The Chinese renminbi appears to be experiencing the painful birth pangs of becoming a global reserve currency. But it is still a long way off joining the global stage
This article was first published in the March 2016 international edition of Accounting and Business magazine.
Having been widely debated for some time, the reserve currency question was given a strong and perhaps final push when, on 30 November last year, the International Monetary Fund (IMF) announced that the renminbi (RMB) was to be included in its Special Drawing Rights (SDR) currency basket.
The IMF’s statement raised more questions than answers. ‘The Board today decided that the RMB met all existing criteria,’ it said, ‘and, effective October 1, 2016, the RMB is determined to be a freely usable currency and will be included in the SDR basket as a fifth currency, along with the US dollar, the euro, the Japanese yen and the British pound. Launching the new SDR basket on October 1, 2016 will provide sufficient lead time for the Fund, its members and other SDR users to adjust to these changes.’
The moot issues raised are: whether or not the RMB can be termed a ‘freely usable currency’; if 11 months will be sufficient for all parties, including China, to adjust to these changes; and how the other currencies will react in the marketplace to a freely tradable Chinese currency.
Its inclusion in the SDR was, the IMF explained, driven by the recognition of the role that China now plays in the global financial system and the progress it has made in ‘reforming [its] monetary and financial systems’ – that is to say, how close it has become to the US-led market system. But the RMB is not free. Instead, it trades in two versions: the onshore, controlled currency called the China yuan renminbi (CNY); and the offshore, more freely tradable proxy version known as CNH.
What we can say is that, according to the banking communications platform SWIFT, the RMB ranked fifth in the table of international payments by value at the end of October 2015. There are now 12 offshore CNH clearing centres spread across Asia, Europe, the Middle East and the Americas, and the CNH is increasingly traded on electronic trading platforms that now handle the bulk of global foreign exchange transactions.
As a measure of how widely used the RMB now is, Michael Go, Thomson Reuters’s head of market development, FX, Asia Pacific, whose platform is one of the world’s largest trading venues, says: ‘In September 2014 Thomson Reuters witnessed a 351% increase in offshore RMB trading on our FX electronic trading platforms versus September 2013, with volumes up a further 51% by September 2015. This is testament to the staggering growth and development of the currency over the past 10 years.
‘Hong Kong has become a leading global hub for RMB trade settlement, financing and asset management, where a wide range of RMB products and services is available to meet the needs of businesses, financial institutions and investors. Renminbi activities in Hong Kong are supported by the renminbi liquidity pool in Hong Kong, which is the largest outside mainland China. At the end of 2014, renminbi customer deposits and certificates of deposit issued by banks in Hong Kong together amounted to over RMB1.1 trillion, according to the Hong Kong Monetary Authority.’
Moreover, in October last year, China launched its own RMB payments system, the China International Payment System. This demonstrates a significant commitment to establishing an international operational infrastructure to accommodate users of its currency. Also significant, however, was that it chose to do so to avoid using the SWIFT system in order to keep control and keep the data surrounding its currency separate from the US-dominated international system.
Path to full liberalisation
This is an indication that China is not simply going to open up its currency to all comers nor relinquish the levers of control over its currency. For the time being China is taking the path to full liberalisation of its currency one step at a time.
‘RMB is the big issue that everyone is looking at right now,’ explains Mark Webster, global head, FX sales at Standard Chartered, based in Singapore. ‘Everybody wants to know what this is going to mean. We have to hold in the back of our minds that we are heading towards a complete liberalisation of the currency at some point. That’s the way the authorities are taking us, but we have to deal with each step on that path as we get to it.
‘There will be more to risk and greater reduction in the regulation. We are seeing greater acceleration of easing on the monetary and fiscal fronts. The People’s Bank of China is obviously working to maintain a stable, trade-weighted exchange rate. We expect there’ll be more measures to come down the track, and that will only lead to more volatility over time.’
The first major shock of that volatility came in August last year when the People’s Bank of China (PBOC) devalued the RMB and announced plans to change the way it managed its currency. This came as a blow to the market.
‘I don’t think the 11 August experiment went particularly well,’ says Keith Pogson, senior partner, Asia Pacific financial services for EY in Hong Kong. ‘In the short term, the PBOC will try and maintain more stability in FX rates. This is especially so that the SDR inclusion isn’t thrown off-track, but I think they are still thinking about how they economically manage the exchange rate. After 11 August and the devaluation, they had to spend quite a lot of money stabilising the RMB. I think we are going to see a number of initiatives that will move them closer and closer.
