For many years now the Chinese government has carefully controlled its currency, tying its value to the US dollar to ensure currency risk is well managed. Many other emerging markets with open currencies have seen their economies wrecked by sudden devaluations against the dollar. The 1997 Asian Financial Crisis stands as a warning from history. Currencies such as the Indonesian Rupiah and Thai Baht depreciated rapidly to unleash economic chaos at home, spreading like a virus which seriously impaired the entire region.
For many years it suited economic policy makers in Beijing to keep the Yuan undervalued. Protecting the currency from speculation also helped ensure Chinese exports were kept competitive. This was a central plank of the country’s mercantilist economic model (and also gave China an unfair trading advantage according to many commentators). But as the Chinese economy matures and grows the government is slowly liberalizing its currency with the aim of the RMB becoming a fully convertible currency.
A note on names:
Most of us know the Chinese currency as the renminbi, prefixed to the RMB, or alternatively the Yuan. However, on a trading floor (in Hong Kong) it’s a CNH, but if it’s onshore (Shanghai) then it’s a CNY. Confusing? Yes. Then again, Chinese financial matters are rarely straightforward.
Time line Chart
2009 – RMB Internationalization begins
2010 – Offshore markets start in Hong Kong
2012 – Chinese companies start using RMB for trade finance
2013 – Chinese RMB trade stands at 8% of currency trade
Over CNY 270 billion in bonds are issued (Dim Sum bonds)
RMB bank deposits reach RMB 100 billion in Hong Kong
2015 – Estimated that 1/3 of all Chinese trade will be settled in RMB
RMB will become third most traded currency in the world after Euro and Dollar
2017/18 – RMB to become fully convertible currency
Shanghai on a clear path to becoming a truly global financial center
Cross the river by feeling the stones
As a first step the Chinese government floated the RMB against a basket of currencies. However, it still managed the movements of the RMB to ensure it did not rise too high or fall too low. Over time, trade with other primarily developing countries such as Russia and India was increasingly cleared in RMB. For some countries, there is the added bonus of undermining the US dollar for geo-political reasons.
In order for the currency to become fully international, Beijing would have to fully liberalize the capital account. This would mean allowing Chinese businesses and people to invest abroad freely which is unlikely to happen as this would require the Chinese government to relinquish a key lever of economic control. For now there is an offshore designation of the RMB – its symbol is CNH, separate from the onshore market designation CNY.
International payments in Chinese currency are rapidly increasing, but still represent less than 1% of the global total in international flows and stand well behind the Yen, Pound and of course the Euro and the Dollar. However, this is changing rapidly with HSBC predicting that it will be the third most traded currency by the end of 2015.
The long and winding road to convertibility…
The final remaining ingredient needed before the RMB is fully accepted as an international currency is that China will have to get over its current (perceived) economic problems and take serious strides towards becoming a “developed” economy. This means transparent financial governance. Even if the currency becomes convertible (fully exchangeable without restrictions) this does not mean it will become truly international. No currency has legitimately challenged the US dollar for 70 years, but given the size of US debt combined with the growth of the China’s economy, the Chinese “Redback” could have a chance. For now a more realistic proposition is for it become another reserve currency alongside the Euro, which would put it in a position to one day have a chance of displacing the US dollar as the world’s premier currency. For this to happen a major realignment in the world economy would have to occur involving a significant blow to US hegemony. This is all difficult to imagine now, but far from impossible.
Where are the Opportunities?
Whether or not the renminbi goes international or ever challenges the greenback is a matter for economists and fortunetellers. What is crucial for now though is that there are interesting opportunities for outsiders to capitalize on during the currency’s transition to convertibility.
Investments in a new asset class – companies can invest in “dim sum” bonds, renminbi commodity funds and renminbi ETFs (exchange-traded funds). Knowledge and use of these by early adopters will create expertise that will be invaluable as the asset class grows in value and importance.
Trade finance – China is the lynchpin of trade in Asia and across emerging markets. Therefore, it makes sense for trade to be settled between a country such as Thailand and China in RMB, rather than the US dollar. Standard Chartered Bank estimates that 15% of trade with China will be settled in RMB by 2015. HSBC forecasted in 2013 that Chinese firms would soon be able to offer improved terms on trade settled in CNH compared to other currencies. Most firms have not yet gotten the facility to use the currency, but banks in London, Luxembourg and Hong Kong will soon be falling over themselves to open accounts in offshore CNH. If you are involved in trade or settlements you should be looking into the possibilities of using RMB before others do it, and you are left trailing in their wake.
Dim Sum – not just for eating
Since Hong Kong authorities gave permission, foreign entities have been able to issue dim sum bonds in Hong Kong. In 2012 HSBC issued the first offshore RMB bond in London. Singapore and Taiwan are also set to become centers for offshore issuance. The catch is that funds cannot be automatically sent into China. It is expected to remain a one-way door for funds in most respects.
Offshore CNH can be used to raise bonds and issue loans, providing financing for companies. This provides an opportunity to reduce currency risk, but also manage cross border flows to and from China – avoiding the issue of cash being trapped there.
Banks and financial institutions will be able to use offshore CNH to diversify their cash/portfolio holdings, and become involved in the CNH foreign exchange market at its early stages. As more RMB funds flow offshore they can be used abroad (still small but expected to grow rapidly), this recycling of funds will allow this sector to grow rapidly. Further liberalization of the capital account will release upward pressure on the RMB, but also allow Chinese finance to flow beyond its borders – more necessary than ever as Chinese private companies look to buy more foreign companies.
London, Taipei, Hong Kong, Luxembourg or Frankfurt – which city will dominate global RMB flows?
The competition between these four financial centers will determine who will dominate the soon to be considerable business of managing, recycling and converting RMB offshore flows. Hong Kong has a massive head start thanks to its long-term usage of the currency and because it is in the same country, albeit a different legal regime. However, usage in Taipei is picking up fast and complacency on Hong Kong’s part could see them lose market share. In Europe, Luxembourg took an early adoption strategy and has many Chinese banks presently using the city-state as their European headquarters. This gives Luxembourg as strong long-term advantage, but it will soon face fierce competition from Frankfurt and London as they are now fully waking up to the business proposition surrounding the Yuan.
Merlin Linehan has worked in development finance within Eastern Europe and Asia, and spends much of his time investigating the risks and opportunities that are created from the ongoing expansion of Chinese businesses that invest overseas in emerging markets.
This column does not necessarily reflect the opinion of the editorial board or Frontera and its owners.