AI 15: Reform pushes RMB closer to promised land

So much hangs on the full liberalisation of China’s local currency and monetary policy, and expectations are that within five years the dream could be a reality.

From inclusion in the IMF's basket of international currencies to facilitating international trade, the benefits of a fully liberalised renminbi would be numerous.

However, a raft of structural reforms will be needed before the renminbi reaches that stage. But given the pace of reform in recent years, the final destination for the renminbi may be reached sooner than expected.

Interestingly, on March 22 there came a revelation from the halls of power in Beijing. The People’s Bank of China (PBOC) governor, Zhou Xiaochuan, said that the central bank was working hard to achieve full renminbi capital account convertibility this year.

This statement was significant not only in giving voice to China’s official policy, but also because it was the first time an official had confirmed a timeline on renminbi internationalisation.

Beijing’s determination is an attempt to meet the criteria of the International Monetary Fund’s discussion of RMB inclusion in the Special Drawing Rights (SDR) currency basket. Today, the IMF’s SDR basket holds four major currencies: dollar, euro, sterling and yen. It is due to review the basket’s composition later this year.

By including RMB, central banks around the world would have to hold renminbi in a structured way, defined by the percentage of RMB in the basket.

In this sense, its inclusion will give an indication for central banks about how much RMB they need to hold in their reserves. If it happens this year, it would be a milestone on the journey to become a global reserve currency, one final marker on the road to full internationalisation.

When AsianInvestor launched in 2000, China’s capital market was tightly closed. In 2004, China allowed Hong Kong banks to start saving RMB deposits and currency exchange, marking the first step in RMB globalisation.

The process was accelerated after the PBOC lifted the peg to the dollar in 2005 and allowed a flexible mechanism of exchange rate and currency appreciation.

In the 10 years since, RMB liberalisation has played a key role in China’s opening. It has been the second largest trade settlement currency in the world since December 2013, according to SWIFT data. Further, China has sped up the process of the RMB becoming an investment currency in the past five years.

“There are three stages in RMB internationalisation and the last stage is to become a reserve currency,” said Candy Ho, global head of RMB business development at HSBC. “In that sense, reserve managers such as sovereign wealth funds and central banks will be moving to increase their RMB holdings.”

Chi Lo, Greater China senior economist at BNP Paribas Investment Partners, said the speculative demand (as an investment currency) and precautionary demand (as a reserve currency) were closely related to the availability of a deep Chinese capital market, with financial products and hedging tools available to foreign players.

One key criteria for the IMF to include RMB in its SDR basket is the opening up of China’s capital account and the deepening of its financial market.

This is happening with some haste now. Thanks to the development of cross-currency swaps in facilitating the offshore RMB bond market’s liquidity and depth, total issuance of dim-sum bonds jumped 109% year-on-year to Rmb280 billion ($45 billion) at the end of 2014, according to Bank of China International. “International issuers now do not consider RMB as an exotic currency but as a normal debt financing currency,” noted HSBC’s Ho.

Lo added: “China needs to make lots of structural changes before making the capital [account] fully convertible without generating shocks to its economy and the global system. Opening up without full preparation, economic and financial flexibility is asking for trouble.”

Measures to broaden the scope of inward and outward investments, while clarifying tax rules, are part of the process. Eventually the QFII and RQFII schemes will be more aligned and ultimately phased out as quota limits become irrelevant.

The Shanghai-Hong Kong Stock Connect will be complemented by the Shenzhen trading link this year. Similar schemes may be established with exchanges in Taiwan, Singapore and Sydney.

These moves confirm the PBOC’s ambition to reform China’s market. “When the currency becomes truly global, a lot of foreign investors would like to hold RMB-denominated assets. In particular, central banks and national pension funds tend to hold fixed income and government bonds,” said Carmen Ling, global head of RMB solutions for corporate and institutional clients at Standard Chartered in Hong Kong.

Peter Alexander, CEO of Shanghai- based consultancy Z-Ben Advisors, said the top consideration for sovereign funds, pensions funds and endowments was to have RMB exposure in the credit market, rather than the equity market. The question for foreign investors is how long it will take for China to open its Rmb36 trillion bond market, particularly the interbank bond market that accounted for 95% of bond market trading at the end of 2014, by Goldman Sachs numbers.

Chinese fund managers would be best-placed to service this pent-up demand. But if they don’t build expertise in credit and duration analysis, Alexander said, it might be that experienced global bond players come in and seize the market.

Growth in China’s mutual fund industry will be another major development in the next 15 years. One key factor will be the extent to which funds are distributed through traditional channels and whether digital can expand. Money-market funds are still the largest part of the industry, but growth has been slowing and sales of equity and balanced funds have risen.

Despite foreigners’ disappointment at the slow pace of expansion, Shanghai’s free-trade-zone programme is being extended to other provinces (Guangdong, Fujian and Tianjin city) – further evidence of China’s market integration.

Cao Yunchuan, deputy general manager at ICBC Singapore, said the Silk Road Fund and Asian Infrastructure Bank would expand usage of the currency. He said China was increasing its effort to add RMB factors to president Xi Jinping’s “One Belt, One Road” plan, with initiatives in terms of investments, labour, contract projects, trade and currency with countries along the belt and road.

Whether China realises the PBOC’s goals on the capital account is a big question, but both HSBC and Standard Chartered expect 2020 to be the landmark year when the RMB will be fully liberalised.

Standard Chartered’s Ling also believes that most of China’s control mechanisms will have been swept away by 2020.

More than 60 central banks have already invested in RMB deposits, by IMF data. Standard Chartered reckons more than $100 billion of central bank reserves are now invested in RMB.

Inclusion in the IMF’s SDR in this year’s review (rather than the next one in 2020) would allow full liberalisation to happen much earlier. But still, that appears outside consensus opinion.