The rise of the renminbi

Now that Islamabad and Beijing are poised to enter into an expanded and intensified bilateral economic interaction as the first phase of implementation of China-Pakistan Economic Corridor (CPEC) project gets into top gear by end-2017, it is time for our official economic managers as well as our private sector to get a closer look at the state of health of our Northern neighbor's currency - the renminbi.
The Chinese currency has already entered the basket that makes up International Monetary Fund's (IMF) Special Drawing Rights (SDRs) - the reserve asset in which the IMF denominates its loans to governments.
Until October last year, only the US dollar, the euro, the British pound, and the Japanese yen were included in the SDR basket. The renminbi's entry into the basket can be regarded as an affirmation of the success of China's economic development and the result of the reform and the phased opening up of the financial sector. Indeed, following the move renminbi became a leading global currency, befitting one of the world's leading economies.
The renminbi has been internationalized by promoting its use as a unit of account, means of payment, and store of value for banks, firms, and governments undertaking international transactions.
China is not new to currency transactions. It was the first country in the world to use paper money. And today the renminbi reflects the bigger picture of the country's ongoing economic and financial reforms.
Beijing has worked hard to encourage the international use of the renminbi, which accounts currently for around one percent of the foreign exchange reserves held by the world's central banks.
Businesses now use the renminbi to pay for about ten percent of all global exports and imports, up from essentially zero a decade ago, most of those payments stem from China's own trade - including trade with Hong Kong (The Renminbi Goes Global - The Meaning of China's Money by Barry Eichengreen - March/April 2017 Issue, Foreign Affairs).
Meanwhile, the renminbi's share of the turnover in the global foreign exchange market stands at two percent, according to the most recent Bank for International Settlements survey, conducted in April 2016. And according to the Society for Worldwide Interbank Financial Telecommunication (SWIFT), the renminbi ranks as the fifth most frequently used currency in financial transactions and renminbi-based transactions account for 1.86 percent of the value of all global payments.
Wanting to achieve speedier internationalization of the renminbi, China is moving fast on a set of broader economic and regulatory reforms. All these changes are taking place at a time when the international environment for economy is fast changing in Beijing's favor because of US President Donald Trump's emphasis on 'America first'.
So, the road to further progress for renminbi looks not too long or too hard as China has already managed to upgrade the renminbi's global status.
Internationalizing the renminbi is being seen by China as a way to free the country from dependence on the dollar. As long as Chinese banks and firms conduct the bulk of their cross-border business in dollars, they face potential losses every time the dollar-renminbi exchange rate changes.
So far, China has attempted to limit these fluctuations by heavily managing the exchange rate. This is bound to change in the future, since with financial development and opening come larger capital inflows and outflows-needing letting the exchange rate adjust as a buffer against their economic and financial effects.
Dependence on the dollar had also exposed China to strategic risks. The fact that so many trade and financial transactions are settled in dollars gives the US government leverage over the international payment system.
"After Russia invaded and annexed Crimea in 2014, Chinese officials watched with trepidation as the United States, the EU, and a number of Nato members imposed financial sanctions on Russia that, among other things, made it impossible to use credit cards issued by Russian banks outside Russia. That measure was enforceable only because such cards relied on dollar-based payment networks operated by the US firms such as Visa and Mastercard.
"The United States and its allies were also able to threaten Russia with exclusion from SWIFT, the electronic network that settles the vast majority of cross-border financial transactions, which are mainly conducted in dollars. This gave China pause and stiffened its resolve to develop an alternative international payment system not dependent on dollars or subject to disruption by the United States."
The internationalization of the renminbi is expected to encourage wider domestic economic and financial reform and soon foreigners too are expected to be able to engage in financial transactions in China itself, where the vast majority of renminbi-denominated financial assets reside following soon to be lifted restrictions on foreigners (and Chinese citizens) who want to conduct cross-border financial transactions in China.
