Internationalization of the RMB
The Renminbi (“RMB”) is the legal currency of China.
Despite China’s prominent role in the global economic order, the country’s currency is not internationalized. It is neither used by non-residents or actors outside of China, nor sought out for investment transactions and trade settlement. This contrasts to the world’s most popular reserve currency, the US dollar, which is used as the medium of exchange in the majority of cross-border transactions. For example, a Thai exporter and Peruvian importer would use USD to denominate, invoice, and settle transactions, even though both companies have their own currencies.
The RMB’s non-convertibility provides one reason for its unpopularity. In other words, economic actors—both international and domestic—cannot freely move money into and out of the country, nor can they freely exchange the RMB for foreign currencies. Capital controls are another explanation for RMB unpopularity. China’s government continues to impose controls in attempt to maintain maximum control over domestic capital allocation and borrowing costs.
Nonetheless, as China’s economy becomes increasingly integrated in the global marketplace, it is a natural trend for RMB to internationalize.
History of RMB Internationalization
China declared capital account convertibility as a long-term goal in 1993 and has reiterated this promise in each 5 Year Plan since.
To achieve this goal, China’s leaders unpegged the RMB from the USD and implemented a “controlled float” system, adjusted with reference to a basket of currencies.
In December 2003, the Hong Kong Monetary Authority permitted banks in Hong Kong to begin conducting RMB business. In practice, the business was limited, restricted to retail deposits and remittances in RMB-denominated accounts. Activity was slow until 2008, when the Global Financial Crisis (2007-2008) exposed the limitations of a system dominated by the US Dollar.
Motivated to internationalize as a shield against future crisis, China took action. The country began:
- Establishing currency swap lines with foreign central banks
- Loosening settlement restrictions on trade and cross-border remittances transacted in RMB
- Permitting issuance of offshore RMB-denominated bonds
- Allowing banks to offer offshore RMB deposit accounts
These measures lead to the most important component of RMB internationalization: the development of an offshore RMB market outside of China.
Onshore vs. Offshore RMB
Prior to 2009, the RMB could only be traded in Mainland markets, allowing policy makers to maintain close control over the exchange rate. However, as China grew and more players wanted market access, an offshore, market-based FX trading regime was developed in Hong Kong.
RMB traded outside of Mainland China is referred to as “offshore RMB” or “CNH,” distinguished from “onshore RMB” or “CNY.” Critically, both onshore and offshore RMB are the same currency, but are traded in different markets. Since the two markets operate independently, onshore and offshore RMB trade at different rates and can move in different directions. Because CNH is free-floating and CNY is semi-controlled, the relative strength of onshore and offshore RMB can vary significantly.
As the RMB continues to internationalize, there have been discussions about convergence of the two markets. However, due to ongoing political disagreement, it is expected that the onshore and offshore markets will remain separate for the foreseeable future.
RMB Inclusion in the IMF’s Special Drawing Rights basket
The most significant internationalization step is the RMB’s October 2016 inclusion in the IMF’s Special Drawing Rights (SDR) basket. The basket is comprised of currencies of biggest exporting nations that have meet the IMF’s standards for “freely usable.”
The RMB is the basket’s fifth entrant. At 11%, it is the third highest-weighted currency following the US Dollar and Euro. The Pound and Yen round out the exclusive club.1
For many decades, China’s capital controls rendered it ineligible to meet the IMF’s “freely usable” criterion. The tide turned after the Global Financial Crisis. Beginning in 2009, PBOC governor Zhou Xiaochuan published a series of papers arguing that the US Federal Reserve played a dominant, yet impossible, role in maintaining the global financial order. Zhou asserted that US monetary policy could never satisfy the needs of the US economy and the rest of the world simultaneously. He reasoned that the US dollar should be abandoned as the primary reserve currency and replaced by a supra-national reserve currency— of which the RMB would be a major player.
Although the IMF was initially hesitant to include the RMB, the organization relented after China implemented reforms to meet the standard for “freely usable” currency.
For now, inclusion in the basket is largely a symbolic sign of importance. Few financial instruments are denominated in SDR. Interest is growing, though. For example, the World Bank issued USD$500 million worth of 3-year SDR-denominated (Special Drawing Rights) bonds in China on August 31, 2016— a maneuver expected to inspire wider usage of SDR-denominated debt instruments.
1 IMF.org, Special Drawing Rights subsection, as of 3.20.2017
RMB Internationalization is a Long-Term Goal
Ultimately, internationalization of the RMB brings both risks and rewards. Although fully liberalizing the capital account will bring new investors and inflows into China— thus promoting economic development— undertaking the process too quickly can result in large capital outflows and exposure to exchange rate shocks. China’s regulators are also concerned about increased SOE borrowing costs. SOEs still contribute a significant amount to China’s GDP and employ roughly a fifth of the population; their dismantling at the hands of international capital markets could be socially explosive.
As a result of this conundrum, the coming years will bring continued policy massaging to open markets in the least socially disruptive way possible. Index provider MSCI’s anticipated inclusion of A-Shares into its Emerging Markets index will represent an important proxy on the success of China’s fine tuning measures. Because the fund is tracked by several hundred billion dollars of international institutional money, acceptance into the index is a key motivator for Chinese regulators to adapt to international best practices of capital market access.
MSCI has refrained from including A-Shares for the past several years, citing continued capital market restrictions. Whether China’s 2016 and 2017 reform efforts do the trick remains to be seen.