As China continues to cautiously move its currency toward convertibility, it will take on greater prominence in global currency markets, even raising the possibility of the renminbi as a reserve currency.
China is one of the world’s largest trading partners – it is the world’s second largest economy, the largest exporter and second biggest importer. As China’s share of world income is forecast to surpass that of the United States by 2016, its influence will continue to grow. But until recently China’s currency, the renminbi (RMB), was completely shut off from the outside business world making it impossible for trading partners to manage any risks associated with its currency.
Today there are two RMBs; one is the landlocked, government-controlled currency inside China. The other is a semi-free floating currency that can be traded on markets in London, Hong Kong and New York. This is slowly changing.
David Pavitt, head of emerging markets FX trading at HSBC in London says, “China is gradually opening the door to internationalizing its currency; it is creaking the metaphorical door open bit by bit. Five years ago the door, allowing cross border RMB flow, was virtually shut.”
The process of internationalization began in 2005, when the People’s Bank of China (PBOC) announced the first step: a managed, narrowly-floating exchange rate in relation to a basket of currencies. But the door remained firmly shut to anyone wanting to trade using the RMB. Then, in 2010, an agreement between the Hong Kong Monetary Authority and PBOC allowed the buying, selling and creation of financial instruments based on the RMB – outside of China. This opened the door to RMB currency trading.
Full convertibility is the goal, Pavitt notes. “To be accepted as a fully-fledged member of the world economy, China needs its currency to be fully convertible,” he says. “But China is determined that it happen slowly, with little market impact. If it were to happen overnight it would be a shock to China’s and the world’s financial system.”
Money coming out of the cash-rich entrepreneurial society into external investments, particularly into emerging economies, could destabilize global markets. And money rushing into China’s economy could cause hyperinflation. Therefore China’s caution appears wise.
Meanwhile, trading on the RMB as it stands today is booming. HSBC said that RMB offshore deliverable market has gone from zero in June 2010 to the current $2 billion per day level. Recently U.K. Chancellor of the Exchequer George Osborne unveiled steps aimed at developing London into an international trading center for the RMB. London and Hong Kong will tighten cooperation on settlement systems, market liquidity and the development of RMB-based financial products.
David Clark, chair of the U.K.-based Wholesale Markets Brokers’ Association, says this makes sense. “It is the world’s largest international financial market and the biggest in FX,” says Clark. “All of the major players in these markets are in London, which is very attractive to the Chinese.”
London has been in the thick of trading the RMB since day one. The Chancellor’s announcement, says Pavitt, had the effect of reinforcing the durability and longevity of the RMB market: “Telling the world that the British government stands ready to help the Chinese internationalize its currency.”
Interest in RMB-denominated bonds shows the currency’s promise. Bond issuance rose 37 percent to a record high of $238.2 billion for the year to December 2011, according to data provider Dealogic. Trading in FX options, swaps, outright and deliverable spot RMB is also growing, and there has been at least one RMB-based IPO – the Hui Xian Real Estate Investment Trust, which floated in Hong Kong in April 2011.
Full convertibility is on the docket for China and when it happens it should benefit China’s economy and therefore its people. Clark notes that the lack of convertibility is a handicap to inward and outward investment.
It also means that the RMB, as a fully tradable instrument in the free market, might become a major reserve currency.
David Gilmore, partner at FX Analytics in New York, believes that this is ultimately China’s goal. “Why wouldn’t it want to be? Reserve currency status carries enormous benefits,” he asks.
This may take some time. Even if the RMB is fully convertible within the next decade, there are other considerations to be met before it can become a reserve currency. Mainly, it must be perceived to remain strong in value and have deep liquidity. Then the RMB may join the ranks of the existing reserve currencies. International Monetary Fund figures show that over 60 percent of world reserves are in U.S. dollars and over 20 percent in euro. The rest is split between the yen, Swiss franc and U.K. pound sterling, says Clark.
Pavitt believes that the RMB becoming a reserve currency will be dictated by market demand and trade flow: “I believe we are moving away from using a single reserve currency to a world where there are perhaps two or three.”
The 2008 sub-prime crisis and credit crunch exposed frailties in depending on the U.S. dollar as the main reserve currency and there has been much discussion since then as to what could supplement it – or replace it. The RMB as a reserve currency would certainly help China to achieve greater influence in global political and economic affairs, especially once it hits the number one status in terms of economy.
Gilmore is not optimistic that it can ever replace the others though. ” I doubt it over my lifetime – the U.S. has to really screw up its balances and go the way of the U.K. after World War II to make that a reality (empire in decline),” he explains. “It is not out of the question, just unlikely.”
On the other hand, deregulation has happened much faster than anyone expected, so full convertibility – and maybe the RMB’s arrival as a reserve currency may not be all that far off.