Based on the analysis of the three determinants of currency internationalisation - ancestry, acceptability and availability - it is obvious that the renminbi still has a long way to go in terms of meeting those conditions. However, favourable trends for the renminbi are unfolding. Friedrich Wu, Rongfang Pan and Di Wang analyse these trends in this second and final part of our special report, which first appeared in the journal of the Institute of World Economics and Politics, Chinese Academy of Social Sciences.

Ancestry: Mixed picture of China’s rise and the RMB

1.    Economic size: Large but not affluent
Since the adoption of the “Open Door” policy in 1978, the Chinese economy has experienced one of the fastest long-term growth rates in the world, and at the beginning of the 21st century, has surged to become one of the three largest economies globally. China surpassed the UK and Germany in 2005 and 2007 respectively, to become the third largest economy following the US and Japan. The US investment bank Goldman Sachs has projected that China will overtake the US to become the world’s largest economy by 2027, should China manage to continue to grow at its current rate.

However, a large GDP size does not necessarily equate to a wealthy or healthy economy. Despite its number three world ranking in absolute economic size, China remains far behind the other leading economies in average per capita income level. By the latter measure, China is still a lower-middle-income country lagging way behind other high-income countries. In 2007, GDP per capita in the US was as high as US$45,592, followed by the UK’s US$45,442, Germany’s US$40,324 and Japan’s US$34,313, dwarfing China’s US$2,432 (World Bank, 2008). In the long run, even though China’s GDP per capita is projected to surge exponentially to US$49,650 by 2050, it will still lag far behind that of the US (US$91,683), the UK (US$80,234), Germany (US$68,253), Japan (US$66,848), as well as other developed and emerging economies.

Furthermore, despite optimistic projections of China’s future growth potential, its economy is still beset by numerous imbalances and risks in the medium term. These include, among others, persistent and even widening regional economic disparity and rural–urban income inequality, rising social unrest and inter-ethnic conflicts, rampant corruption and serious environmental degradation (Wu, 2006). An eruption of any one of these, or a combination of several “fault lines” could put a sharp brake on the ascent of the Chinese economy, and concomitantly propel the RMB onto an inordinately volatile trajectory.

2.    Trade volume and settlement
Mirroring its high economic growth rate, China has also experienced an uninterrupted surge in exports and imports of goods and services during the past two decades. According to the World Bank (2008), the trade volume of China grew from US$109 billion in 1988 to US$2,376 billion in 2007, overtaking that of Japan and the UK in 2004. In the first half of 2009, the WTO reported that China had surpassed Germany to become the second largest exporting nation in the world.

Accompanying the surging foreign trade is the expanding trade settlement by the renminbi (RMB), which has already evolved into a major currency for cross-border trade settlement with neighbouring countries such as Vietnam, Cambodia, Russia and Mongolia. As the dollar has been losing its appeal since the 2008/09 global financial crisis, the Chinese government has recently taken aggressive measures to reduce the risks of exchange rate fluctuations and transaction costs, and at the same time promote the use of the RMB in international trade settlement.

At end-2008, the Chinese government announced pilot programmes allowing Guangdong Province and Yangtze River Delta (including Shanghai) to use the RMB to settle trade deals with two special administrative regions, Hong Kong and Macao. A similar arrangement has been proposed to allow Guangxi and Yunnan Provinces to use the RMB to settle trade accounts with selected member countries of Asean. Another recent and significant step is the announcement by the State Council that five trial cities (Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan) are designated to spearhead international trade settlement in RMB with overseas counterparties.

Moreover, to mitigate exchange-rate risks arising from trade settlement in the dollar, China has entered into bilateral currency-swap agreements with several trading partners. Since December 2008, the PBOC has signed a total of RMB650 billion worth of currency-swap agreements with Hong Kong Special Administrative Region, South Korea, Indonesia, Malaysia, Argentina and Belarus. Moreover, the PBOC is still in talks with other central banks to ink additional swap agreements, and is likely to expand them to cover all of the country’s trade with Asia, excluding Japan. Such recent progress signals that the Chinese government is beginning to set the RMB on a liberalisation path, starting with a gentle push of the unit to raise its profile as a medium of exchange in its regional backyard.

