Market is bullish on renminbi internationalization amid China wobbles

By:
Simon Watkins
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Concrete advances towards the full tradability of the Chinese currency are at last seemingly being made, helping to rebalance the country’s growth model but heaping on short-term risks to China’s economic and financial stability.

Talk of when the renminbi will occupy a status on the global foreign-exchange markets on a par with the dominant economic position of China has permeated the world’s financial markets for decades.

Concomitant with this has been speculation about how the imperfect proxies of the onshore traded yuan (CNY) – the CNH in Hong Kong and the CNT in Taiwan (see chart 1) – will also fare.

There is a divergence of opinion on the broad economic trajectory of China, which has negatively fed through to many other Asian assets in general and on the timing of any loosening of the renminbi’s trading policy in particular. 

Road to RMB internationalization {PhotoSlideshow}

On the one hand, Michael Spencer, Deutsche Bank’s head of Asia Pacific research in Hong Kong, predicts China’s growth will surprise markedly to the upside this year and next, expanding by 8.6% for 2014 and 8.2% for 2015.

“China’s export growth has followed growth in the US and EU economies very closely since 2008 and as those economies recovered in the second half of last year, so did Chinese exports,” he says.

“In fact, we estimate export growth has averaged 20% quarter-on-quarter Saar over the past six months, and sustained growth in the US and EU will take export growth in year-on-year terms much higher than we think most investors expect.”

On the other hand, many believe that in continuing to shift the country’s principal growth engine from a manufacturing base to a consumer one, the period of rebalancing will see growth, at the most, remain at current levels, if not much worse.

“The stress in China’s economy may worsen in H1 [of this year], particularly in the financial sector, so we expect the monetary tightening bias to remain, at least in Q1, to contain these risks,” says Zhiwei Zhang, chief China economist for Nomura, in Hong Kong.

“The PBoC [People’s Bank of China] launched measures to calm rising repo rates and meet liquidity demand early this week, but we take this as a way to contain financial risks rather than a sign of policy loosening, and if monetary policies remain tight, interest rates will likely remain high in H1 and pressure highly leveraged companies and shadow banking institutions.”

As such, the bank maintains its view of a one-in-three likelihood of a hard economic landing – defined as an abrupt slowdown in real GDP growth to an average of 5% year-on-year or less over four consecutive quarters – commencing before end-2015.

Since banking sector and capital-account liberalization – which would expose indebted corporates to bankruptcy risks given rising interest rates and FX volatility – is a pre-requisite for meaningful currency reforms, Beijing is unlikely to make meaningful efforts to internationalize its currency, say China bears, adding the short-term need to maintain stability has increased amid headwinds to growth.

However, Patrick Zweifel, chief economist for Pictet Asset Management, in Geneva, tells Euromoney, both as a medium of exchange and unit of account, the yuan is on course to acquire international status in three years, and, within 10 it might unseat the dollar as the world’s reserve currency.

Indeed, if the main consideration for a substantial upgrading of the CNY’s FX status was its use in global trade alone, then it would already be an international reserve currency, alongside the US dollar and the euro.

According to Swift, the yuan replaced the euro in October as the second-most heavily used currency in international trade finance, after the US dollar. The renminbi was used in just under 9% of such transactions at that time, up from just under 2% at the beginning of 2012.

In this context, as long ago as the G20 summit in London in April 2009, Zhou Xiaochuan, governor of the PBoC in Beijing, flagged the notion that the Chinese wanted a new global reserve currency to replace the US dollar.

Initially, it was thought that Zhou simply wanted to expand the use of special drawing rights (SDRs), delineated as they are as a 95% mix of the four key currencies of USD, EUR, GBP and JPY.

However, in later conversations, it appeared the Chinese government thought that incorporating an element of the RMB into the mix, and using the newly redrawn SDR – including the RMB constituent – would be a justified way of proceeding.

The basic economic case for an upwards re-rating of the yuan over time is lent further weight by the latest estimates from the IMF that by 2030 the USD-valued economy of China will have overtaken that of the US for the number-one spot, and that by 2050 the Asian Tiger will have almost double the GDP of the US.

To tweak an old adage, it is not just the size of an economy that counts, it is what you do with it that counts, and if you cannot trade it freely, a currency is not moving anywhere.

