Pivotal moment for the renminbi and China

The challenges posed to the global financial order by the rise of China could hardly be more fundamental. For several decades, the arbiters of the world’s monetary system have been developed, western democracies with fully convertible currencies and open capital markets that are governed by the rule of law.

But China is different in every aspect; a developing nation ruled by a Communist party that has striven to limit the convertibility of its currency and shelter its domestic capital markets from foreign capital and influence.

Thus, the International Monetary Fund’s intent to induct the renminbi, the Chinese currency, into its elite basket of reserve currencies represents a potentially pivotal moment. Eswar Prasad, a former IMF economist and China mission head, calls it a “momentous event in the annals of international finance”, adding: “It represents an important step in the renminbi’s ascendancies to the status of a global reserve currency, and will have gradual but significant repercussions in global currency markets and on international capital flows.”

However, the expected inclusion of the renminbi into the IMF’s Special Drawing Rights (SDR) basket is only one expression of the currency’s growing influence beyond China’s borders. The “redback” is also becoming an increasingly important unit of trade settlement, a store of value and a vehicle for investment in assets linked to China’s economy.

In all these senses, 2015 has been a banner year for the Chinese currency. It surpassed the Japanese yen to become the world’s fourth most-used payments currency, in spite of an unexpected devaluation in August and concerns about slowing Chinese growth. The renminbi accounted for 2.79 per cent of global payments in value terms in August, up from 2.34 per cent in July and higher than the yen’s 2.76 per cent share, according to Swift, the payments services provider.

The renminbi is currently used to settle 24.6 per cent of China’s own trade and Standard Chartered, an investment bank, expects that this will rise to 38 per cent by 2017 and 46 per cent by 2020. In absolute terms, this means that more than $2.6tn of China’s annual trade will be settled in renminbi by 2020, a dramatic rise from $821bn in 2014 and $212bn in 2011, according to Robert Minikin, head of Asia FX strategy at Standard Chartered.

“China’s global trade dominance, prudent capital account opening, relatively steady currency value, and rising global influence in commodity markets and geopolitics should allow the renminbi’s share [in trade settlement] to rise further,” Mr Minikin wrote in a report.

Underpinning the currency’s growing popularity in trade settlement is its increasing attractiveness as a unit for investment, a process driven by China’s slow but steady opening of its domestic capital markets to overseas investors. According to Goldman Sachs, at the end of the first quarter of this year, foreigners owned Rmb4.2tn ($680bn) of investment assets in China in the form of bonds, equities, deposits and loans.

For those investors approved by Beijing, the main benefit of holding the renminbi is that it brings access to China’s domestic bond market, where yields are often several percentage points higher than the US and Europe. At the end of 2014, overseas funds managers held Rmb713bn in domestic Chinese bonds, up 78 per cent from a year earlier, according to official statistics. The amount, while small in comparison with the size of the overall Chinese bond market, is significant when compared with the capitalisation of other regional local currency bond markets.

Beijing remains cautious over which foreign institutions can invest in its domestic markets. It restricts access to its interbank bond market to central banks, sovereign wealth funds, multilateral organisations and other carefully-selected institutions. Similarly, the Chinese equity market remains off limits to general participation from abroad, with quotas for limited participation granted to some 320 institutional investors deemed “qualified” by Beijing.

Paul Mackel, head of global emerging market FX research at HSBC, says that not only should SDR membership provide comfort over the renminbi’s stability and liquidity, it will also encourage Beijing to keep opening its domestic capital markets to foreign participation.

Such a process should, in turn, convince central banks around the world to shift an increasing portion of their reserves into the Chinese currency. Mr Mackel says that even if the renminbi’s weighting in the SDR basket is assumed to be 14 per cent (relegating the Japanese yen to an estimated 8 per cent weighting), central banks are not likely to shift more than about 10 per cent of their reserves into renminbi by 2025.

If this happens, it will go some way toward addressing the current imbalance in international finance, under which less than 1 per cent of global central bank reserves are held in renminbi in spite of the fact that China comprises 13 per cent the global economy and more than 15 per cent of world trade. Given that China is the biggest trade partner for 120 countries, it is reasonable to expect their central banks will be keen to boost holdings of renminbi.

Such moves, however, do not obscure the fact that the renminbi is the odd one out among its SDR peers. The IMF’s key criterion for SDR inclusion was that the renminbi should be “freely usable” — a definition that falls short of a “fully convertible” currency like the US dollar, euro, sterling and yen.

David Lubin, head of emerging markets economics at Citi, notes that Beijing does not intend to move its currency toward full convertibility. Zhou Xiaochuan, China’s central bank governor, has defined the goal as “managed convertibility”, saying clearly that “the capital account convertibility that China is seeking to achieve is not based on the traditional concept of being fully or freely convertible”.

Mr Lubin says China, in fact, wants to keep hold of discretionary powers to limit speculative capital inflows, and thus to restrict capital movements in order to deal with balance of payments problems as they crop up.

“What China would like to do, over time, is to gently reassert the role of the state in shaping the international monetary order,” Mr Lubin wrote recently in a comment for this newspaper.

*This article has been amended since original publication to clarify what Paul Mackel assumptions are about the proportion of renminbi in the SDR basket and in future central bank reserves.