For those interested in the internationalization of the RMB, Chinese Vice Premier Li Keqiang’s recent visit to Hong Kong was an important event. On August 17, the vice premier announced the central government’s “Six Measures” to support Hong Kong’s future economic development. Among these measures was the decision to give Renminbi Qualified Foreign Institutional Investors (RQFIIs) an initial quota of RMB20 billion to invest in mainland China’s RMB-denominated securities market, as well as to allow mainland Chinese investors to invest in the Hong Kong Stock Exchange’s “Exchange-Traded Fund.” At the same time, China’s Ministry of Finance announced that it would issue RMB20 billion in RMB-denominated bonds in Hong Kong. Chinese media and businesses have greeted these announcements as substantial steps in internationalizing the RMB — “closing the circle for the global circulation of China’s currency.”
Major Step Forward
The new measures are a significant step forward in promoting China’s national currency as a major international reserve currency, and their implications become even more apparent if we consider the ominous prospects of a global economy now plagued by massive debt in Europe, and also in the US.
Allowing investors in Hong Kong to invest in the A-share markets of mainland China will give more support to Hong Kong’s rise as an offshore RMB centre — as a global financial centre.
Hong Kong is uniquely positioned to promote the RMB as a reserve currency. In the early 2000s, Beijing began considering the role that Hong Kong could play as an RMB offshore centre given its attributes — a pool of financial talent and position as a free trade port — and its openness to international markets. This combination of factors has kept Hong Kong at the top of the Index of Economic Freedom.
Chinese authorities have, nonetheless, taken a cautious approach to internationalizing the RMB. The experimentation started with the creation of incentives and institutional infrastructure to settle trade transactions in RMB. At the same time, central monetary and financial regulators have been careful about managing the opening of China’s domestic capital markets to overseas RMB-denominated investment. They have focused on managing the pace and scope of Chinese currency internationalization to ensure that national economic security interests are protected.
However, the announcements are a major step forward in pushing ahead on internationalizing the RMB on the investment side. They create further incentives for international banking and financial institutions to become more involved in holding RMB-denominated financial products.
Escaping the Dollar Trap
To understand the real significance behind the recent announcements, we need to understand how the latest steps in advancing Chinese currency internationalization were motivated, in part, by the excessive and extended drama over the US debt debate.
China’s RMB internationalization efforts have been shaped by the broader context of the debt debates in the United States — by the dilemma of the so-called “balance of financial terror,” coined by Laurence Summers. In China, more people are turning their attention to the inherent pitfalls of holding too much US debt. Sentiment is growing that given its large dollar-denominated holdings China is exposed to immense risk, and that a “great loss” is coming.
Chinese financial institutions have purchased more than US$1 trillion in Treasury bills, making China the largest official creditor to the US government.
The growing challenge that the US is experiencing in managing its now massive debt burden and a weakening dollar are believed to threaten future returns on US bonds. The extended saga over the US debt ceiling has registered in the Chinese public that a number of “dark scenarios” can be anticipated if China continues to maintain massive dollar holdings. Growing public criticism of US bond operations inside China has even forced the Chinese leadership to show that they are now giving serious consideration to measures that can be taken to reduce China’s role in financing American debt.
The Future of the RMB and Hong Kong
The implementation of RMB internationalization is, however, more complicated than merely drafting a blueprint and then executing it. The steps must be handled properly in relation to a number of considerations, such as how to reform capital control measures, the convertibility of RMB and how to manage the impact of further opening China’s domestic capital markets, even if only to Hong Kong–based financial institutions.
For China’s current senior leaders, who want to ensure, foremost, a smooth power transition in 2012, having an internationalized Chinese currency may seem like a desirable outcome. However, the process of getting there is laden with risk. There is now debate at the top of the party and government leadership over whether the time is ripe to dramatically move ahead on such currency reforms, or whether it is better to wait and continue to be cautious. The usual preference is to be cautious and incremental.
However, the recent US debt debate, the return of financial turmoil to the world economy and the increasingly intense scrutiny of the domestic media and the general public (assisted by new information technologies and the growing popularity of microblogging) are putting pressure on the top leaders to take bold steps to respond to the rising skepticism over China’s US debt purchasing. Li Keqiang’s recent policy announcements to allow more investment scope for RQFII should be seen as partially motivated by the public outcry.
There have also been more enduring factors at play in internationalizing the RMB. Hong Kong’s RMB savings or deposit reached 550 billion yuan at the end of June 2011. The Hong Kong–based banking industry has lobbied Beijing heavily to open more investment windows. These business interests worked hard to convince Beijing that the expected risks in allowing Hong Kong’s RMB saving back into the mainland’s capital markets could be managed, and that the time was right to further expand the role of Hong Kong as an RMB offshore centre, and to help the yuan become one of the major reserve currencies.
The cultivation of Hong Kong as an offshore RMB centre was already written into China’s twelfth five-year plan. Vice Premier Li’s announcements on RQFII were another clear endorsement of Hong Kong’s proposals.
Other considerations have also been part of the mix of factors. For example, numerous mainland companies have sold shares in both A-share and H-share markets. But A shares and H shares are priced differently, even for the stock of the same company. Overcoming the difference in pricing for shares of the same companies — and thus reducing capital market fragmentation — is also cited as a reason to further integrate capital markets.
Now, the worsening sovereign debt crises in the EU and the US are further adding to the internal Chinese financial market integration arguments. In recent months, the RMB exchange rate has appreciated faster than before and among the public, consensus is now emerging that the conditions are right for China to grasp the chance to push forward the RMB as the third reserve currency in the global economy, joining the US dollar and the euro.
Despite the growing pressure to internationalize, Beijing will most likely continue taking a careful approach to internationalizing the RMB. The RMB20 billion quota assigned to Hong Kong investors is evidence of such caution.
Given the entire set of considerations, it is clear that prudence is justified. Internationalizing the RMB requires China to fundamentally restructure its system of capital controls and the existing foreign exchange regime, to allow for greater capital account convertibility, marketize interest rates, and further open domestic financial markets. Only through such restructuring, opening and integration will China be able to increase the attractiveness of holding RMB assets for international investors.
What this suggests is that while the RMB may be able to gradually join the dollar and the euro as a reserve currency option in the near future, it will still be a while before it can compete with the US dollar, or even the euro, as an alternative reserve currency.