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China And Reserve Currency Aspirations

International | Apr 16 2015

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– Moving to capital account convertibility
– Applying to the IMF for world currency status
– Risks of inflows/outflows
– Ambitious goal

 

By Greg Peel

It’s no secret Beijing’s ultimate goal is to make the Chinese renminbi (aka yuan) the world’s reserve currency, replacing the US dollar in that role. Considering China’s population growth rate, economic growth rate and dominance of world trade, this does not seem like such a wild concept. But it is not something Beijing can achieve overnight.

In trademark fashion, Beijing has been very gradually easing China towards more open financial markets over the past decade – a prerequisite for reserve currency potential. Top of the list of such reforms is obviously the currency itself, which was previously pegged to the US dollar, then pegged in a range to the US dollar, and more recently allowed to “float” in current account transactions.

Current account transactions include export/import and the payment/receipt of dividends and interest to/from foreign corporates or individuals. The next step is to allow full currency convertibility in China’s capital account, which represents capital flows into and out of the country for the purpose of investment. A surplus in the capital account implies foreigners are increasing their ownership of Chinese assets. A deficit means China is increasing its ownership of foreign assets.

Beijing has applied to the International Monetary Fund (IMF) to make the renminbi a Special Drawing Rights (SDR) currency. The “fund” that is the IMF is, for example, being currently used as a component of Greece’s bail-out. Whereas once the IMF operated in gold and US dollars, the SDR represents a greater diversity of globally significant trading currencies. The IMF’s current SDR basket comprises 41.9% US dollars, 37.4% euros, 11.3% British pounds and 9.4% yen. Every five years the IMF rebalances the SDR weightings.

The next rebalance is due this year, and is expected in October. There is little doubt China has now joined this elite group as a global trading force, hence its application for renminbi inclusion. However in order for the IMF to even consider including the renminbi in the next SDR basket, the renminbi must satisfy various criteria, including full currency convertibility.

Which is where capital account convertibility becomes a necessity, alongside current account convertibility. China’s recent establishment of the Asia Infrastructure Investment Bank – a variation on the World Bank of sorts and to which Australia has signed up, displeasing the US – indicates Beijing is willing to play a bigger role in the international financial system. Analysts assume Beijing will point to the AIIB as reason for the renminbi’s inclusion in the SDR basket.

But it is not just as simple as Beijing suddenly announcing the renminbi will now float freely. Or as the Hawke-Keating government did in Australia in 1983, shutting down fixed foreign exchange markets on the Friday evening and open them again with a fully floating Aussie dollar on the Monday. There remain various hoops Beijing must jump through, with regard the reform of China’s financial markets, before the renminbi could realistically be rendered fully convertible.

The People’s Bank of China governor has outlined three policy actions that would be required up front: the revision of guidelines on exchange controls, the liberalisation of more Chinese financial markets, such as the bond market, and allowing investors inside and outside of China to make cross-border investments.

Once the capital account becomes fully convertible, Beijing risks a disruptive outflow of capital into foreign investments. Deutsche Bank assumes the government will be cautious in the early stages of liberalisation, having measures in place to control such outflows. But Deutsche also believes removing capital controls may lead to more inflows. Aside from foreigners currently facing restrictions on investment in mainland China, global interest rate differentials would favour such investment inflow. China’s current “cash rate” equivalent is 5.35%. Australia’s is 2.25%, and Australia is being swamped by offshore investors seeking better than the near-zero yields on offer elsewhere.

The PBoC would need to carefully consider its rate setting mechanism. And the PBoC also currently sets a deposit rate, as well as a lending rate, which it will need to abandon. And Beijing will need to address the issue of the two stock markets – one in Shanghai and one in Hong Kong – that operate for locals and foreigners respectively.

CBA analysts see various obstacles on the path to full renminbi convertibility. In floating the renminbi, Beijing will no longer be able to return to a currency peg against the US dollar, as it has done on occasion in times of crises. Deposit rates will no longer be able to under government control. And a wider issue is that of the Chinese banking system. Despite being well capitalised, non-performing loans continue to accumulate in China’s banks and large state-owned banks have not yet fully shifted to operating under market-based principals.

CBA believes the greater risk to the renminbi, once convertible, is to the outflow side of the equation, given the currently weak macroeconomic backdrop and expected policy normalisation (the first Fed rate rise) in the US. The analysts do not see inclusion in the SDR as guaranteeing currency inflows. But certainly Beijing will need to weigh up the possibility of currency inflows, which would serve to appreciate the renminbi. The recently released Chinese trade data for March showed a much bigger than expected plunge in Chinese exports, which many exporters blame on a too-high renminbi exchange rate to QE-supported currencies such as the euro and yen.

CBA believes Beijing is being rather ambitious in assuming the renminbi could be accepted into the SDR basket this year. If rejected, China can apply again next year. Deutsche Bank is ascribing a 40% chance of acceptance this year and a 70% chance in 2016.

“We believe the market may be surprised in the next few years,” says Deutsche, “by how fast China moves on renminbi internationalisation and capital account liberalisation”.

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