Treasury Today Country Profiles in association with Citi

Where next for the renminbi?

There is no doubt redback is on the rise. China’s currency is slowly adjusting to the geopolitical status attached to the second largest economy in the world. But in which direction will it head and at what speed?

Since the implementation of market reforms in the late 1970s, China has become the workshop of the world. Anything from simple toys to iPods and tablets are assembled, manufactured and exported from along its industrial coastline. Slowly but surely, the Asian giant has emerged as a powerful force in the global economy. But now the country enters the next phase of development: the integration of its currency into the plumbing of the world’s financial system.

The 21st Century is looking to be China’s. And empires, formal or otherwise, have always been underpinned by a strong currency. The impressive reach of the Holy Roman Empire was evident by the ubiquity of its Roman coinage in southern and western Europe; just as the American greenback symbolised the global power of the United States in the 20th Century.

Is it China’s turn now? To date, the minimal role played by the renminbi in the global financial system has stood in stark contrast to the country’s economic and military prowess. In mid-2011, for example, the yuan made up for just 0.9% of FX trades, according to a recent SWIFT whitepaper. This figure pales in comparison to the US dollar’s 45.9% and the 16.9% of the euro (see figure 1 below).

Historically, the renminbi has been carefully guarded by strict capital controls. Two strategies have underlined this caution. First, controls protected the Chinese government and economy from financial crises, such as the Asian Financial Crisis in 1997. ‘Better safe than sorry’ was the leading motto. Secondly, capital controls have brought the country prosperity. China rose to become the world’s leading exporter by pegging its currency tightly to the US dollar so as to guarantee a high degree of competitiveness. But ironically, it was a policy that further supported the greenback’s dominance as the world’s reserve currency – a position that Chinese officials now hope the renminbi will eventually overtake. For years, however, China’s economic integration was a one-way street. For example, even as late as 2002 China’s domestic market was sealed to foreign investors. The Asian Tiger took to globalisation on its own gradual terms.

Renminbi: open for business

But is this still the case? Since mid-2010 the Chinese government has been implementing a number of reforms liberalising the renminbi for foreign trade and investment (see figure 2). Now corporates located anywhere in the world can settle trade transactions in renminbi. Following the establishment of the offshore renminbi market in Hong Kong, more than 10% of cross-border trade is now settled in yuan – a significant (and rapid) jump from the mere 0.7% 12 months previously. ‘Dim sum’ bonds and renminbi IPOs are growing in popularity. And according to SWIFT, already more than 900 financial institutions in over 70 countries are doing business in the currency.

The redback is on the rise then. There are a number of factors supporting the renminbi’s growth, argues Thomas Poon, Head of Business Planning and Strategy at HSBC Hong Kong. “The first is that the Chinese government has already demonstrated the determination to continue the development of renminbi internationalisation.” This boosts investor confidence, both domestic and international. The spate of recent reforms sends the message that the country is increasingly open for business – particularly if you are paying for that business in renminbi.

Figure 1: Underrepresentation of renminbi in FX.

Rank Currency Share FX June 2011 Share GDP 2010 Share FX/Share GDP
1 USD 45.9% 23.3% 197%
2 EUR 16.9% 19.4% 87%
3 JPY 6.8% 8.7% 79%
4 GBP 5.8% 3.6% 162%
5 AUD 3.7% 2.0% 189%
6 CHF 2.9% 0.8% 348%
7 CAD 2.4% 2.5% 94%
8 SGD 1.6% 0.4% 446%
9 HKD 1.2% 0.4% 334%
10 KRW 1.0% 1.6% 62%
14 CNY 0.9% 9.5% 9%
27 THB 0.2% 0.5% 46%

Source: SWIFT

The second reason is the increasing familiarity with trade settlement in renminbi for both Chinese and overseas companies. Of course, it is early days yet. But with an acquaintance established, experience and expertise will soon follow leading boosted volumes of renminbi transactions.

“And if more companies are becoming familiar with the use of trade settlement in renminbi, the banks will soon follow. Therefore the third factor is that more banks in other parts of the world will hopefully develop more RMB products and services,” says Poon.

Trading in renminbi can offer overseas companies a more stable and wider supply chain, by tapping into suppliers that avoid hedging structures.

According to James Hickman, Managing Director of Caxton FX, one key advantage will be the transparency and visibility of the exchange rate. As things stand, overseas finance directors have difficulty budgeting when placing or accepting an order with a Chinese company. “With a wider trading currency, you will find that higher liquidity creates tighter pricing. The more people trading in renminbi the better pricing businesses will be able to get wherever they are trading, whether it is London, Hong Kong or China directly.”

Furthermore, given that many Chinese suppliers are SMEs trading, many do not have the available resources and workforce to specialise in risk management. Indeed, many are quite new to the discipline. Until recently in China, hedging tools were broadly limited to the non-deliverable forward markets, in order to prevent speculation. But since December 2011 the Chinese national currency regulator has allowed the trading of call and put FX options.

