The Renminbi Goes Abroad

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Signs of the growing international presence of the Chinese renminbi (RMB) have fueled speculation that the yuan will be the world’s next reserve currency. The Chinese economic miracle has catapulted the RMB to a spot among the top 10 traded currencies in the global economy, thanks to high GDP growth, consecutive current and capital account surpluses and an aggressive People’s Bank of China (PBoC) policy since 2009, a time when China found itself in the “dollar trap.”

However, the yuan’s rapid offshore growth, driven by increased trade settlement, offshore deposits, central bank currency swaps, and issuances of RMB-denominated bonds, may be a function of investor speculation, not organic acceptance of China’s economic weight in the international economy. Unless offshore RMB use becomes more international and less driven by speculation, it could threaten China’s internationalization timetable.

It has long been thought that the RMB is undervalued due to the PBoC’s policy of promoting the export-dependent tradable goods sector. By accumulating nearly $4 trillion in foreign exchange reserves through a “twin surplus” (current and capital account surpluses), China has been able to suppress the RMB’s value through sterilization. Foreign investors have relished the opportunity to invest in the RMB since 2005, when China unpegged the currency from the dollar, seeing appreciation as a certainty. If investors hold RMB or RMB-denominated assets, they can anticipate translation gains when converting those assets back into their local currencies. As of April 2014, the RMB had appreciated 34 percent versus the dollar since it was unpegged.

However, the problem with holding RMB is the difficulty of investing in China’s tightly controlled short-term capital markets. China tightened controls to insulate itself from large capital movements when hot money portfolio outflows provoked currency instability across Southeast Asia in 1997. Foreign direct investment, a form of long-term capital, has an easier time entering China than do short-term portfolio flows in RMB or RMB-denominated assets. For instance, foreign investors interested in investing in China’s RMB-denominated A-share market must apply to the Qualified Foreign Institutional Investor (QFII) program, which had a $150 billion quota ceiling as of July 2013. Even if investors receive permission to invest under the QFII scheme, investments are subject to a one-year lockup and repatriation of capital is subject to the State Administration of Foreign Exchange’s approval.

China has allowed the RMB to become more accessible after PBoC Governor Zhou Xiaochuan spoke of including the RMB in the International Monetary Fund’s prized Special Drawing Rights in March 2009. In mid-2010, China introduced the RMB trade settlement scheme, allowing Chinese enterprises and foreign firms to transact in RMB. Foreign exporters accepted RMB for goods they sold to China as imports (import trade settlement). Fewer foreign importers accepted RMB for Chinese goods (export trade settlement) because they would realize losses in their local currency if the RMB appreciated. Therefore, import trade settlement has outpaced export trade settlement. As of June 2013, the share of the PRC’s trade in RMB trade settlement compared to its total foreign trade was approximately 17 percent (about $170 billion in nominal terms).

As import trade settlement outpaced export trade settlement, liquidity accumulated offshore. In response, China allowed an offshore RMB (CNH) market to develop and designated Hong Kong as the main hub for recycling RMB accumulation. Since 2009, RMB deposits in Hong Kong and RMB-denominated bonds have enjoyed rapid growth in the offshore market. More specifically, the liberalization of the RMB allowed offshore RMB deposits in Hong Kong to sore 1,254 percent from the end of 2009 to October 2013. Through November 2013, “Dim Sum” bond issuances rose to $9.7 billion, up from $7.1 billion in 2012, on strong demand. High growth rates in offshore deposits, large demand in RMB-denominated assets and a persistent PBoC monetary policy helped make the RMB the number two currency in trade finance as of December 2013.

Foreign central banks have also taken note of the RMB’s importance in international trade and finance, engaging in a series of swaps with the PBoC. Swaps allow central banks to access the RMB for liquidity and encourages foreign domestic banks and firms to transact directly with RMB. By October 2013, the PBoC had bilateral RMB-denominated swap agreements with 23 other countries, compared with just two in 2009 (excluding arrangements made during the Chiang Mai Initiative agreements).

However, figures can be misleading.

Even though currency swaps with other central banks are useful for examining RMB liquidity, most are medium-term agreements that will be unwound. Since the trade settlement scheme was introduced in 2010, more than 80 percent of RMB trade settlement have occurred in Hong Kong. According to University of California Professor Barry Eichengreen, more than 75 percent of RMB-denominated “Dim Sum” bond issuances are sourced by mainland Chinese and Hong Kong firms, while the European Central Bank states that, as of the second quarter of 2013, a mere 0.3 percent of global bonds and notes outstanding were RMB-denominated. The QFII program, according to ChinaQFII, is slated to constitute a mere 10 percent of China’s market capitalization in 5 years. This signals that the offshore RMB still has significant work to do to develop its international role.

More concerning is the strong growth of RMB use driven by exchange rate and interest rate arbitragers. According to Dr. Yu Yongding of the Chinese Academic of Social Sciences, “the experience so far shows that exchange rate and interest rate arbitrages are two key drivers for the progress in renminbi internationalization.” Though arbitragers provide liquidity, RMB demand driven by speculation can lead to sudden outflows as global capital flows become more “herdlike” in nature. While China sits on nearly $4 trillion dollars of foreign exchange reserves to protect its onshore currency (CNY), when the offshore RMB (which is market determined) is thought to be overvalued, demand shrinkage will cause the offshore RMB and RMB-denominated asset prices to disconnect from onshore prices.

The expansion and success of the offshore RMB market is intricately linked to RMB internationalization. Currencies associated with developing financial markets are rarely given second chances once investors lose confidence. In other words, if offshore RMB interest falters, the progress of internationalization may stall.

So the key hurdle RMB internationalization must clear is for offshore RMB usage to become more organic and more international. Organic use means international firms transacting in RMB because of its stability and convenience, rather than for speculative purposes. In February 2014, the PBoC surprised the market by allowing the onshore RMB to depreciate sharply against the dollar by historical standards. This may signal that China’s central bank has recognized the risks associated with speculative demand. On the other hand, international use will require PRC firms to transact outside of Hong Kong, which presently accounts for more than 80 percent of RMB trade settlement. After all, a currency is international when it is used and stored by non-residents outside its borders.

There is little doubt that the RMB will eventually become an international currency that stands with the likes of the dollar, euro, yen and pound as China’s economic clout grows. Technically, complete internationalization of the RMB will require making the RMB fully convertible, liberalizing interest rates and developing deep and liquid financial markets, all of which require China to liberalize its capital account. Other elements will also prove decisive: a strong and stable dollar will dent RMB appeal while tighter monetary policy to prevent inflation will continue to encourage RMB use internationally. What is in question is the pace at which the RMB will develop into an international, mature currency.

To date, RMB internationalization has been largely driven by PRC policymakers. Some have speculated that internationalization of the RMB is an effort to push structural changes to China’s financial markets, much as former Premier Zhu Rongji used World Trade Organization accession in 2001 to liberalize agricultural subsidies and open the services market. Although there is ample precedent to show the preconditions to becoming an internationalized currency, there is no simple formula. More organic, international usage of offshore RMB may ultimately depend on sentiment as to whether the RMB is a “store of value” or “safe currency,” which is largely outside the realm of Chinese policy. By that logic, true internationalization of the RMB may take a lot longer than Chinese politicians expect.

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