China’s share of the World’s FX market at 1.5% is disproportionately small relative to its share of World GDP and Trade. The 1% increase over three years from 2010’s 0.5% was due to the birth of CNH and the Dim Sum bond market.
Deepening both the Renminbi onshore (CNY) and offshore (CNH) financial markets coupled with reforms in the domestic capital markets are needed before China can fully liberalize and internationalize its currency.
Ultimately the timing and pace of the reforms will depend largely on China’s policy priorities. When China’s economy deepens and grows further, the need for a world class capital market will outweigh the benefits of a fixed exchange rate centered mercantilist policy.
As discussed in the path to becoming a major reserve currency - part 1 (click here), China’s Renminbi (CNY) was first unpegged from the US Dollar (USD) in 2005 and its relevant economic foundations. The second part of this focus shows a contrast, the gap between China’s economic fundamentals versus its share of the World’s capital and foreign exchange markets. Moreover there are sign posts that are likely to occur first before full liberalization of the currency can occur.
Current state of currency turnover
While China is the World’s second largest economy and provides one-fifth of world trade, the share of the CNY in the global currency market of USD 4.7 trillion is disproportionately small. From Chart 1 below, China’s share of the World’s FX turnover, has grown from 0.5% in 2007 to 1.5% in 2013 and is still dwarfed by the US share of 43.5%. While China is the second largest trading nation after the US, the bulk of its trade is settled in US dollars. China’s export revenue is paid in USD which has led to a massive accumulation of primarily USD-denominated FX reserves of USD 3.8 trillion. China has signaled intentions to diversify from the high USD concentration in its reserves but this could prove challenging without significantly impacting the mark to market valuation of its reserves.
Chart 1 – OTC foreign exchange turnover by currency
Source: Bank for International Settlements
The increase of China’s share of World’s FX turnover, by 1% from 2010 to 2013 was largely the result of establishing a market for the CNY on an off-shore basis from July 2010 through the CNH (Renminbi traded in offshore markets).
Chart 2 shows the increase of the CNH denominated bond market also known as the Dim Sum bond market from 2010. As noted in part 1 (click here) while China runs a current account surplus versus developed countries, it typically runs a current account deficit versus other emerging countries because of its huge importation of energy, materials and resources.
Chart 2 – Dim Sum bond market (CNH denominated bonds)
Source: Hong Kong Monetary Authority
The policy decision to make the CNY tradable off-shore led to the birth of the offshore Dim Sum bond market. This gave the economies that run trade surpluses versus China a means to buy Chinese assets with their Renminbi trade receivables. Due to a lack of full capital account convertibility, foreign investors have only been able to buy into onshore Chinese assets on a limited quota basis under the Qualified Foreign Institutional Investor scheme (QFII). Separately, the Dim Sum market which is only into its fourth year is still small in comparison to other global bond markets. The most recently revived plans to link together the Hong Kong Exchanges and Shanghai Exchange can help to address the shortfall of flows into China to some degree. Although the scheme is strictly meant for investors in Hong Kong and China and not open to other countries at this point.
For China to increase its share of global FX turnover and ultimately for the CNY to become a major reserve currency, China must open up its domestic capital markets to foreign investors. While Shanghai will play a key role in this, China is expected to continue further reform of its domestic capital markets to a point where market forces determine the pricing and allocation of capital. At the moment, the State and large state-owned financial institutions are primarily fulfilling the role.
Further, from a policy development perspective, market structures must also become more efficient and elegant so that the Peoples Bank of China (PBoC) can effectively execute monetary policy decisions aimed at balancing economic growth and inflation.
Interest rates market reform and currency internationalization
While the exact time line of CNY liberalization will be unknown, there are necessary foundations or signposts that investors can look out for before full liberalization can be achieved. Full liberalization can be defined as firstly, complete current account convertibility and secondly, complete capital account convertibility without restrictions to merchants, investors or other market participants.
