Challenges with China’s RMB Internationalization Process

Chinese authorities have been making concerted efforts of late to internationalize its currency (renminbi, RMB) by trying to increase its use in international trade settlement and investment. Their efforts are paying off as international RMB payments and trade settlement have grown rapidly since 2010. The whole process consists of three broad steps beginning with the use of RMB in trade settlement, then investment and then as a global reserve currency. The first step is well underway and has received the most traction of the three – around 10-15% of China’s international trade is settled in RMB at present. China has currency swap agreements with 24 central banks allowing them to directly settle international RMB trade. Use of RMB for investment purposes is still limited due to lack of development of the Chinese capital markets and strict controls imposed by the Chinese authorities. Use of RMB as a global reserve currency is the most ambitious step and likely to take the longest time. At present several central banks have expressed interest for increasing RMB holding as part of their reserve. However, the quantum of holding is small at present and primarily geared towards diversification of foreign assets.

In spite of these developments, there are challenges with China’s efforts to internationalize the RMB. Even though the Chinese currency recently broke into the list of top ten currencies globally, its share is still miniscule (~1%) in total global payments. At a broad level, RMB is mostly used to settle imports, but not exports – roughly a third of imports and less than 5% of exports are settled in RMB at present. Even in imports, invoicing is often done in US dollars while settlement happens in RMB.

A necessary requirement for RMB internationalization is to first make it fully convertible. China is planning to do this first through the offshore markets. Doing the same in the onshore market by opening capital account and liberalizing interest rate regime will be more challenging.

Then there are operational challenges for banks that need to be addressed. New systems and processes will be required to support clearing and settlement of payments in real time by domestic and international players. They also need to support different languages including Chinese, English and other regional ones and to accommodate working hours in different time zones to bring about a truly international system of operations.

These will also require strengthening of China’s anti-money laundering (AML) framework. AML practices in China have been in development for over 15 years, however, the AML regulations were largely inadequate until as late as 2006-07. As a result the internal control systems and company culture at banks in China tend to be inadequate, and they do not go beyond meeting basic regulatory requirements at present.

Given the rapid developments in the RMB internationalization process over the last three years, there has been a lot of enthusiasm and optimism expressed by several players regarding its potential to bring in major changes in the immediate future. However, it is safe to assume from past experiences that China will follow a planned, controlled, and slow but steady path in trying to raise the importance of its currency at a global level. True internationalization of RMB will require fundamental changes on many fronts including regulatory, market infrastructure, political and geopolitical aspects. An intermediate step in realizing the ultimate goal may be to first make RMB a dominant currency at a regional level (ASEAN/Asian). The extent of its adoption at a global level will however be long drawn and closely watched.

China’s road towards Currency Internationalization

China is the world’s second biggest economy, largest exporter and second largest importer. Yet China’s currency, the Renminbi (RMB), accounts for less than 1% of global FX turnover. The Chinese authorities have been making concerted efforts since late 2008 to internationalize the Renminbi by trying to increase its use in international trade and investments. Their efforts are paying off as RMB settled trade has grown since late 2010 and accounts for 8-10% of all international trades at present. The following highlights some major successes of their efforts: •    From October 2010 to June 2012 value of RMB payments grew by 17 times. Currently 91 countries are processing renminbi payments. •    Hong Kong is the dominant offshore centre for RMB trading accounting for around 80% of all renminbi payments; share of Singapore, Taiwan are also significant. UK is positioning itself as a major offshore trading centre for renminbi. •    RMB is among world’s top ten currencies traded. Three FX markets exist for RMB: onshore CNY market which is tightly controlled, offshore CNH market in Hong Kong which is relatively free, and USD denominated non-deliverable forward market. The currency sometimes trades at different rates in the CNY and CNH markets and many firms, especially large ones with subsidiaries outside borders, use it to conduct exchange rate arbitrage in these two markets. Given that China’s currency is not fully liberalized, this arbitrage sometimes is not settled by market forces and it creates pressure on the currency, as was evident late last year. Some therefore argue that significant proportion of RMB settlement comes from speculation in the two markets while imports are still invoiced and mostly settled in US dollar. Bank of China Hong Kong (BOCHK) and Bank of China, Macau, are the only two entities approved to clear offshore RMB transactions. Other banks can engage in offshore RMB business through agreement with BOCHK, or through relationship with other banks which have existing agreement with BOCHK. This presents an opportunity for many regional and international banks to tap into this burgeoning market of RMB clearing and trade related services. Moreover, two of the world’s biggest exchanges, the Hong Kong Exchange (HKEx) and the CME Group, recently announced plans to launch offshore yuan futures in Hong Kong by the end of 2012. This is likely to facilitate exporters and importers hedge their currency risks, especially now that the currency is showing some volatility. The forwards market at present is very efficient with tailor made contracts; therefore some think currency futures may not gain traction immediately among traders. However, along with importers and exporters who use currency futures and forwards to hedge exposure, this will also attract asset managers and other financial institutions as the contracts will be standardized and tradable at the exchanges. The outcome of these initiatives remains to be seen, but these moves are likely to further strengthen China’s efforts towards Renminbi internationalization. It must be mentioned that in spite of these developments, there are challenges with China’s efforts to internationalize the RMB. At a broad level, RMB is mostly used to settle imports, but not exports. Even in imports, invoicing is often done in US dollars while settlement happens in RMB. It is argued many Chinese corporations use the different currency markets (CNH-CNY) to engage in speculative activities and not that much for pure trade purposes. This effectively allows for interest rate speculation between the two markets as well. Many of these problems are intertwined as China has traditionally had very strict capital control, and the internationalization of renminbi is taking place before fully liberalizing its interest rate, exchange rate or capital account. Therefore how China attempts to internationalize its currency and manages its key rates at the same time will be closely watched.