One area where China’s economic ascent has conspicuously failed to leave a mark is on foreign exchange markets, in large part due its longstanding closed capital account and currency peg to the US dollar. Outside China, the Renminbi (RMB) is little known or used. But not for much longer if mainland authorities get their wish.
While the share of RMB traded on international forex markets is little more than a rounding error, the currency is increasingly circulating outside China as it is used for trade settlement, bond issuance or held as offshore deposits. This year began with fresh efforts to pry open China’s capital account as qualified investor programs going in and out of Hong Kong were extended, and the first cross- border RMB loan scheme in Qianhai, Shenzhen was launched. The exact timing is uncertain, yet it looks as if the RMB is on an unstoppable course to becoming a freely traded global currency.
This is something global investors and treasurers need to be prepared for. The launch of CME Group’s new CNH Deliverable Offshore Futures contracts on its CME Exchange takes the RMB one step further on the road towards internationalization.
Yet the RMB will inevitably face various hurdles as it seeks to establish marketplace credibility and gain a place among the world’s heavyweight currencies, especially in advance of China fully opening its capital account. To get a better understanding of what lies ahead, we sat down with Dr Hai Xin, director of Haxius Consulting and a noted expert on the RMB and author of multiple books about the currency, including “The RMB Handbook: Trading, Investing and Hedging” and “Currency Overlay: A Practical Guide”.
China is taking an incremental approach to internationalizing the RMB. How far has it come?
Already the RMB has made good process. After all, it was only in July 2010 that RMB trade settlement was introduced for the first time. Already annual trade settlements have reached over 3 trillion RMB and by 2015 Deutsche Bank forecasts this figure will rise to 8 trillion RMB or 30 percent of trade volumes. `
As well as trade settlement, we are also seeing more instance of import pricing being done in RMB. This means domestic importers can take out the currency risk and often get a better price.
Of course while this is encouraging, trade settlement alone is not sufficient to promote international RMB circulation and offshore RMB liquidity.
Indeed, there has been a flurry of initiatives by China aimed at boosting offshore RMB liquidity from increasing the quota for the RMB Qualified Foreign Institutional Investors (RQFII) and approval of Taiwan to settle RMB onshore, to direct trading of the Yen and RMB. But perhaps the initiative that looks the boldest is the launch of onshore RMB lending in Qianhai, the new Economic zone in southern China last month. Can you tell us where this fits in?
The Qianhai initiative is particularly significant as it allows offshore RMB to be recycled back for lending onshore. This marks the first offshore participation in onshore renminbi lending since 1949.
It should also improve offshore RMB liquidity. While Hong Kong has seen a surge in RMB deposits to over 600 billion, liquidity has not grown to the same extent. This is because there has been a lack of demand for RMB loans, meaning the money has just been sitting on deposit earning a low return.
So far the lending quota is restricted to 10 percent of deposits held in Hong Kong. Yet this pilot is also important as banks will be setting market interest rates for lending into China. Interest rate liberalization is a key milestone on the path to full internationalization of the RMB and eventual full opening of the capital account.
To some, China is putting the cart before the horse by promoting RMB internationalization without first opening its capital account. Can you explain this approach?
China hopes to achieve various goals from RMB internationalization, ranging from the RMB being used as a currency for trade settlement, to securing reserve currency status at the IMF (as a Special Drawing Rights) and becoming a pricing currency for global commodities. But to quote Deng Xioaping “To cross a shallow river, one must follow the rocks under the water.” China will take an incremental approach.
After a steady appreciation in the RMB against the U.S. dollar in recent years, it appears there is no longer an expectation it is a one-way trade. How do you see the RMB trading going forward?
I expect RMB appreciation to continue, albeit at a much slower pace. There will also be much higher two-way volatility in the exchange rate. The offshore rate is still anchored by the daily band movements in the onshore market. My expectation is going forward the People’s Bank of China will increase the band by another 1-2 percent. This means the return on directional play on RMB appreciation is likely to be much lower on a risk-adjusted basis. This is good, however, because there is always a danger of an overshoot where you have a one-directional trade.
Some volatility is also good as it means there will be more short-term trading and arbitrage opportunities. If you are just looking at holding a currency for appreciation, you do not trade. So this will help increase liquidity in the RMB. After all, most forex transactions are trading related. Only 3 percent is actually related to a real need.
What role will CME Group’s new futures product play in internationalizing the RMB?
As we have more volatility in the RMB, this is going to increase the demand for hedging services. The increase in Dim Sum bond issuance by foreign players is also going to increase the need for risk management. As the most popular duration of these bonds tends to be three years, the three-year tenor range of the CME’s CNH contract is a good match for hedging purposes.
To make a currency international, clearly it needs to be trading in multiple offshore markets and around the clock. Here CME’s exchange network provides a ready international footprint, while the CNH Futures themselves can be traded 23 hours a day.
It appears as if the time horizon for China opening its capital account keeps getting pushed back. How far down the road are we?
I think in 5 to 10 years most capital controls will be lifted. The practical changes will likely be that you will just have to report capital movements, not seek prior approval. We need to see reform in the domestic interest rate market where a bank’s lending is determined by credit assessment and prices.
Ultimately, China will move ahead with opening its capital account because it is in its interests.
China’s existing exchange rate mechanism with a pegged currency and closed capital account served well its investment and export driven growth model. But as China ran huge surpluses, instead of the RMB appreciating, it just accumulated trillions of dollars of foreign currency reserves. This has created problems where additional supply of renminbi to absorb trade surpluses has been misdirected into construction and investment. It brings about the potentially severe problem of inflation. Reform of China’s capital account is important as it will help it solve these domestic problems.
The other issue is more practical. The Chinese government knows that if they do not open up the capital account, the market will do it through unofficial channels.
And what do we need to see before the RMB starts looking like a major currency on foreign exchange markets?
As well as greater liquidity we need to see third party transactions being conducted in RMB. Just now all trades include a China party being part of the transaction. We would also need to see non-resident demand grow, and see greater on-shore and offshore circulation. At the moment RMB is still a very small part of global forex transactions at 0.56 percent.