With the renminbi set to gain Special Drawing Right status in October, what does the inexorable rise of the Chinese currency mean for international finance, trade and investment?
Mao Zedong once railed against taking “the capitalist road”. Yet with his image gracing almost every Chinese banknote, the Communist revolutionary is now well on his way to becoming one of the faces of global finance.
The rise of the renminbi (RMB) has been startling. A decade ago, the currency was simply not a factor in global currency discussions. Yet today, as China establishes itself as the world’s second-largest economy and top trading nation, the RMB is increasingly popular.
According to global transaction services organisation SWIFT, it is already the world’s second most-used currency for global trade finance. In August last year, the RMB overtook the Japanese yen to become the world’s fourth most-used payment currency.
A decision made by the International Monetary Fund (IMF) last November will see the RMB become part of the Special Drawing Right (SDR) basket of currencies later this year. SDRs – created in 1969 by the IMF – are international reserve assets used to supplement foreign currencies, and their value is currently based on the US dollar, euro, yen and pound sterling.
Now that the IMF has granted SDR status to the RMB, analysts estimate that anywhere between US$1 trillion and US$3 trillion will migrate into Chinese assets over the next few years. Beyond that, the trade and investment influence of the RMB’s new status remains to be seen. It’s a potent signal, though, that the Chinese currency is maturing.
The Nobel Prize-winning economist Robert Mundell once wrote that “great powers have great currencies”.
“The big question is, how long will this rise take” Adrian Gostick, Thomson Reuters
On this view, the RMB’s rise is both necessary and indicative of China’s growing importance in the world order. As former US Federal Reserve chairman Ben Bernanke blogged after the announcement: “The Chinese authorities, who very much want their country to be recognised as a global economic power, care a lot about symbolism.”
Beginning of the end?
The RMB’s new SDR status will please those who would like to see China’s economy continue to liberalise. The IMF and foreign governments hope that this development will encourage Beijing to keep loosening its grip on China’s financial system.
The RMB is not yet managed in the same way as the other four SDR currencies. So far, the internationalisation of the RMB has mainly taken place in cross-border trade settlement, RMB-denominated bond issuance, RMB-denominated foreign direct investment (FDI) and currency swaps.
The formal peg to the US dollar was lifted in 2005, but an informal peg remains and other government controls are still in place, too. While recent reports hint at the possibility of lifting these controls by 2020, ushering in what is known as full convertibility, this has not been confirmed by the government.
Observers such as Merlin Linehan, a financial analyst who consults on China’s “go global” strategy, expect Chinese authorities to loosen control only very slowly. “Beijing won’t expose the Chinese economy before it’s ready,” says Linehan.
China in transition
China’s policymakers have much more than currency liberalisation on their mind in early 2016. These policymakers – including China’s central bank, the People’s Bank of China (PBOC) – face the task of managing China’s slowdown and transition to a more domestic consumption-based economy.
Bloomberg Intelligence estimates that capital flight from China surged to more than US$1 trillion in 2015. After the bank unpegged the RMB from the dollar in December, the Chinese currency fell to a five-year low in January.
“Greater volatility in RMB trading actually makes it more akin to liberalised currencies.” Frankie Au, Standard Chartered Bank
The Chinese Government has now implemented an aggressive raft of measures to better manage capital outflows, including restrictions on the ability of China-based foreign companies to repatriate earnings, curbing RMB lending by Hong Kong-based banks and banning RMB-based funds for overseas investments. “Further liberalisation of the RMB will have to wait until things have stabilised,” notes Linehan.
Yet many, including Yi Gang, deputy governor of the PBOC, predicted such volatility after the RMB gained SDR status and continued its journey toward a “clean float”. They hold a less pessimistic view.
“Greater volatility in RMB trading actually makes it more akin to liberalised currencies,” says Frankie Au, head of RMB products at the Standard Chartered Bank in Hong Kong. “This also creates more urgency for hedging currency exposures, increasing RMB forex settlement flows.”
However the renminbi’s role evolves from here, there’s an increasingly strong case for China-exposed companies to look at making the RMB part of their cash-management strategy. This can increase leverage on prices with Chinese customers and suppliers, improve the effectiveness of corporate investments and reinforce business partnerships.
“Chinese companies look favourably on foreign partners using their currency; it reinforces commitment to China,” says James Hogan, head
of commercial banking for HSBC in Australia.
