David Line | September 7th 2012 | @GlobalMkts
China’s moves in recent years to allow greater freedom in cross-border currency flows have followed closely Deng Xiaoping’s cautionary aphorism about reform: that China should “cross the river by feeling for the stones”. Great leaps forward are now the antithesis of Chinese government policy. But there are signs that the renminbi could be on track to become a major international currency.
On the trade side China has made steady progress. Although it was sanctioned only from 2009, renminbi-denominated cross-border trade transactions now account for around 9% of China’s total trade.
Capital-account reform has been much more tentative, especially with regard to portfolio inflows. Initially, China was worried about a loss of competitiveness should such inflows push up the value of the currency. However, the kind of serious trade imbalances that implied an undervalued currency have diminished. From 7.5% of GDP in 2007, China’s trade surplus fell to around 2% of GDP in 2011. China’s colossal holdings of foreign exchange reserves have been falling too, dropping a record US$65bn in the first quarter of 2012, suggesting a strengthening of the renminbi is likely.
China’s decision in April to widen the range in which the renminbi trades was taken as a sign that a renewed wave of reforms to internationalise the currency was in the offing. Indeed, China has recently raised limits on foreign investment in local capital markets by raising the annual investment limit of the qualified foreign institutional investor (QFII) scheme to US$80bn from US$30bn. China has also expanded rules allowing local companies to borrow more renminbi offshore and repatriate the funds.
Becoming a major international currency won't happen overnight, however. In 2010, the renminbi was used in fewer international currency transactions than the Polish zloty, according to the Bank of International Settlements. The QFII scheme, although recently expanded, is still worth just a few percent of the local stock market value. More importantly, for the renminbi to become an international reserve currency foreigners would need the opportunity to accumulate large holdings of the currency - implying a sustained period of current-account deficits, which looks unlikely in the near future. Finally, any signs that currency liberalisation is having adverse effects on the economy will likely lead to instant retrenchment.
It doesn’t require much imagination to foresee the opportunities that Chinese currency reform will continue to present for financial intermediaries of all kinds, worldwide. The growth in renminbi trade finance has been phenomenal, allowing banks to offer a greater variety of renminbi clearing and settlement services, as well as derivative contracts. And with each new step along the road to capital-account liberalisation, new asset classes such as dim sum bonds (renminbi-denominated bonds), issued in Hong Kong, have proliferated. The voracious hunger of retail and institutional investors for renminbi-denominated assets has only just been whetted.
For China’s policymakers, having a freely traded global currency is a step toward the distant goal of achieving reserve-currency status. Currently this might seem far-fetched, but in the early years of the 20th century it didn’t take long for the US dollar to usurp sterling as the global default reserve currency (as Barry Eichengreen points out in his recent book, Exorbitant Privilege).
China looks keen to follow a similar path by first positioning the renminbi as a systemically important trade-finance currency and then promoting its use as an investment vehicle. In so doing the renminbi will meet the three criteria of a reserve currency: use as a medium of exchange, a unit of account and a store of value. And there are plenty of supporters for an alternative to the US dollar and the euro. Malaysia, for instance, decided in 2010 to include an unspecified sum of renminbi bonds in its foreign-exchange reserves. Arguably, the renminbi is already a more promising store of value than the beleaguered euro.
Whatever happens, progress is likely to be cautious. Which means the financial services industry will have plenty of time to devise the new products and services that users of a fully tradeable, international renminbi will need.