China’s Slow and Steady March to Global Currency Throne Continues

In the prevailing age of global economic uncertainty, China’s currency remains the emerging market apple of the investor’s eye, and according to the Society for Worldwide Interbank Financial Telecommunication (SWIFT), it’s one of the 10 most-used currencies on the planet.

It is no longer a secret that China wants to see a greater utilisation of its currency, the yuan (CNY) or renminbi (RMB), on the international stage. There is good justification for it beyond national pride – China accounts for more than 10% of global trade and investment, but less than 1% of global payments are made using the RMB. Hence, it makes perfect economic sense for China to encourage other countries to use the RMB, as it would result in lower transaction costs and exchange risks for Chinese businesses.

Furthermore, having an internationally recognised currency would also make it easier for China’s financial system to raise funds and invest in other countries. That’s important to note as the pace of China’s outbound foreign direct investment (FDI) has increased seven-fold from 2006 through to 2012 – a much faster pace of growth compared to gross domestic product (GDP) and import to export ratios. Despite this, the RMB has not been embraced far and wide. Why is this?

Currency Tricks of the Trade

The reason certainly is not due to a lack of demand. Data from
Singapore
– the second-biggest RMB trading hub after Hong Kong – showed the total amount of RMB cleared in 2013 amounted to RMB2.6-trillion. Deposits made in the currency have also increased by 70% over the same period, while local banks have reported seeing as much as a doubling in RMB-denominated trade financing activities. This is a remarkable pick-up rate, given that the nation state was only granted permission to start its RMB clearance operations last May.

This phenomenon is not limited to Asia. Chinese banks have found success in their funding activities in London – the third-largest RMB trading hub and the first in Europe. The latest round of RMB-denominated bond sales by the state-run Bank of China (BoC) in early January drew a RMB2bn order book within the first two hours, highlighting the strong demand for RMB products. If this figure seems amazing, consider that banks are expecting RMB-denominated debt issuance to rise by as much as 60%, bringing the total figure to more than RMB500bn in 2014.

The main reason why the world has not fully embraced the yuan is of China’s own doing (or undoing). Beijing prefers to maintain tight control over any issue relating to economic development. Lest we forget, the communist state only opened up economically to the world in 1978, and China’s financial system is much less sophisticated compared to those in developed markets. As such, controls on its currency transactions are a necessity to prevent hyperinflation from the flood of incoming foreign funds, and rapid deflation when foreign funds high-tail it out of the country at the first sign of trouble.

From an objective point of view, such protectionist measures are definitely not ‘wrong’, even though the US and other nations have long complained that Beijing’s interventions distort market prices, thereby giving China an ‘unfair’ advantage. China can simply shrug off these criticisms and point to several other Southeast Asian, EMEA (Europe, the Middle East and Africa) and South American nations with similar protectionist policies in place shielding their respective currencies.

Shanghai Test a Possible Blueprint

However there are holes in the Chinese defence. For starters, China is a financial giant compared to the countries it cites for toying with their currencies. Frankly, when you desire to be the global market leader and potentially rival the US, pointing a finger at less influential nations is not going to assuage or impress the market. China knows that, hence we’ve been seeing a slow but steady march toward an open market policy. For example, the Shanghai free-trade zone (FTZ) pilot is one small step toward that final objective, and it may one day transform the city into an international financial hub such as Hong Kong, although it remains to be seen if that is even necessary.

If unrestricted foreign currency exchange and full-RMB convertibility within the Shanghai FTZ is deemed harmless by Chinese authorities, the next step may be to extend full-RMB convertibility capabilities to the other three trading hubs. Alternatively, Beijing could do away with the trading hub model altogether and go with full convertibility of RMB immediately after the experiment in Shanghai is concluded. However, that is unlikely to happen. The ink on the
agreement between the Bank of England (BoE) and People’s Bank of China (PBOC)
is still wet and the clearing agreement with Singapore is less than a year old. As such, the popular notion that RMB will have full convertibility by the end of 2015 seems unfounded.

Of Shadows and Regulation

There is another major factor that will delay the loosening of the central government’s desire for control: the enormous shadow banking system. It has been said it is far larger than China’s regulated banks. When the RMB is liberalised, the demand and attractiveness of the shadow banks will decline, but that may not be a good thing, as the likelihood of shadow banks going bankrupt and defaulting on loans will be extremely high. For what it’s worth, the shadow banking system provides higher returns on capital for depositors and it functions as a key component of the asset conversion cycle for small enterprises when they are deemed too risky or too small by the regulated banks. If China removes these unofficial lenders but fails to put in place proper credit infrastructures, a meltdown outside of Beijing, Shanghai, or Shenzhen is inevitable.

Facing internal and external risks, Premier Xi Jinping and his advisers would do well to not rush any drastic changes. Going by the recent
third plenary session
, it is clear that Jinping’s administration is not looking to implement any economic reform measures soon. Many beyond China’s shores have bemoaned that Jinping “failed to deliver”, as without these reforms it will be hard for foreigners to conduct business in China. However, Jinping’s first and foremost responsibility is to China’s long-term economic sustainability. Thus, the headache for foreign investors will continue to throb, but it is unlikely that the difficulty of doing business with China will result in investors totally boycotting the second-biggest economy in the world. Unfortunately for the rest of the world, China knows it too, and it will leverage that fact to its utmost advantage.

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