pitch the RMB is a dollar alternative, nor to depict a battle between the two. “The question is not whether the RMB will become as dominant as the US dollar,” Liu says. “It is better to think of it as representing the EM bloc. That is more important than it challenging the dominance of the dollar.” Once more, it is a view echoed at HSBC. “We are not saying that the RMB will take over US dollars or euros any time soon to become the biggest reserve currency,” says Ho. “But the RMB, because of its economic importance in the world, will be one of the reserve currencies.”