‘There has been a relaxation over time of the processes that you need to go through to gain permission for certain types of FX operations,’ says Pogson. ‘I think the two-year liberalisation programme that PBOC has announced is a statement of intent, but it will be a question of how the economy plays out as much as anything. Foreign exchange stability has given them a valuable basis for import/export activity, and they have sizeable reserves that they have built up with this FX environment.’
For the moment, international attention is focusing on the PBOC’s daily fixing of the RMB’s value. The August ‘experiment’ was the PBOC’s abandonment of the daily fixing of the onshore CNY exchange rate that established a mid-rate, allowed for a 2% fluctuation up or down. Now, instead of simply fixing its chosen rate, it prefers to use indications from the market the previous day to determine what the rate should be. This has introduced considerable volatility – that is, uncertainty – into the exchange rate. The offshore CNH maps the path of the CNY, with occasional variations in its one-to-one parity. What used to be a one-way bet as the PBOC controlled the exchange rate is now no more, and the effects of the new volatility were violently in evidence in the early days of January, with drastic knock-on falls in China’s equity market and contagion being felt across markets around the world.
China’s foreign currency reserves are depleting rapidly. ‘There was a US$512bn decline in reserves last year. They still have reserves of US$3.3 trillion, but of this only about half could be turned into cash at short notice,’ says external senior adviser to UBS, economist George Magnus. ‘This could disappear quite quickly in the event of further outbreaks of capital flight.’ So where might this lead?
There have been many examples in foreign exchange market history of what happens when currencies’ formal controls are removed, even partially. The most recent and disturbing was the sudden unpegging of the Swiss franc (CHF) to the euro (EUR) on 15 January 2015. Then the Swiss franc made an immediate 15% appreciation against the eurozone currency, resulting in considerable gains or losses to investors, depending on which side of the EUR/CHF trade they were holding positions.
This was a revaluation, but Argentina’s unpegging of its currency to the US dollar in 2002 resulted in the Argentine peso losing 75% of its value over the following few months. However, the good news for Argentina’s exporters was that their products became cheaper on international markets, just as Swiss exports became more expensive when it revalued.
The consequences of the free flotation of the RMB will therefore be of significant economic effect for China. Cheaper Chinese exports play well in terms of the country’s continuing competitiveness on international markets. However, in classic emerging market fashion, this does not go down well with foreign investors whose onshore investments – whether in terms of direct investment in property, plant or equipment or of portfolio investment – lose value against their base currency. Devaluation does not encourage confidence among foreign investors, but then China may be different.
China is no ordinary emerging market. Already the second largest economy in the world, businesses globally want a piece of the mainland China economic action, which is, after all, why news of a slowdown in growth causes such waves in the international economy. Whether the Chinese currency falls or rises, it is still home to 1.3 billion potential customers.
Both the trading and the investment opportunities will remain. The free floating of the RMB should ultimately stabilise such economic relationships, especially if the currency and derivatives markets deepen sufficiently to provide ready markets in forward foreign exchange, swaps and options to hedge currency risk.
As the RMB becomes more widely used, it can become a de facto reserve currency used by markets to price a range of commodities. Provided the currency is stable, it would make sense for, say, an oil-producing company to sell in RMB if it was also purchasing goods in RMB from the Chinese or other parties.
Such high-level use of the currency would tend to lend stability in its relationship with other currencies, as there would be ‘real-world’, not just speculative, supply and demand for it. One need look no further than the US dollar to see this working in practice. So one question might be whether or not the inclusion of the RMB in the very short list of global reserve currencies would impact supply and demand for the others on that list – the dollar, for example.
Inevitably the answer would be yes, in the long term. However, it is worth remembering that the vast bulk of the daily US$5.3 trillion turnover in global foreign exchange markets is conducted in three currencies: the US dollar, the yen and the euro. The dollar alone is a component of the vast majority of all transactions. It would take the RMB a very long time to significantly disrupt this pattern.
However, if the Chinese economy is to become the world’s largest over the long term, it is inevitable that its currency would achieve reserve status. What we are seeing now are the convulsions of a currency and of a government coming to terms with its growing presence in global, free markets. How that relationship will play out in the run-up to its inclusion in the IMF’s SDR basket this October, and to full RMB liberalisation in due course, is something that the markets are also coming uncomfortably to terms with.
What’s for sure is the inevitability of China’s increasing global economic and market presence. It is what we should expect from a country that is home to approaching a fifth of the world’s population. Reserve currency status for the RMB is merely a consequence of this.
Richard Willsher, journalist
"We are heading towards a complete liberalisation of the currency, but we have to deal with each step as we get to it"