The Chinese renminbi reached new highs against the dollar several times in December and is projected to appreciate further in 2014. The worry is that foreign exchange arbitrage is driving up demand for the Chinese currency and this may cause large capital outflows in future.
In August 2010, a rusting coin was unearthed in Mambrui, a small coastal village in southeastern Kenya. About one inch in diameter, the coin has a square hole in the center and four Chinese characters on each side of it—Yong Le Tong Bao.
The coin belongs to a trade currency minted by China’s Ming Dynasty in the early 15th Century. Historians believe that the coin was taken to Kenya together with other gifts by the legendary Chinese admiral Zheng He, who sailed seven times through the South China Sea into the Indian Ocean between the years 1405 and 1430.
Not many of the coins traveled far enough to East Africa, but according to historians, at that time Yongle Tongbao was widely circulated in a dozen Asian countries including Japan, Vietnam and Sri Lanka. Because of stronger buying power overseas, hundreds of thousands of coins were shipped out of the Middle Kingdom over decades, legally or illegally, in exchange for goods, exotic treasures and silver.
But behind the prosperous trade scene lurked a crisis. Due to limited minting capacity, the Ming government could not make enough coins to meet the demands of economic growth. Instead, it tried introducing paper notes but failed to gain public support. Gradually, the country had to rely on imported silver as its main currency, as domestic production of precious metals was insufficient. This system worked just fine until the international supply of silver went into freefall in the early 1600s, resulting in a fatal depression that contributed to bringing down the entire dynasty.
Will History Repeat Itself?
Although scholars around the world differ on how much the economic crisis is responsible for the collapse of the empire, the inability of Ming rulers to better control their monetary system is still viewed as a fresh warning for today’s policy makers, who are internationalizing China’s currency—the renminbi (RMB) or yuan—in order to reduce the country’s excessive dependence on the US dollar.
Since 2009, the People’s Bank of China (PBOC), China’s central bank, has signed currency swap agreements worth RMB 2.5 trillion with 23 countries and regions; and offshore RMB markets have expanded from Hong Kong to Singapore, Taipei and London, with cities like Paris, Sydney and Toronto waiting to join the game. In December, a report released by the Society for Worldwide Interbank Financial Telecommunication (SWIFT) ranked the RMB as the second most-used currency in trade finance in 2013. Another SWIFT report last month gave the RMB the eighth place in global transactions in December 2013.
The acceleration of RMB output has prompted some bullish economists, such as Simon Johnson from MIT and Arvind Subramanian from the Peterson Institute for International Economics, to predict that the yuan will dethrone the US dollar and become the world’s leading reserve currency by 2030. And to make that happen, they say, China will have to liberalize its capital account by 2020.
This would mean that capital could enter and exit China through the foreign exchange market with very little restriction. Currently the Chinese government operates programs like Qualified Foreign Institutional Investors (QFII) and Qualified Domestic Institutional Investors (QDII) to control capital inflows and outflows, respectively. In November 2013 PBOC Governor Zhou Xiaochuan said that Beijing might loosen the quotas assigned to both programs, and eventually drop the restrictions when “conditions are mature”.
But once the authorities let go of their hold, “the key question is: will foreigners be happier than the Chinese to move money into China than the Chinese to move money out of china?” says Paola Subacchi, Research Director of International Economics at Chatham House, a renowned policy institute based in London. Despite the Chinese government’s “interesting experiment” to make the RMB more appealing to the rest of the world, Subacchi says that the impact is limited.
The concern is that the demand of the RMB is largely driven by its rising exchange rate. The Chinese currency has appreciated more than 12% against the US dollar since June 2010, and some analysts say that it will continue to break records in 2014. Subacchi points to the fact that China’s US dollar reserve is still growing; and even though the RMB’s use in China’s trade has increased over the years, the growth of RMB settlement in import actually outpaced that in export, exposing China even more to the US dollar.
By the end of 2013, China’s foreign reserves have grown to $3.8 trillion. Though the government never made public the proportion of assets denominated in US dollar in the reserve, a report published by the Brookings Institution in November suggests that the figure could be as high as 70%.
But in the longer term, the appreciation could slow or cease, triggering a sudden outflow of hot money and causing a market crash.
“We do believe that the RMB is much closer to its market equilibrium point,” says Louise Liu, Deputy Director of the China Forecasting Service at the Economist Intelligence Unit. She says that the RMB is more stabilized and its valuation is much closer to where it should be.
Louise Liu of EIU talks about the pros and cons of RMB
capital account liberalisation (video by Major Tian)
“A key indicator would be the current account surplus and its ratio to GDP”, which has come down from the peak of 10% in 2007 to about 2% in 2013, Liu explains.
This scenario is somewhat similar to what the Ming Dynasty faced 600 years ago, and that’s why Beijing is taking very cautious measures. Last week, the RMB depreciated slightly against the US dollar for four consecutive days, leading some analysts to believe that PBOC was sending a warning signal to exchange rate speculators. “Don’t expect anything major in the next five years, at least,” says Liu, about freeing up of the RMB capital account. “…Before China is ready to open up its financial market to the world (it has) to reform its banks.”
They All Connect Together
Subacchi agrees that “a surplus economy without a good capital market” could be dangerous during the opening up of its financial sector. So the standard prescription that many China watchers offer is this: internal reforms before external reforms.