3.    Foreign direct investment flows
Aside from being the world’s third largest economy and second largest exporting nation, China is now becoming one of the world’s largest recipients of FDI. Indicating the increasing openness of the Chinese economy to foreign capital, the inward FDI stock to GDP ratio rose from 5.1% in 1990 to 10.1% in 2007. Going forward, China will remain a magnet for multinational investors. The latest survey by the United Nations Conference on Trade and Development (Unctad, 2009) ranks China the world’s most attractive FDI destination for multinational corporations, while the Economist Intelligence Unit (2007) predicts that China will be the globe’s third largest recipient country for inward FDI during 2007–2011. Continuous strong foreign capital inflows will inevitably help to energise China’s capital and foreign exchange markets, rendering the RMB a more actively traded currency.

Likewise, since the adoption of the openness policy in the 1990s, Chinese companies have been aggressively expanding their investments abroad through both greenfield investments as well as merger-and-acquisition purchases. According to Unctad, outward FDI flows had recorded a dramatic rise from US$0.8 billion in 1990 to US$22.5 billion in 2007, and outward FDI stock as a share of GDP had increased from 1.1% to 3% during the same period. Despite a ranking of 20th as a source country of FDI in 2007 and a much lower level of outward FDI compared to other leading economies, China has great potential to expand its transnational business operations in the short and medium term.

First, projections of continuously fast economic growth, coupled with rapid urbanisation, rising car ownership and accelerated infrastructure construction will raise the nation’s appetite for and boost outward FDI to the commodity and resource sector.

Second, many years of large current account surpluses and accumulation of huge official foreign exchange reserves will enable the Chinese government to help finance overseas acquisitions by state-owned enterprises. Third, a forecast trend-appreciation of the RMB in the next few years would make overseas assets targeted by Chinese companies cheaper.

Last but not least, the process will be backed by supportive government policies. According to The Wall Street Journal, “China’s outward direct investment will overtake FDI inflows as early as 2010… China will become the fifth largest global foreign investing nation behind the US, Britain, Germany and Japan.” Even though most of China’s inward and outward investments are currently made in the dollar, an acceleration of these two-way flows of capital into and out of China will inevitably facilitate the cross-border use of the RMB in the future.

Acceptability: Capital markets and monetary policy in China
Since 1980 when China assumed seats at the World Bank and the IMF, the government has embarked on capital market reforms, albeit cautiously, resulting in the gradual evolution of “enhanced market infrastructures, a better legal framework and a unified regulatory system”. However, the opening up of capital markets began to gather pace only after China’s accession to the WTO in 2001 and the launch of the Qualified Foreign Institutional Investor (QFII) programme in 2002. Nevertheless, China’s growing participation in the global financial system and gradual liberalisation of capital markets over the past five years have resulted in large cross-border portfolio investments. Foreign portfolio investments in China reached a peak of US$43 billion in 2006, and on average, increased by 51% between 2003 and 2007, reflecting strong foreign demand for securities from the country. In addition to ongoing financial reforms, China’s State Council declared in March 2009 that it plans to elevate Shanghai to an international financial centre by 2020.

Despite some modest progress, compared to other more developed capital markets, it is clear that China’s capital markets are still in their infancy, and it may take China one to two decades to develop capital markets into comparable breadth and depth. First of all, China’s capital markets are relatively shallow such that fundraising opportunities by Chinese companies through domestic capital markets are limited. By global standards, the size of China’s equity and particularly bond markets remains fairly small despite dramatic increases in the past five years. China has lower equity and bond market capitalisations to GDP ratios compared to those of issuing countries of major currencies.

Furthermore, despite having a banking sector holding of as much as 9.1% of total global bank assets, China’s equity and bond market capitalisations only make up 5.9% and 2.4% of the world’s equity and bond markets respectively (Deutsche Bank Research, 2009).

