China's renminbi is set to become one of the world's major reserve currencies. Philip Poole anticipates more supply of RMB-denominated bonds to foreign investors to fuel that project
Over the past decade China has become a major - in some respects even dominant - player in the global economy. But its currency, the renminbi (RMB), has lagged. Prior to recent reforms, the RMB was strictly a domestic currency with few international characteristics. Things are now changing and the currency is internationalising at pace, with the ultimate ambition to make the RMB a global reserve currency for investment, trade and settlement purposes.
This push is partly because China feels trapped by relying on the US dollar as the principal unit of exchange for its exports and the store of value for the lion's share of its accumulated foreign exchange reserves holdings, but also because - like the US and the UK in the past - policy makers have come to appreciate the benefits of having a global reserve currency.
Reserve currencies play a crucial global role for both the private and official sectors. As trade vehicles they facilitate processes such as the ongoing globalisation of the supply chain and are dominant as stores of value for accumulated wealth holdings, particularly emerging markets central bank holdings of foreign exchange reserves.
The ongoing internationalisation of the RMB is fortuitous because the world is keen to acquire new reserve assets and the spectrum of investors from retail to central banks and sovereign wealth funds is looking to diversify away from the US dollar over time, particularly given concerns raised over potential debasement as a result of quantitative easing.
Chinese policy makers have also mentioned the IMF's Special Drawing Right (SDR) as a potential alternative reserve currency but this looks like a low-probability event. The potential for other emerging markets currencies to play such a role also seems to be limited. Russian politicians want a group of regional reserve currencies to replace the dollar in regional trade but little has been achieved, so far. There has also been some discussion about using the Brazilian real to settle trade between Brazil and some of its trading partners but the immediate prospects do not appear bright.
China's motivation and challenges
China has no aversion to the dollar per se, but to potential dollar weakness and particularly its implications for accumulated external savings, much of them held in US treasuries and other dollar-denominated assets. The authorities in China fear that dollar weakness could lead to substantial losses in the local currency value of these dollar assets. This also explains their vocal opposition to quantitative easing from the Federal Reserve, because of the belief that it would serve only to drag the dollar lower.
China owns so many dollars that it can't sell them without driving the price down against itself.
Given the nature of this starting point and liquidity constraints, the shift away from the dollar's global dominance will necessarily take time. However, with such high stakes, China has been at the forefront of the reserve currency debate, actively looking for possibilities to diversify away from the dollar. Gold and commodities have been beneficiaries and, in our view, will continue to be so.
Gold and other precious metals are the only financial assets that are not someone else's liabilities. China has increased its gold holdings rapidly in recent years and last year China and India together accounted for more than half of gold demand globally. But the gold market and flows into it are relatively small in relation to global FX reserves. Less than 5% of China's reserves are equivalent to a full year of global gold production. In other words, size will limit the extent to which international reserves can be parked in gold.
China is on track to become the world's largest economy and exporter and historical parallels imply a role for the RMB as an important reserve currency at some point in the future. But there is much work still to be done to achieve reserve currency status. China needs to open up the capital account for international transactions and make the RMB fully convertible for such transactions and it needs to make its bond markets more liquid.
FX policy changes
Like most of China's economic policy, changes in the approach to the currency have, for the most part, been unfolding gradually. The current foreign exchange regime now has greater flexibility and the authorities appear to be a little more prepared to allow the currency to appreciate than in the past. Recently, on the regulatory front change seems to have gathered pace. China has set up currency swaps with many other countries including in Latin America and Asia and RMB bond issuance in Hong Kong (so-called ‘dim sum' bonds) is growing, as a first step towards creating a deep investable bond market for the redback. Projects for RMB settlement have been in place for sometime. In 2009, RMB trade settlement schemes began in a number of mainland cities and HK participating banks were allowed to provide trade finance to foreign traders settling trades in RMB.
As such changes proceed they will have the immediate advantage of reducing foreign exchange risk for Chinese companies that switch to RMB settlement. Last year there was a global roll-out of RMB trade settlement and an offshore RMB products platform was launched in Hong Kong. The RMB interbank market was also opened to selected offshore RMB holders and an RMB Overseas Direct Investment trial launched. In the coming years we expect to see a significant increase in global RMB trade settlement and increasing liquidity in the off-shore RMB bond market as dim sum bond issuance increases.
Chinese policymakers are keen to internationalise the RMB and the process is already well under way. The offshore RMB market is central to the strategy to internationalise and there are likely to be major developments on this and other fronts in the coming years. This will open up new investment opportunities in what we believe is likely to remain one of the world's most rapidly growing, dynamic economies. In particular, dim sum bonds are likely to continue to prove interesting to international investors that cannot directly access RMB-denominated bonds in the Chinese domestic market and issuers are also likely to be keen to leverage this growing market for funding.
Philip Poole is global head of macro and investment strategy at HSBC Global Asset Management