Face-off

To gauge the potential of China’s tightly controlled currency, look to Hong Kong. The territory’s offshore yuan market has expanded rapidly since 2008, when mainland authorities began to allow some Chinese companies to price their exports in renminbi instead of US dollars. Roughly 9% of China’s total trade is now settled in yuan, with around RMB627 billion (US$99.3 billion) deposited in Hong Kong banks as of November 2011, up from practically nothing in 2009.

While that growth is impressive, the currency was used in only 0.29% of global trade as of November 2011, according to the financial information firm Swift. That leaves a huge gap between China’s economic heft and the renminbi’s pygmy presence. Most economists and analysts expect the renminbi to catch up eventually, perhaps even leapfrogging the dollar to become the world’s primary reserve currency. Some, such as Arvind Subramanian, a senior fellow at the US-based Peterson Institute for International Economics, have projected that the renminbi will “eclipse” the US dollar within this decade.

These pundits point to steady, rapid internationalization of the renminbi on nearly all fronts, including the growing share of cross-border trade settled in renminbi and booming offshore market in Hong Kong, as well as loosening restrictions on cross-border capital flows and currency “swaps” with other central banks. The renminbi’s rise, they say, is an inevitable consequence of China’s ascent to economic superpower status.

Others, however, are more cautious. Internationalization and reserve currency status may eventually come, but it will require serious trade-offs: allowing the value of the yuan to fluctuate, opening up China’s closed bond and stock markets to international investors and curbing bank loans to state companies, to name a few. These changes would force the government to further relax its hold on the economy. For this reason, Pieter Bottelier, senior adjunct professor of China studies at Johns Hopkins School of Advanced International Studies, doubts the renminbi will become convertible – or readily bought and sold without government restrictions – in the near term.

“If you want to make the renminbi an international reserve currency, then China would have to give up all the controls on its capital account, and it would have to completely liberalize its domestic interest rates,” said Bottelier. “That has very significant domestic political implications that the system may not be ready for at this point.”

Main Street vs Wall Street

The process of internationalization creates winners and losers, pitting different sectors of the economy against each other. Almost all widely-used currencies are fully convertible, because companies and investors need to exchange large amounts of capital without applying for government permission. The value of the US dollar, the euro and other fully convertible currencies is allowed to rise and fall with market demand; otherwise, the opportunities to arbitrage prices and interest rate differences would encourage investors to move huge amounts of capital in and out of currencies, destabilizing the system.

Although there is some debate over how undervalued the yuan really is (see page 35), few doubt that the currency’s value would rise if it could be freely traded on open markets. This would make China’s export sector less competitive, and because export businesses employ roughly 70% of the country’s work force, it might lead to social unrest.

Jeffrey Frankel, professor at Harvard University’s Kennedy School of Government, has written that the internationalization of any currency pits the country’s proverbial “Wall Street” against “Main Street.” This is no less true for China, where the Ministry of Commerce, which oversees the nation’s exporters, lobbies hard in favor of slower appreciation.

The People’s Bank of China (PBoC), on the other hand, typically pushes for financial reforms and a free-floating currency. The central bank has many reasons for wanting an internationalized renminbi: It could help to dampen inflation, rebalance the economy and cap the growth of China’s US$3.18 trillion in foreign exchange reserves.

Some observers speculate that PBoC governor Zhou Xiaochuan and other market reformers “tricked” China’s senior leadership into embarking on currency internationalization in 2008 and 2009 by couching their reforms in the guise of nationalism. China needed to reduce its exposure to the shaky US financial system, the pro-reform lobby argued, and currency reform could decrease China’s reliance on dollar-denominated assets while strengthening its global trade status and national prestige.

However, some allege that Zhou neglected to spell out the ramifications of currency reform. Members of the Politburo and State Council, few of whom have backgrounds in economics, are now confronted with the policy’s inevitable consequences, such as a free-floating yuan and liberalized capital markets. “Internationalization of the RMB was dreamed up by Zhou, who conned the leadership into approving it,” Arthur Kroeber, managing director of Beijing-based consulting firm Dragonomics Research, told The Wall Street Journal in June last year.

The rumor has made the rounds in Beijing’s chattering classes, but in truth, very little is known about how China’s leadership made its decision to begin serious reforms in 2008-9. “I have heard these comments, but I’m dubious about their validity,” said Bottelier of Johns Hopkins. “China’s central bankers and its governor Zhou Xiaochuan are all senior Party members, and are part of the same system.”

Command and control

Regardless of how the decision to begin reforms was reached, political bottlenecks could slow progress. One major obstacle will be the reform of the banking system, which “has lagged far behind China’s[broader economic] reform and opening process,” said Yang Tao, director of the Institute of Finance and Banking at the Chinese Academy of Social Sciences, a Beijing-based think tank.

Beijing has resisted liberalizing banks in large part because the system helps to support the state-owned companies that make up 40-50% of the broader economy. These companies are kept afloat by monopoly positions and government subsidies, chiefly the “hidden subsidy” of cheap financing. Estimates vary, but state companies probably receive a 2.5-percentage-point discount on their interest rates compared with private companies.

State banks can afford to dole out these cheap loans because they earn a steady stream of income from government-fixed deposit rates. Since 2004, deposit rates have been negative when adjusted for inflation. In other words, household savers have lost money on their deposits, and banks have used these funds to offer cheap loans to SOEs.

Full convertibility of the renminbi would require regulators to liberalize this system. Otherwise, China’s depositors would be likely to move their money abroad in search of higher interest rates, creating a liquidity crisis.