Therefore, in the case of the CNY, the stumbling block to this element of its becoming a more internationally significant currency has for many years remained the non-convertible capital account, against the backdrop of FX having been historically regarded by the PBoC principally as a monetary tool against inflation.

Given this, it is little surprise to find that, as it stands, only 0.01% of world central bank foreign-exchange reserves are held in renminbi, compared with around 60% in US dollars and 25% in euros.

“According to the PBoC, the currency is managed with reference to a basket of currencies, although its constituents are undisclosed and adherence to a basket framework has not been consistent, but progress towards capital-account convertibility is under way,” says Deutsche Bank’s Spencer.

However, he adds, in tandem with RMB capital financing in the form of CNH bond issuance having become widespread for domestic and foreign corporates, RMB overseas domestic investment and foreign direct investment are now permitted, and the liberalization of QFII and RQFII (renminbi qualified foreign institutional investor) scheme quotas has steadily been upsized.

In fact, renminbi trade settlement has taken off apace since a small pilot RMB trade settlement scheme was introduced in July 2009.

Haibin Zhu, head of Greater China economic research for JPMorgan, in Hong Kong, tells Euromoney that total trade settled in RMB for 2012 hit a record in this context, with whole year cross-border RMB trade settlement totalling Rmb2.94 trillion, about 12% of China’s total trade.

“Trade settlement remains the main channel for RMB flows,” says Zhu. “In the third quarter of 2013, RMB trade settlement accounted for 16.9% of total trade, higher than the 12.6% in 2012, and the 9.4% in 2011.

“But to ensure sustainable development in the long run, the renminbi also needs to strengthen its investment function, in addition to cross-border trade settlement function.”

Indeed, given this backdrop, the yuan has dramatically moved up the rankings of the world’s most-traded currencies in the past three years, according to the Bank for International Settlements’ triennial FX surveys, from 15th place in 2010 to ninth in 2013, with turnover having soared from $34 billion to $120 billion.

Much of this has been focused on the offshore CNH, especially, and CNT markets, but, as the capital account continues to open up, and the moves to permit greater investment into real estate, stocks and bonds gather pace, there will inevitably be a convergence between the offshore and onshore markets, says Pictet’s Zweifel.

In this regard, a further expansion of the QFII scheme that has opened China’s domestic equity markets to overseas investors is expected, despite it having only recently seen the quota increase from $30 billion to $80 billion, and the RQFII from Rmb20 billion to Rmb270 billion.

Additionally anticipated is a concomitant lifting of restrictions on foreign investors participating in the domestic bond market and the futures market, such as they are, and an increase in the quota for individual foreign-exchange purchases, which stands at $50,000 per year.

“There has been no evidence that there has been an increase in the risk of money outflows, despite a rapid rise in the number of Chinese tourists,” says Qu Hongbin, chief economist for Greater China at HSBC, in Hong Kong. “So this quota is likely to be lifted to $200,000 in the coming years.”

With broader and deeper bond markets across the temporal curve, and accessible equities markets, the converged CNY, CNH and CNT should allow for a continuation of the recent pattern of rising use internationally.

“From before 2005, when China had fixed exchange rates, to now, the renminbi’s influence in global FX markets has gone from none at all to a situation in which a 1% move in the currency causes a 0.1% to 0.2% corollary shift in other emerging currencies and, as China’s economic influence grows, this tendency can only strengthen,” says Zweifel.

“Should trends persist, the currency could account for 30% of central bank foreign-exchange reserves by 2025, when it begins to threaten the dollar’s reserve currency status.”

The final part of the puzzle is that, on the international political front, pressure from the US – and other international governments – for a relaxation of the renminbi’s trading policy to bring it more into line with developed market norms has increased.

Indeed, says Craig Chan, head of FX strategy, Asia ex-Japan, for Nomura, in Singapore, this was evidenced in the October 30 2013 US Treasury FX report as well as US Treasury secretary Jack Lew’s November 15 visit to China to discuss issues including FX policy and the rebalancing of the Chinese economy.

“The latest US Treasury report highlighted six factors on band widening compared with only two in the April 2013 FX report,” he concludes.

“These included: the Chinese authorities having publicly indicated their intention to widen the USD/CNY +/- 1% trading band in the near future; the conditions for such a move having improved as global markets have stabilized; and the idea that a wider band should promote two-way foreign-exchange flows Chinese authorities have long desired.”