Second, due to regulatory barriers on access to China’s capital markets, the latter’s interaction with foreign markets and openness to the rest of the world are still very restricted. In terms of inward portfolio investments to China, the average amount between 2003 and 2007 represented a mere 0.7% of total portfolio investments globally. As for the structure of China’s equity markets, the proportion of domestically listed shares subscribed to by foreign investors (B-shares) and shares listed on the Hong Kong exchange (H-shares: the largest of overseas listings) remain modest compared to domestically listed shares subscribed to by domestic investors (A-shares), to which foreign investors have very restricted access. As of mid-2009, only 87 foreign institutional investors were entitled to the QFII status, 12 which allows them to trade A-shares on secondary markets with an aggregate limit of not more than US$30 billion, or just 1% to 2% of the Shanghai exchange’s market capitalisation. Furthermore, the purchase of B-shares is also limited to a selected group of foreign institutional investors, and Hong Kong-listed H-shares are but a fraction of the two mainland markets. Third, low efficiency, high transaction costs, and weak supervisory and regulatory frameworks have been major constraints to the integration between China’s capital markets and the international financial system. As for equity issuance, China still practises a merit-based approval system in contrast to the registration-based systems observed in most overseas mature capital markets. In addition, China’s equity and bond transaction costs are much higher than those in more developed markets. According to a comparison of financial transaction costs done by the China Securities Regulatory Commission (CSRC, 2008), the Shanghai and Shenzhen exchanges have an average cost of 50bps (with 20bps as average commission and 30bps as a transaction fee), which is more than double the average of 21bps in most mature markets. As for bond transaction costs, China has an average basis point of 6.3, dwarfing the 1bp in the UK, South Korea, India and Singapore, 0.4bp in the US and 0.5bp in Japan. In view of the increasing competitiveness among world financial markets, the current bureaucratic supervisory system in China needs to be reformed to a more professional framework by international standards, and transaction costs also need to be reduced substantially.

Nevertheless, some progressive steps have been initiated recently to add more breadth and depth to China’s capital markets. These include regulators’ latest announcements of plans to allow qualified foreign-invested firms to list on the Shanghai exchange from 2010, to raise the investment limit per QFII to US$1 billion from US$800 million, and to approve foreign banks to issue RMB-denominated corporate bonds. Likewise, in an unprecedented move, the Ministry of Finance unveiled in September 2009 that in order to promote the yuan in neighbouring countries and improve the yuan’s international status, it would help establish an offshore RMB bond market by starting to sell US$879 million worth of RMB-denominated sovereign bonds in Hong Kong to foreign institutional and retail investors.

Despite these encouraging moves, it will be some years before China’s capital markets can successfully transit to a more open and mature stage. According to the development strategies published by CSRC in 2008, it is forecast to take roughly a decade for China to undergo “the drive to maturity stage”, and it will build up well-developed capital markets by end-2020. Still, Deutsche Bank Research (2009) has predicted that continuous growth of China’s capital markets would significantly raise the country’s profile in the international financial system, and by 2018, China could account for 13% of global bond markets, more than 40% of global stock markets and 18% of global banking markets.

Even with these optimistic predictions, our rough estimate is that China’s capital markets may need another decade to mature. As discussed earlier, only when domestic capital markets in a country are open and deep can its currency become extensively accepted in other capital markets around the world. Therefore, allowing a reasonable time lag, the earliest timeline for the RMB to become a global currency is likely beyond 2025.

Monetary policy and currency stability
Stability and low inflation has been the nominal anchor for China’s monetary policy during the past decade. In the wake of a high inflation period (1992 to 1997), the inflation rate in China has stayed at a fairly low level despite the slight upward surge during the 2008/09 global financial crisis.