Establishing convertibility might also push the country to open its entire capital account, including bond and equity markets, to global capital flows. This is not a strict prerequisite for an internationalized currency: The Japanese yen is widely traded, yet domestic capital accounts for the bulk of its securities markets. But foreign holders of the renminbi will want to use it, and China may eventually need deep bond and stock markets to absorb yuan flowing into the country and prevent asset bubbles.

These changes “would have very serious implications for the way China is run at this point,” said Bottelier of Johns Hopkins. A 2011 study by Nick Lardy and Patrick Douglass of the Peterson Institute suggested that a deposit rate increase of just 1.1 percentage points would have eliminated all profits in China’s banking sector in 2009. Banks probably could not continue doling out cheap loans to SOEs without taking losses, which would force them to raise rates on all borrowers.

According to some studies, this would plunge many – if not most – state companies into the red. Many analysts feel that interest rate liberalization will lead to a substantial loss of control for Beijing, something authorities may not readily give away.

However, the politics cut both ways, says Charles Kupchan, a senior fellow at the Council on Foreign Relations and professor at Georgetown University. The importance Beijing attaches to the political prestige and status that come with a global currency “should not be underes- timated.” These accomplishments fit well into the official narrative of China’s rise from its ‘century of humiliation’ under the aegis of the Chinese Communist Party.

And while financial liberalization would be painful for state-owned companies, it would have obvious benefits for households. Interest rate reforms would increase the returns of bank depositors, while renminbi appreciation would make imports cheaper – both critical prerequisites for the oft-repeated goal of increasing household consumption and raising the country’s overall standard of living.

“I think they’re sort of caught between the pull of catering to domestic interests… versus dealing with the problem of growing economic inequality and the desire for a faster rise in the standard of living for the working class,” Kupchan said.

Pregnant pause

Yet while the urge to retain political control of the banking system may slow the process, the overall trajectory is clearly one of gradual internationalization. No senior Chinese leaders have spoken of the yuan as a reserve or even convertible currency, instead focusing on the more modest goals of regional trade settlement.

“Chinese authorities have taken a measured approach to renminbi internationalization, starting by encouraging its use as a trade settlement currency, while progressively permitting renminbi to be used for cross-border capital investments in both directions,” said Magnus Montan, head of international business at HSBC China.

But some economists wonder if the process, once started, can be stopped. “It’s a bit like being pregnant,” said Ron Schramm, professor of economics at Colum- bia University. “You’re not sort of pregnant – you either are or you’re not. And to some extent with the renminbi, in the end it’s either going to be convertible, or it isn’t.”

He adds that China is trying to be“half-pregnant” by developing an offshore currency market in Hong Kong while gradually loosening the restrictions on bringing that money in and out of the mainland. The danger is that investors might exploit cracks in the wall of capital controls to arbitrage different onshore and offshore prices and interest rates. If enough capital flows across the border, that could trigger destabilizing bouts of inflation or deflation.

Arbitrage has so far been limited, but the threat is serious (see page 36). That’s why many investors reacted with alarm to news that China’s foreign exchange reserves dropped on a quarterly basis in late 2011 for the first time since 1998. The data, which was accompanied by a stalling property market and rumors of depreciation, suggested that companies and wealthy individuals might be taking advantage of looser capital controls to search for higher returns offshore. Yu Yongding, a former member of the PBoC’s monetary policy committee, stated in an op-ed that the outflow was probably due to investor arbitrage.

Schramm said that managing the situation is becoming more and more difficult, but he is optimistic that the government can manage the transition. “They’ve had great success in doing this in the past, and my bet would be on the Chinese government, that they’ll be successful in managing that transition,” he said.“But it will take time, and the question [is whether] they can they buy enough time in order to manage that.”

Tricky though a transitional phase may be, a sudden shift in policy would probably be worse. “If China begins renminbi convertibility without sufficient preparation, it will impact China’s economy a lot,” said Jiao Wenhui, a foreign exchange trader at a Shanghaibased Japanese brokerage.

Feeling the stones

The difficulty is not just in assembling the nuts-and-bolts “hard infrastructure”of technology, liquidity and trading systems that banks and financial institutions require to work with a convertible currency and open capital markets. Bankers and traders caution that the less measurable “soft infrastructure” is just as crucial. Regulators need time to perfect guidelines, banks must learn how to better evaluate loans, and markets must prepare for the arrival of international investors.

China currently lacks the financial talent and rule of law needed to facilitate all the components of renminbi internationalization, said Jiao. Even many of the investors he works with “are not familiar with foreign currency investment, and have little knowledge on the impact of renminbi appreciation,” he said.

The considerable groundwork required means that Beijing will likely stick to its gradualist approach for some time. Damien Ma, a China analyst at Eurasia Group, a political risk consultancy, says that despite the concerns voiced by economists like Schramm, China’s leaders think they still have time to promote the renminbi globally without committing to an open capital account.

“They want to see how the global renminbi push goes,” he said. “And then when it gets to a certain point [that] they decide must require more internal liberalization, then that’s when they’re going to move.”

Aligning the political stars takes time in any country. Kupchan of the Council on Foreign Relations points out that there’s usually a long lag between when a country achieves economic superpower status and when it achieves global reserve currency status. For example, the US surpassed Great Britain as the world’s leading economy in the early 1870s, but the US dollar did not supplant the British pound until after World War II.

But whatever the timeline, renminbi internationalization – and perhaps reserve currency status – seems eventually to be in order, particularly once international investors and companies can better access assets in the mainland.

“In the end, when you think about a currency, what is it? It’s a claim on fundamental underlying real assets,” said Schramm. “When it becomes easier to lay claims on those underlying assets in China, then people will want to hold on to those currencies.”