A report by the Institute of International Finance last week showing that the use of the Chinese renminbi has become the sixth most used currency in global transactions is being used to support arguments that the genuine internationalisation of the RMB is close, rapid and all but inevitable. I have consistently argued that this is far from the case.
In this article, I will reiterate the argument that we should not get too excited by RMB internationalisation. Genuine RMB internationalisation is not possible without genuine and profound Chinese economic reform. And until that occurs, RMB will remain a niche and speculative currency rather than one reflecting China’s status as a great trading nation and the second largest economy in the world.
Let’s start with some numbers. The RMB has become the ninth most traded foreign currency on foreign exchange markets, in addition to being number six in all global transactions mentioned above. In 2010, $US34 billion per day was traded, rising to $US120bn per day currently.
This appears a dramatic rise, but from a very low base. Payments in RMB still only accounts for about 1.6 per cent of forex transactions. In March 2014, the US dollar accounted for 40.19 per cent and the Euro 31.78 per cent.
Since the majority of transactions in RMB are for the purpose of settling trade, so-called ‘swap agreements’ with the People’s Bank of China will become more important. China conducts the majority of its trade in American dollars, and a small percentage in Japanese yen. In 2012, RMB was used in only 15 per cent of China’s imports and nine per cent of its exports. (This is in contrast to the US, where 90 per cent of its trade is in US dollars and Japan where 70 per cent of its trade is in Japanese yen.)
This means that local currency needs to be converted to the greenback, and then into RMB (and vice versa) when trading with China. The extra cost of intermediary conversions to and from the US dollar in IOUs increases the transactions costs of trade, and precludes businesses from hedging against rises or falls in the American dollar. It also carries the additional risk of a liquidity crunch during transactions with China should American dollars be in short supply into the future, even though the prospect of this is minimal for the moment.
To minimise transaction costs and other settlement risks, the PBoC has signed over twenty currency swap agreements with central banks of major trading partners including Australia. These agreements differ in the maximum amount of currency available for the swap. They also vary as to whether the direct swap applies to the principal or only the interest payment of any IOUs from bilateral trade. But the point of these agreements – besides providing central banks a buffer against possible shortages in American dollars required for trade with China – is to establish a future foundation for importers and exporters to exchange RMB with local currency without having to sign IOUs that are denominated in American dollars.
While the vast majority of payments and settlements in RMB are in the context of trade activity, the emergence of financial centres outside China and Hong Kong (such as Singapore, Taiwan and London) as a clearing house for RMB are intended to be more meaningful and extensive than merely facilitating more efficient payments for trade transactions. In addition to utilising swap agreements, the prospect is that key financial centres such as Singapore can emerge as a global financial centre to buy, sell and ‘park’ RMB-denominated assets whether they be bonds, shares, IOUs or other assets.
Yet while the RMB is used in increasing but still relatively small amounts as a medium of exchange in settling trade transactions, it has virtually no international status as a ‘store of value’ for central banks to accumulate in official reserves or as an investment currency for use outside China. Besides using RMB to settle trade invoices, currency speculators also periodically buy RMB (through illicit use of the trade account and other methods, otherwise known as ‘hot money’) on the prospect that the RMB will be partially liberalised and rise in value. But until the RMB is seen as a legitimate and reliable store of value, international demand for RMB will not match the top five or six currencies, meaning that the RMB will have limited relevance and penetration in financial centres such as Singapore beyond trade purposes.
The genuine internationalisation of the RMB — and its emergence as a ‘store of value’ for central banks — is unlikely to occur for a number of reasons.
First, China still maintains a de facto fixed currency regime linked to a US dollar dominated ‘basket of currencies’. Until this is changed, there is little incentive to hold too many assets and IOUs in RMB since the prospect of dramatic appreciation in the value of China’s currency is slight. Bear in mind that Beijing places significant restrictions on the band within which conversion rates utilising swap arrangements can deviate from official, fixed conversion rates for RMB into US dollars.
The prospect for dramatic change in China’s fixed currency regime is also poor. China’s two largest export markets in America and the EU are still deleveraging and will grow relatively slowly; and the margins of its exporters are increasingly suffering from competitors in rising Asian manufacturing hubs such as Vietnam, Cambodia and Indonesia. To protect an export-manufacturing sector that employs 50 million people directly and another 100-150 million people indirectly, Beijing will not float the RMB and allow it to significantly appreciate into the future. Besides, rapid appreciation of the RMB against the US dollar would severely reduce the value of its U.S. dollar-denominated foreign exchange reserves and dramatically increase the liabilities of the PBoC vis-à-vis IOUs issued to domestic banks on behalf of exporters as explained earlier.
Second, foreign governments, firms and individuals will remain reluctant to hold too much RMB-denominated assets for the simple reason that there is not much use for the currency outside China (and Hong Kong). This will remain the case until China opens its capital account, liberalises its domestic interest-rate regime (deposit and lending rates), and removes obstacles currently in place to restrict the presence and operation of foreign firms in Chinese financial and other domestic sectors.
Without an open capital account, foreign holders of RMB-denominated assets will not be able to transfer capital in and out of China freely and without restriction. Without a liberalised interest rate regime, deposit and lending rates in China will remain artificially suppressed, decreasing the incentive to ‘park’ capital inside China. Without being able to invest freely and openly in major domestic sectors of the Chinese economy, there will be limited utility and therefore demand for RMB-denominated assets for investment purposes.
Due to Beijing’s determination to maintain the dominance of its state-owned banks in the domestic financial sector, corporate bond markets within China will remain relatively undeveloped, meaning that RMB fixed-income options will remain shallow and relatively illiquid compared to other major currencies.
The point is that until there are deep, lasting and irreversible reforms to the Chinese political-economy – and there is little evidence of that so far – the role of the RMB in regional and global financial markets will be far smaller than it could be given the size of the Chinese economy. In other words, the much lauded ‘capitalism with Chinese characteristics’ is preventing China from becoming a global financial player commensurate with its absolute size.
Until you see hard evidence of reform and opening of the Chinese capital account, domestic financial system and corporate sectors, ignore headlines about the rise of the RMB as a genuine international currency.