Current account convertibility
In the context of China and many other emerging countries, current account convertibility is easier to achieve than convertibility with restrictions. In this context, trade flows of goods and services can occur without impediment as long as it is legitimately supported by trade documentation e.g. import and export papers, letters of credit. The flow of foreign exchange as a medium of transaction in this context is rarely an issue and hence, full current account convertibility is the easier of the two to achieve.
For full capital account convertibility, foreign traders and investors must be able to buy and sell financial assets without impediments. Typically, central banks and foreign exchange authorities will impose restrictions to prevent the free-flow of money across borders because of the potential for these flows i.e hot money to destabilize economies and markets. During the Asian Financial Crisis of 1997, the outflow of funds from some Southeast Asian economies caused interest rates to spike which subsequently helped contribute to economic recessions. Only a handful of countries in the world have deep enough financial markets that can weather the adverse impact of large amounts of funds freely flowing in and out of their markets.
In international finance, countries are restricted by the ‘Trilemma’ which is illustrated in the diagram below. Countries are able to choose between positions A, B or C. For a country that has free capital flow and a fixed exchange rate regime, it cannot have sovereignty over its monetary policy. Similarly for a country that has free capital flow and sovereignty over its monetary policy, it cannot have a fixed exchange rate. In China’s case, which is similar to position C, the lack of free capital flow, allows China to control its currency as well as set interest rate levels.
Chart 3 – The Trilemma
As China moves towards further liberalization of its currency which ultimately will bring it closer to points A or B, China has to choose between maintaining control over its currency or its monetary policy. Given the size of China’s economy at USD 9 trillion, the second largest in the World, policymakers could see much at stake in the prospect of giving up sovereignty over its monetary policy. China would likely gravitate towards point B.
What the theory means is that there is a basis for the CNY to delink itself further from the USD, and possibly reference its relative value to a basket of currencies of top trading partners. When this happens, the pin point precision that authorities currently can influence the CNY will cease and the CNY will behave more as a freely floating currency where global markets will set its value.
Authorities can of course intervene in the currency market, buying and selling occasionally to “set the tone” for the currency but it without a peg - policymakers cannot control the currency as it did before.
When China exerts control over its monetary policy, it first needs to further reform its domestic interest rates and fixed income markets. Currently, the People’s Bank of China (PBoC) still has control over various interest rates like deposit rates, lending rates and of course PBoC’s rates. In July 2013, the PBoC moved the floor of its lending rate to 4.2% with the benchmark rate at 6%. At the same time, the PBoC also sets the mid-rate for the CNY versus the USD.
As China moves towards having free capital flows and adopts interest rates as an anchor for its monetary policy, money markets, interest rates markets and bond markets which are all inextricably linked also need to harmonize and integrate closer. Piecemeal setting of individual rates will be a thing of the past as interest rates markets become more efficient. China’s monetary system will ultimately be one where the PBoC sets the policy rate similar to a Fed Funds Target Rate and the markets will then reflect that monetary policy decision in various segments of the yield curve. The CNY will then draw its international value base on supply and demand and relative interest rate differentials vis-à-vis other currencies.
SGX to introduce RMB futures in Q3 2014
Singapore Exchange (SGX) will introduce a new set of Asian currency futures to expand its current suite of foreign exchange (FX) futures in the third quarter of 2014, subject to regulatory approval. The new Asian FX suite includes currency futures contracts on Chinese Renminbi (RMB), Japanese yen and Thai baht follows closely after the initial launch of six FX futures contracts in November 2013, which have seen over US$1.3 billion in notional value traded in the five months since it began trading.
SGX’s introduction of Asian FX futures is in line with global G20 regulatory reforms where all standardised OTC derivative contracts should be traded on exchanges or electronic platforms, where appropriate, and cleared through central counterparts. The trading of FX derivatives on a regulated exchange platform will promote greater transparency, and better serve investment and risk management needs in the Asian time zone.