One has to admit that China’s banking system has made great progress in the past decade. Today, 14 of the world’s 100 largest banks are headquartered in China, according to financial information firm SNL. The most recent statistics from China Banking Regulatory Commission show that Chinese commercial banks logged $1.2 trillion in profits in 2012, a 19% increase from the year earlier. Industrial and Commercial Bank of China, the world’s largest lender in assets, clocked a net margin of $38 billion in 2012, making it also the most profitable bank in the world.
While Chinese banks are getting better and better at pricing risks, their success stories also owe much to PBOC’s babysitting on interest rates. Until July 2013, Chinese banks couldn’t lend at rates below 70% of the guideline rates set by the central bank, and the 110% ceiling on deposit rates remains today. Critics have long accused that those policies squash financing of small-and-medium sized enterprises and savings of average households.
On the bright side, Beijing is taking steps to phase them out. Range limits on borrowing and lending rates have been eased multiple times (limits on most loan rates have been removed). In December, PBOC introduced negotiable certificate of deposits (NCD) to the inter-bank lending market, letting financial institutions decide the interest rates of new certificates of deposit among themselves.
Another key reform that waits to be done is the marketization of the RMB’s exchange rate. PBOC currently uses a “managed floating exchange rate regime”, under which the central bank allows a daily floating band of 1% of the yuan’s trading price against the US dollar (the band was 0.5% prior to April 2012) around a published central rate. The central rate is determined by the PBOC based on “market supply and demand with reference to a basket of currencies”.
The problem is that a less flexible exchange rate draws more short-term speculating capital since foreign exchange risks are lower. This could be disastrous in the case of a large-scale capital outflow, when the market forces would fail to shift RMB’s price effectively lower.
“China has done a lot about (freeing its) exchange rate recently,” says Subacchi. “But the fluctuation band can be opened more and interventions can be done less frequently.”
The marketization of both interest rates and exchange rates would not only help internationalize the RMB, but also transform China’s current top-down system into a more market-driven one, says Liu Jing, Professor of Accounting and Finance at CKGSB.
Liu Jing of CKGSB on the difficulties of economic reforms
(video by Major Tian)
“That’s why it’s difficult to do—you cannot successfully reform one sector without touching the others because they all connect together,” he says. For example, Liu says that the reform of the financial system would change the environment for state-owned enterprises, which are used to receiving favorable treatment in the current system, such as borrowing at lower costs than private companies.
So when will China free its capital account? “2020 is a wild card,” says Liu Jing . “That’s the date when fundamental transformation of (the) Chinese economy is going to happen.”
Free vs Full Convertibility
But instead of waiting for all the reforms to be done, there are measures that can be taken right now to further internationalize RMB and reduce the credit and foreign exchange risks associated with holding a large amount of US dollar-denominated assets, says Joseph Yam, former Chief Executive of the Hong Kong Monetary Authority and now a member of the Board of Directors of UBS.
“The stability risks can be managed by being prudent in capital account liberalization, in going for full rather than free convertibility,” he adds.
The critical distinction between free and full convertibility of RMB, according to Yam, is whether a domestic currency is convertible to foreign currencies without approval and constant monitoring by the government, which is the practice in most of the capitalist, free market economies.
In terms of the current status of China’s capital account, Yam points to a paper published on the website of China’s State Administration of Foreign Exchange (SAFE), which states that most capital account transaction items that are strictly limited by the government are related to financial derivatives, and the QFII and QDII programs have allowed controlled transactions under almost all of the remaining items, such as bonds, money market instruments and mutual funds
“China can, in fact, go for full convertibility anytime”, and exert effective control and monitor those transactions, says Yam, who argues that at the current stage, “free convertibility” is not necessarily beneficial to China, as it generates huge volatility that has “proven to be highly destabilizing for emerging markets”.
The Great Rebalancing
Stability is one of the most important considerations for China’s policy makers. Even though the government is willing to accept a slower but healthier expansion rate while trying to shift its main growth drivers from export and investment to domestic consumption, it also wants to make sure that the number doesn’t slip too much.
This adds another variable to the internationalization of the Chinese currency, as the direction of capital flows influences the valuation of the yuan and thus impacts exports, which accounted for more than 23% of China’s economy in 2013.
“A stronger RMB is good for China when adjusting the economy,” says Subacchi of Chatham House, because it leads to cheaper imports and increased spending. “But it also impacts wages and affects exports, so the government doesn’t want (the) RMB to rise too much. It’s a fine balance.”
The changing role of exports in China’s economy was reflected in the GDP last year—net exports contributed to a negative 4.4% of the overall growth of 7.7% (not to say that this is based on export data that has been widely scrutinized for being intentionally inflated). A drop in exports, if not compensated enough through consumption and investment, could possibly drag the growth rate below the 7.5% target set by Beijing.
Therefore, the authorities need to use the outflow of capital to cool off the RMB, Subacchi says. And this serves as another driver to loosen capital account controls. According to SAFE, China recorded a surplus of $242.7 billion in its capital and financial account in 2013, a sharp reverse of the $16.8 billion deficit a year earlier, adding pressure on Beijing to spur more outbound investment to counter the hot money coming in.
“The balancing of (the) Chinese economy is a complex matter; the exchange rate and convertibility of the currency are only parts of it,” says Joseph Yam, who believes that the internationalization of the RMB and its “allowed” appreciation can be beneficial, or at least “that they would not undermine rebalancing”.