It has been a decade since China took the momentous decision to move its currency away from a peg to the US dollar. During that time, China’s economy has grown by 10 per cent per year on average, more than doubling in size to become the largest economy in the world in 2014 in purchasing power terms.
A common theme throughout China’s economic development since its opening up in the 1980s is globalisation. It is this commitment to opening up to international trade, investment and now finance that leads us to believe that the internationalisation of its currency, the renminbi (RMB), will accelerate.
China’s economy was still mostly closed before the 1980s – total trade was less than 10 per cent of GDP – and so its currency was both fixed and inconvertible. Nowadays, prices and markets are playing an increasingly important role in providing signals for producers and consumers. Similarly, a currency regime is also becoming an important mechanism for balancing internal and external demand.
The evolution for China from a dual exchange rate system to a conventional hard peg to today’s managed float was not smooth – financial crises in 1997 and 2008 would pause the flexibility of the exchange rate. However, the direction has remained consistent: China’s economy and its currency are both becoming more open, not less.
Chinese policymakers have consistently pushed for currency reforms and the RMB’s internationalisation. This is an integral part of China’s overall economic rebalancing and domestic financial reforms. A more balanced current account goes together with the RMB’s appreciation over the past decade. Much of this is a natural consequence of the increased importance of domestic demand (thereby pulling in more imports), as well as the sectoral shift from industry to services.
A more balanced current account will set solid foundations for further opening up of the capital account. This will be an important catalyst for improving China’s financial market efficiency through greater competition, increasing market liquidity, and putting local government finances on a more sustainable path. To achieve these objectives will require policymakers to implement planned reforms, such as domestic interest rate liberalisation and removing barriers to foreign investor participation.
If China continues along the path of full convertibility, then its currency will be increasingly determined by market forces
Viewing the RMB’s internationalisation as part of the broader package of economic reform means policymakers will bring about full convertibility sooner than expected. To that end, restrictions on firms’ abilities to make FX transactions will be loosened further, while individuals’ FX quotas will also be increased or maybe even removed.
In addition, opening more channels for two-way capital flows, such as through the ‘Q-schemes’ or ‘Stock Connects’ between Shanghai and Hong (and later Shenzhen and Hong Kong), will allow more opportunities for diversification for both international and domestic investors.
The RMB’s internationalisation has reached a critical point and now is the right time to give it a final push to full convertibility. The benefits in terms of more efficient capital allocation and as a catalyst for reforms are significant, and China’s economic development in the coming decade is likely to tip the cost-benefit analysis further towards: 1) capital account liberalisation, and 2) a free-floating exchange rate regime.
China has a manageable stock of foreign currency debt relative to the size of its economy and has the potential to denominate external debt in its own currency. These factors will likely insulate the country from the kind of balance sheet shocks that periodically hit economies with no option but to borrow in foreign currency.
The conditions are in place for change to keep happening at a faster pace than the market expects. More importantly, the past 10 years have shown that once one component of the liberalisation process is in place, it is not taken away. Some of the key steps to look out for next include a further widening of the CNY trading band with a more transparent and market-oriented reference rate.
The rapid growth in the offshore RMB market will lead to a convergence between onshore and offshore exchange rates; a deep and integrated RMB market will facilitate the financing of China’s trade and investment in its local currency.
Some key steps to look out for include further widening of the CNY trading band with the exchange rate increasingly determined by the market, leading to the eventual convergence of onshore and offshore exchange rates into a single RMB rate. The globalisation of China’s trade and investment also makes it logical to finance overseas activity in RMB, and the growth of offshore RMB hubs will also accelerate.
If China continues along the path of full convertibility, then its currency will be increasingly determined by market forces. Demand for the RMB will increase as China grows and becomes a larger part of global GDP, trade and investment. The steps taken towards full convertibility will also have played a vital role in reforms of China’s domestic economy and financial system.
We believe the inclusion in the IMF’s Special Drawing Rights (SDR) basket will be inevitable, meaning the RMB will have gone from a hard peg behind tight capital controls only a decade ago to being an anchor of global trade, investment and finance.
(This article has been provided by HSBC Global Research)