Relaxing controls on financial transactions is expected to allow more capital to flow into and out of China. To cope with that greater volatility, Beijing is likely soon to complete additional financial reforms by upgrading the government's supervisory and regulatory regimes to prevent banks and other financial firms from borrowing excessively and becoming overleveraged.
Corporate governance is also likely to be strengthened to prevent Chinese enterprises from incurring too many short-term debts denominated in foreign currencies. Beijing is also likely to fully liberalize interest rates in phases to eliminate artificial differences between onshore and offshore rates, which encourage capital flight. And China's monetary policy is likely to be allowed soon to respond freely to changes in the direction of capital flows.
In their efforts to internationalize the renminbi, the Chinese authorities have already taken steps that enhance the access of foreign investors to Chinese financial markets. These measures have ratcheted up the pressure to undertake other reforms, such as those on the regulatory and corporate-governance fronts.
Authors Eswar S. Prasad (Gaining Currency-The rise of the renminbi) and Paula Subacchi (The peoples' Money) in their respective books emphasize the built-in tension between financial liberalization and China's growth model. The authorities in Beijing have long relied on state-owned banks to direct credit toward more technologically advanced industries and enterprises. That model of economic management would come under strain were the party to reduce its direct role in setting interest rates and step back from its tight control of the banking sector.
As Subacchi puts it, policymakers in China will "have to figure out a way to open its financial markets and banking sector while maintaining the unique hybrid, 'socialism with Chinese characteristics,' where economic planning and state control coexist with markets, foreign investments, private property, and individual initiative."
The alternative would be a system of private banks and capital markets capable of more efficiently allocating credit. But such institutions take a long time to develop; Subacchi describes this, appropriately in the Chinese context, as a "long march."
Subacchi highlights China's distinctive two-pronged approach to overcoming these obstacles to currency internationalization. The first prong involves encouraging domestic and foreign companies to use the renminbi in their trade settlements, hoping that the currency's use in financial transactions will follow organically. For Beijing, this approach represents a logical path of least resistance: trade settlements are less risky than purely financial transactions because the merchandise being traded serves as collateral and the loans are paid off as soon as the goods in transit arrive. Once foreign firms receive payments in the renminbi, they make deposits with local banks, which put that money to work in Chinese financial markets. In this way, encouraging the use of the renminbi in trade settlements leads naturally to its use in financial investment.
The second prong of China's strategy relies on offshore markets to develop a financial clientele for the renminbi. With prodding from Beijing, financial centers from London to Singapore have begun encouraging the direct trading of their countries' currencies against the renminbi. For each foreign financial hub, China has designated one of its so-called Big Four banks to act as an official clearing bank. Meanwhile, the Peoples Bank Of China (PBOC) has negotiated currency-swap arrangements that effectively give foreign central banks a renminbi credit line. In the absence of this credit line, the Bank of England, for example, couldn't easily provide an emergency loan denominated in the renminbi to a customer in London, since the bank can't print the Chinese currency. But because the Bank of England has a swap agreement with the PBOC, it can act as a renminbi "lender of last resort." Beijing hopes that over time such arrangements will make foreign regulators less apprehensive about allowing their national banks and firms to do business in the renminbi.
"To be a safe haven, a currency has to be traded in deep and liquid markets; during a crisis, investors value nothing more than liquidity. Moreover, for a currency to act as a safe haven, investors need to feel confident that there won't be unpredictable changes in the rules of the game.
"In the country that controls that currency, the central bank and financial regulators must be insulated from politics; they should be legally and financially independent. Contract enforcement must be evenhanded, treating residents and foreign investors alike. Finally, the system of government must feature institutional checks and balances on the arbitrary decision-making power of the executive.
"Still, Prasad and Subacchi are cautiously optimistic. Both their optimism and their caution are appropriate. China already boasts one of the world's largest economies and is the largest exporter in the world; over time, it will develop some of the world's largest financial markets."