The whole process consists of three broad steps beginning with the use of RMB in trade settlement, then investment and then as a global reserve currency. The first step is well underway and has received the most traction of the three – around 10%-15% of China’s international trade is settled in RMB at present.
China has currency swap agreements with 24 central banks, allowing them to directly settle international RMB trade. Use of RMB for investment purposes is still limited, due to lack of development of the Chinese capital markets and strict controls imposed by the Chinese authorities. Use of RMB as a global reserve currency is the most ambitious step and likely to take the longest time. At present several central banks have expressed interest for increasing RMB holding as part of their reserve. However, the quantum of holding is small at present and primarily geared towards diversification of foreign assets.
Increasing use of RMB in the international arena offers opportunities for many players in the ecosystem. First, corporates engaged in international trade can use the currency for settlement of international flows. More adoption of the currency in the international arena increases liquidity and lowers the cost of transactions. It also provides a natural hedging option, as corporates can directly pay for domestic expenses through the RMB receivables, thereby removing, at least partially, the need to hedge currency risk arising from cross border operations.
Moreover, it has long been argued that China’s currency is undervalued, and with gradual removal of barriers it is likely to appreciate significantly in the medium- to long-term. Therefore many Chinese exporters offer significant discounts, typically 3%-4%, to foreign importers to settle trades in RMB. This is a win-win situation for both parties as the Chinese company benefits from savings in the FX management front, while the foreign company stands to gain from the discount offered. This has resulted in high growth in the letter of credit (LC) business in recent times in Asia where China is the most dominant trading partner – despite LC issuance globally remaining more or less flat.
These developments will have direct impact on the landscape of financial services providers in the region. International banks are in the process of building up capability to serve the rapidly growing RMB business, operating primarily from Hong Kong. Other countries such as Singapore, Taiwan and the UK will also see rapid development of the RMB business as Chinese authorities widen the scope of the currency. In addition to direct financing needs, the need will also arise to manage exchange rate risk as international traders engage more in RMB trades. This will create another level of opportunity for both domestic and international banks operating in the region. These will be further bolstered by the opening up of China’s capital markets, which will attract more brokerages and securities servicing firms in the country, although this is likely to be a slightly longer-term phenomenon.
Despite these positive developments, there are challenges with China’s efforts to internationalise the RMB. Even though the Chinese currency recently broke into the list of top ten currencies globally, its share is still miniscule (about 1%) in total global payments. At a broad level, RMB is mostly used to settle imports, but not exports – roughly a third of imports and less than 5% of exports are settled in RMB at present. Even in imports, invoicing is often done in US dollars while settlement happens in RMB.
A necessary requirement for RMB internationalisation is first to make it fully convertible. China is planning to do so initially through the offshore markets. Doing the same in the onshore market by opening the capital account and liberalising the interest rate regime will be more challenging. Lack of transparency in the Chinese capital markets and the quality of information available on Chinese companies continue to be areas of concern for international players looking to invest in the domestic market. This is an issue that is unlikely to be addressed solely by regulatory initiatives; rather it requires a concerted effort from all participants and therefore is likely to prove a lengthy process.
Then there are operational challenges for banks that need to be addressed. New systems and processes will be required to support clearing and settlement of payments in real time by domestic and international players. They also need to support different languages, including Chinese, English and other regional ones and to accommodate working hours in different time zones to bring about a truly international system of operations.
These will also require strengthening of China’s anti-money laundering (AML) framework. AML practices in China have been in development for over 15 years, however, the AML regulations were largely inadequate until as late as 2006-07. As a result the internal control systems and company culture at banks in China tend to be poor, and they do not go beyond meeting basic regulatory requirements at present. Recently, non-compliance with AML regulation has been attracting increasing scrutiny from the Chinese regulator, and institutions are slowly waking up to this reality. A number of Chinese banks which are technologically relatively advanced have started to adopt a centralised approach to AML by developing internal guidelines and IT systems, and improving monitoring capabilities and staff training. Foreign banks working in China are ahead of the domestic banks; following their global practices many foreign banks have implemented centralized AML systems and approach this as a business challenge rather than just an operational issue.
A Slow Process
Given the rapid developments in the RMB internationalisation process over the past three years, there has been much enthusiasm and optimism expressed by several players regarding its potential to bring in major changes in the immediate future. However, it is safe to assume from past experiences that China will follow a planned, controlled, and slow but steady path in trying to raise the importance of its currency at a global level. The current stage of evolution can at best be described as the process of increasing the convertibility of the RMB, which is a necessary but not a sufficient condition for achieving full internationalisation.
The case of the Japanese yen (JPY) is a good example of how a fully convertible currency may not be able to achieve the status of a global reserve currency. True internationalisation will require fundamental changes on many fronts, including regulatory, market infrastructure, political and geopolitical aspects. This process is therefore likely to take time. An intermediate step in realising the ultimate goal may be to first make RMB a dominant currency at a regional (ASEAN/Asian) level.
Many emerging countries in the region are highly tied to the Chinese economy through real trade, and therefore should welcome such an opportunity. Furthermore, since the global financial crisis of 2008 some central banks, within Asia and outside, are looking for newer reserve currencies to diversify holdings and reduce their dependence on the US dollar. These should augur well for the RMB at a regional level. The extent of its adoption at a global level will however be long drawn and closely watched.
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