“All businesses, including Australian ones, need to be RMB-ready.” James Hogan, HSBC
China has been busy establishing the financial architecture and global liquidity to enable RMB trade. The Cross-border Inter-bank Payment System (CIPS), launched in October 2015, should make cross-border RMB payment quicker and cheaper. Beijing has also signed currency swap agreements with more than 30 countries and is establishing a growing number of offshore RMB clearing centres.
Room for growth
Given the current conditions and imperatives, many experts believe businesses around the world should be doing more to leverage the benefits of trading in RMB.
“Too many companies are waiting, determined not to be bleeding-edge,” says David Blair, managing director of Singapore-based Acarate Consulting.
“Nearly a decade into RMB internationalisation, this is no longer a bleeding-edge issue.”
According to a 2015 survey by HSBC Australia, 13 per cent of Australian companies used RMB for cross-border business in 2015, up from 9 per cent in 2014. Despite this, the survey found that 40 per cent of Australian non-RMB users had not even considered using the currency for cross-border business with China.
“Our latest forecast indicates that more than 50 per cent of China’s total trade will be settled in RMB by 2020,” says the HSBC’s Hogan.
“All businesses, including Australian ones, need to be RMB-ready.”
The Chinese economy’s financial architecture and policies are still evolving. Over the next five years, Beijing will be looking to improve the RMB’s international liquidity and risk profile through more financial sector reform.
While China’s economy is slowing and in transition, it’s hard to see the RMB’s use in the world financial system going anywhere but up. Banks and businesses around the world will become increasingly used to the sight of Mao’s benign countenance.
Managing RMB risk
RMB usage may bring certain advantages, but there’s a flip side to every coin. A recent uptick in the volatility of the RMB has seen a growing number of China-exposed companies looking to mitigate risk.
Following the recent liberalisation of trade flows by Beijing, many international companies have moved their RMB exposure offshore by buying from and selling to China in Chinese currency. Their offshore RMB risk can then be hedged according to global best practice, which typically means using forward contracts.
“There are some natural hedging strategies, such as matching sales and procurement currencies and borrowing in RMB to offset RMB sales or the reverse,” says Acarate’s David Blair.
“But in general, hedging with forwards offshore is cheaper and more convenient.”
The curse of the reserve currency
The US dollar’s status as the sole global reserve currency has become a symbol of US power, allowing it to borrow easily and maintain assertive foreign policy.
But it has also presented the US Government, and the rest of the world, with a headache, known as the “Triffin dilemma”.
Nations with reserve currencies enjoy the “interest-free” loans generated by selling currency to foreign governments and the ability to raise capital quickly, thanks to high demand
for reserve currency-denominated bonds. At the same time, these countries also want to use capital and monetary policy to keep domestic industries internationally competitive and to make sure that their domestic economy is healthy and not running excessive trade deficits.
These two desires are largely incompatible. The need for global liquidity, coupled with rampant domestic spending, has seen the US live beyond its means for years, with federal debt now at US$18 trillion and counting. While international demand for American debt currently appears healthy, many analysts argue that the US is on an unsustainable path.
RMB to the rescue?
Is there a solution to the Triffin dilemma? Some economists have advocated a multiple currency system based on the US dollar, yen and euro. Others have argued for the development of a counterbalancing “Asian dollar”, along the lines of the euro.
Some now suggest that the Chinese currency could play this role, but in the short to medium term this seems unlikely. There is a distinct difference between a currency used for trade and a currency used to store wealth. A comparison of the current US and Chinese financial markets shows a big gap between their currencies.
Yet as market and policy-driven changes take effect over the longer term, some see the RMB joining the dollar in providing both hedge and liquidity for financial markets and central banks.
Adrian Gostick, managing director of financial & risk, China, at Thomson Reuters, believes the rise of the RMB as a second major global currency will help rebalance the international monetary system. “The big question is,” he says, “how long will this rise take?”
“Great powers have great currencies.” Robert Mundell, Nobel laureate
The SDR system
The International Monetary Fund (IMF) created the Special Drawing Right (SDR) system in 1969 to address concerns that gold and US dollars were the only means of settling international accounts. While the SDR is not technically a currency, IMF member countries that hold SDRs have the right to immediately obtain any of the currencies in the “basket” – the US dollar, euro, yen and pound sterling, and soon the RMB.
As of 1 October, the value of the SDR will be based on the following weighted rates:
- US dollar (41.73%)
- Euro (30.93%)
- RMB (10.92%)
- Japanese yen (8.33%)
- Pound sterling (8.09%)