According to the IMF’s forecast, inflation trends in China will remain at approximately zero, at least until 2014 (IMF, 2009a). At the same time, the RMB has been a stable currency with a record of low volatility. From 1994 to 2005, China’s central bank pegged the RMB to the US dollar at an undervalued exchange rate of RMB8.28 per dollar. Despite the currency policy reform in 2005, which shifted the RMB from a fixed peg to a regime of managed-float against a basket of currencies, the RMB has remained stable since 2005. This is because the government, although allowing the RMB to appreciate gradually, has intervened heavily to keep the foreign exchange rate at targeted levels. Furthermore, the RMB was only allowed to fluctuate within ±0.3% against the basket on a daily basis, although since then the trading band has been widened to ±0.5% daily against the US dollar. Therefore, the upward trend of the RMB is estimated to follow a steady, slow and stable track in the foreseeable future. As Hu Xiaolian, deputy governor of the PBOC, has argued, China’s gradualist approach helps safeguard the stability of its financial system and create a favourable environment for advancing and deepening financial sector reform, which is expected to promote the RMB’s internationalisation (Hu X, 2007).

Availability: The agenda for renminbi convertibility
Currently, the RMB lacks the foremost prerequisite to become a global currency: free and full convertibility. Although the RMB became convertible for trade transactions and conditionally for FDI in 1994, it has been largely nonconvertible for all portfolio capital transactions until now. Even though every country maintains capital restrictions to a certain extent, in China’s case, despite capital account liberalisation reforms over the past 15 years, it still retains a firm grip on capital account transactions. Always mindful of the risk of widespread financial instability, the Chinese government is most reluctant to undertake more aggressive relaxation until the reform and recapitalisation of the state banking system are completed. However, recent policy initiatives taken by the government have demonstrated the likelihood of a faster pace of relaxation. According to Guo Shuqing, former head of the State Administration of Foreign Exchange, the RMB would be convertible by 2010 for approximately 70% of the 43 capital transaction items under the IMF classification.

Implications for Asia and the rest of the world
Looking ahead, the replacement of one dominant international currency by another depends not only on the rising status of the new currency-issuing country, but also on erroneous economic policies committed by the existing dominant currency-issuing country. Amidst the current global crisis leading to continuous downward pressure on the US dollar and a deteriorating US economy, the role of the greenback has diminished to some extent. Hence, some influential economists in China have become more optimistic in advocating accelerated internationalisation of the RMB. With its massive foreign exchange reserves, China has been able to keep the RMB stable and, consequently, some countries have expressed cautious welcome of the RMB as a settlement or reserve currency.

Despite this emerging sentiment, in the medium term, the RMB is only likely to evolve into a regional currency. In light of the important economic linkages between China and the rest of Asia, the internationalisation of the RMB is likely to confer some positive impact on the region. This is understandable because it has been empirically demonstrated that establishing a common currency in a region will raise trade volume among regional member countries (Frankel and Rose, 1998). Furthermore, using a gravity model, IMF economist Kazuko Shirono estimates that the “welfare gains” yielded by the RMB as a regional currency are much higher than those by the yen or the dollar for all East and Southeast Asian countries, except South Korea.

Specifically, he finds that a currency union with China will deliver higher welfare gains than that with Japan, ranging from by 0.1% to 9.1% for various regional economies (see chart).

It is probably too optimistic, however, to expect the RMB to become a global currency before 2025. It would require fundamental economic, financial, regulatory and political reforms to remake China into a global and responsible stakeholder. On the one hand, it takes time to complete a variety of reforms in China. After all, the prospect of RMB internationalisation is closely associated with its convertibility as well as depth and openness of capital markets. These are not expected to be achieved before 2025. In addition, out of concern for political, economic and social stability, the adoption of a gradualist approach has made the Chinese government extremely cautious toward financial liberalisation. Therefore, it is not a sure conclusion that the government will have the political will to push forward aggressive reforms in capital markets, even though it has recently shown some interest in using the RMB for trade settlement. Furthermore, politically it is also not certain whether other countries will have the confidence to accept the RMB for various international uses, the RMB being a currency issued by a country controlled by a communist party. Hence, the RMB is not in a position to challenge the preeminent role of the US dollar in the foreseeable future.

Friedrich Wu is adjunct associate professor at S Rajaratnam School of International Studies, Nanyang Technological University, Singapore. Rongfang Pan and Di Wang are, respectively, former and current research assistants at the S Rajaratnam School.

This article appeared in Corporate page of The Edge Malaysia, Issue 792, Feb 8 – 14, 2010