So hedging can be a significant burden. Trading in renminbi can offer overseas companies a more stable and wider supply chain, by tapping into suppliers that avoid hedging structures.

Last but not least, however, are the substantial savings in transactional costs on offer when using the renminbi in cross-border trade settlements. While this is no doubt a fortunate development for Western businesses, struggling to survive in debt-laden economies characterised by sluggish demand, the real potential of transactional cost savings lies elsewhere: China and the emerging economies. “Right now, the majority of trades between China and the emerging markets are using the US dollar as a settlement currency,” notes Poon.

The logic is simple. As things stand, the US dollar is a third-party currency. Chinese importers and suppliers (and their emerging economy counterparts) are exposed to FX risk. Hedging costs are incurred on both sides of the transaction. “If some of these transactions can be settled in RMB, then, potentially, there could be 50% savings in hedging costs. And part of these savings can be translated into a reduction in the overall transaction costs,” says Poon.

Of course, savings vary from industry to industry, and are dependent on the geographical source of the factors of production. Take the manufacturing and electronics industry for example. With microprocessors and CPUs having to be imported from the United States, hedging cost reductions will be minimal.

It is estimated that, by 2015, up to two trillion US dollars-worth of global trade will be denominated in the renminbi. No wonder, then, that corporates are pushing to establish customer and supplier bases in China sooner rather than later. With ever growing amounts of renminbi cross-border transactions, international trade looks set to acquire more of a reddish hue.

Figure 2: The process of renminbi internationalisation
Figure 2: The process of renminbi internationalisation

No free lunch

But not everything is so rosy. Overseas businesses are not yet falling in love with the redback. ‘Where next for the renminbi?’ they ask. The answer largely depends on how international business overcomes the following difficulties.

The first, simply put, is policy risk. 2012 is an important year in Chinese politics. Every decade the top echelons of the Communist Party are replaced by a younger generation; and later this year both President Hu Jintao and Premier Wen Jiabao will step down. Over the years, Chinese politics has been rocked by tumultuous events. And there is a risk that overseas companies, still new to operating in China will be hit by a sudden change or reversal of currency policy when the younger generation takes the reins of power.

“We remain pretty confident that the Chinese government is determined to continue the path of renminbi internationalisation, but politics being politics we have to include policy risk as a consideration,” cautions Poon.

However experts argue the chances of this occurring are minimal. China is no longer governed by a single individual, such as Mao Zedong or the ‘paramount leader’ Deng Xiaoping in 1980s. Instead it is a government by consensus, says Poon. And where there is consensus, there is usually policy stability.

Furthermore, in a period of transition, few leaders will risk their careers by rocking the governmental boat. Particularly when that boat is lifted by a rising tide of economic growth. So international business can take comfort in the fact that, at least in terms of direction, the liberalisation of the renminbi will continue.

“We remain pretty confident that the Chinese government is determined to continue the path of renminbi internationalisation, but politics being politics we have to include policy risk as a consideration,” cautions Poon.

Did you know?

The terms ‘yuan’ and ‘renminbi’ are often used interchangeably by traders. While both words refer to the same currency, there is a subtle difference between the two. Yuan is the primary unit of account in China, and the renminbi means ‘people’s currency’, launched prior and after the Chinese revolution in 1949 in territories controlled by the Communist Party.

Learning curve

Outside the offices of China’s government, however, there is more to be worried about for corporates. Expanding the frontiers of your business can be costly. Updating the company’s internal ledger and accounting system may carry a hefty price tag. And that is not the only concern.

“There are obviously risks in ensuring that company bank accounts are compliant with the regulatory requirements in China,” says Hickman. “It can be a steep learning curve.”

Perhaps the biggest obstacle is changing mind-sets, particularly when it comes to American corporations. Grown complacent with the US dollar as the world’s reserve currency, chief executives will have to alter their strategies so as to accommodate the renminbi’s growth.

The same is true for businesses in the emerging markets. Commentators speak of a new ‘Southern Silk Road’, a reference to the exotic trading route that underpinned the backbone of intercontinental trade and commerce a millennium ago. Trade and capital flows between China and emerging markets are booming once more.

HSBC forecasts that trade and capital flows between emerging markets could rise by a factor of ten in the next four decades. Rising prosperity in Asia, for example, has led to an increase in regional trade; China and India signed trade deals worth $16 billion in December 2010 – $6 billion more than the Sino-US trade deal agreed a month previously.

Chinese companies, then, can expect Middle East and South American corporates to be changing their ways and increasingly adopt the renminbi as the trading currency of choice. But this will be a slow and gradual process. Emerging market business will be tied down by existing banking services; and developing economies are often dependent on local banking systems that creak.

Speed limits on the expressway to liberalisation?

In mid-April 2012, Chinese monetary authorities announced plans for the development of a new cross-border payment system in a move that promises to further liberalise the Asian Tiger’s burgeoning currency. The China International Payments System (CIPS) promises to be a more advanced and efficient network, allowing banks to clear renminbi-denominated trade settlements and will partly replace China’s existing clearing system that largely passes through Hong Kong.

“There will be a growing use of yuan in international trade and investment and this system will serve as an expressway in cross-border [yuan transaction],” Li Bo, Head of the Chinese central bank’s second monetary unit, is reported to have said at a press conference.

It is expected that the new system will be SWIFT-compliant, allowing for standardised international messaging between banks located in the world’s second largest economy. “The latest announcement by the Chinese government will also enhance the payment clearing infrastructure to support the global influx of cross-border flows for the renminbi,” says Ann Lin Khoo, Product Manager, Cash Management, Hong Kong, J.P. Morgan Treasury Services. “It is expected to be operating up to 17 hours a day, a significant change from the current eight hours in the existing clearing system.”

But the development of CIPS, while certainly positive, is also an indication of the cautious approach adopted by the Chinese government when it comes to renminbi liberalisation. The implementation of CIPS is up to two years away. Not exactly a high-speed ‘expressway’.

The Communist Party is taking its time when it comes to reforms. “The Chinese proverb, ‘more haste, less speed’, is quite relevant here,” says Poon, hinting that the Chinese government is cautious of accelerating the dismantling of currency controls lest it make mistakes.

Renminbi’s place in the sun

But there is no doubt that the renminbi’s presence in the global financial system will continue to grow. Demand for the redback is enormous both in the developed and developing economies. Foreign governments are now getting in on the action. At the start of this year the British Chancellor George Osborne announced an agreement with the Hong Kong Monetary Authority to establish London as an offshore trading centre for the renminbi.

“The United Kingdom has been chosen by the Chinese,” says Hickman. “It is not as simple for the British to say, ‘well, let’s start trading in the renminbi’. The whole process has been carefully managed by the Chinese: London is obviously the global centre for FX.”

With more emphasis on boosting domestic demand, the Chinese government may be less strict in future with regard to safeguarding the currency with capital controls.

Again, a careful strategy underlies this decision. “The Chinese want the slow release of renminbi trading. They will control it. If the renminbi were to free-float, what we will see is a dramatic firming in the renminbi against all currencies. China would go from an extremely competitive country to an extremely expensive country,” adds Hickman. “Economically, a free-float right now would strangle the life out of the country.”

While this cautiousness can be traced to the immediate importance of China’s export market, it is a policy that may soon alter. Already changes are starting to appear. The financial crisis in 2008 hit Chinese exporters hard, exposing the economy to cold winds of falling trade. Furthermore, when the Federal Reserve tackled the crisis head on with bouts of quantitative easing, China’s US dollar reserves fell substantially in value.

The Chinese government is changing strategy. The latest five year plan seeks to achieve a more balanced approach to growth and development. In order to meet this goal, the sources of economic growth need to be diversified. A new key priority is boosting domestic consumption, weaning the country from its dependence on exports.

China’s current account surplus rose sharply from 2.8% to 10.1% of gross domestic product between 2003 and 2007. By 2011 it had fallen dramatically to 2.9%. What does all this mean for the renminbi? With more emphasis on boosting domestic demand, the Chinese government may be less strict in future with regard to safeguarding the currency with capital controls.

Claims that the renminbi will become a fully convertible currency within five years are exaggerated. There is no doubt that full convertibility is the eventual goal in the long run. But a quick transition is not borne out by the evidence thus far.

In this sense, London’s adoption is significant. “London in itself is already a thriving renminbi centre for the rest of Europe,” says Poon. According to SWIFT FX traffic data, London already accounts for a large amount of the global renminbi traffic flow. “Beyond China and Hong Kong (the world’s biggest RMB offshore centre), London did 30% of RMB payments and 46% of RMB FX in Q4 of 2011, placing it on par with Singapore in RMB payments and first in RMB FX,” the SWIFT report stated.

But Britain is not alone. In December 2011 the Japanese government signed a memorandum of understanding with the Chinese government to encourage more bilateral trade to be conducted using their home currencies, either renminbi or the Japanese yen. The following March, China signed a $31 billion currency swap agreement with Australia in a move that raised the redback’s profile in the developed market.

“Australia is probably the first developed economy to have executed a currency swap with China,” says Poon. The Asian giant’s redback may yet have its place in the sun.

Small steps, long journey

So, where next for the renminbi? The answer will depend on the tug-of-war played out between investors and traders, whose demand for the redback is enormous, and the Chinese government, which remains as cautious as ever in restricting its development to a slow pace. Claims that the renminbi will become a fully convertible currency within five years are exaggerated. There is no doubt that full convertibility is the eventual goal in the long run. But a quick transition is not borne out by the evidence thus far. More cautious observers suggest that a renminbi free-float is anywhere between ten and even 20 years away.

The renminbi still has a long way to travel. In June 2011, for example, 98% of payments in and out of China were not conducted in renminbi. Indeed, nearly 80% were executed in US dollars. So far, the Chinese government has taken small steps in changing this situation. With a cautious approach paying off dividends at such an early stage, investors can expect the government to follow this approach in future.