Herbert Poenisch: RMB Offshore Market Construction

2015-07-20 IMI

Herbert Poenisch:Former Senior Economist, Bank for International Settlements While most conference participants accepted the notion of offshore market construction as the only road for internationalisation of RMB, this contribution raises some concerns regarding this route. Although the PBoC has designated a number of offshore trading centres for RMB and negotiated swap facilities with local central banks (see contribution by Lim, Korea Institute for International Economic Policy), we have yet not seen the adoption of one strategy for the internationalisation of RMB as the official route. It will be argued that presently the internationalisation of RMB is over-regulated, stipulating the location as well as the eligible participants of this market (see ADBI Ceballos, Didier and Schmukler 2012). It will be recommended to determine both, participants and location (ie offshore financial centres) as a transitory arrangement and to stipulate only the eligible participants as the lasting solution 1.History of Offshore Financial Centers (OFC) Offshore financial centers historically have been a product of market dissatisfaction with onshore regulations. Market participants have therefore shifted their business to these OFC in order to escape regulations and transparency. By doing so they have drawn the suspicion of authorities from onshore jurisdictions. Authorities from onshore jurisdictions were less concerned with the functioning of financial market segments in OFC, such as the interbank market in USD in London, than with the backlash for onshore monetary and financial stability. In the 1970s, their main concern was the money multiplier of USD deposits in the Eurodollar market. They subsequently commissioned the Bank for International Settlements (BIS) to collect data on the size of OFC in order to gauge the impact on national as well as on the international money supply. In fighting inflation, controlling the money supply, however defined, was foremost on their mind.The ensuing discussion focused on whether to include the offshore money supply into the national monetary aggregates, first and foremost the USD. During this period there was also an agreement among central banks not to fuel the offshore market development by placing foreign exchange reserves in this market. The result of this investigation was that offshore currency markets neither contributed to inflation (the feared money multiplier was less than expected) nor had a deflationary impact, as offshore deposits were recycled to the major economies through the international banking system. This in itself proved disastrous for some banking system in the early 1980s, which had over extended their balance sheets. Offshore centres proved less of concern during the 1980s, a period characterised by financial deregulation and liberalisation. It was argued that as regulations were abolished, the advantages of doing offshore business diminished. The incentives for round tripping had disappeared. The next time offshore financing appeared on the radar screen of policy makers in the major onshore financial centers was during the Asian crisis in the late 1990s. It emerged that a major non-recorded part of international lending to the Asian countries in crisis had been channeled through the offshore financial centres. Subsequently, the lack of transparency of offshore financing moved into the limelight of international attention, most recently on the agenda of the G20. The reasons for this were fighting tax evasion, terrorist financing, raising financial stability concerns (in view of the light regulation in these centres) as well as their general opaqueness. The reports on OFC by international bodies, such as the International Monetary Fund (IMF) and the Financial Stability Board (FSB), both published in 2000, have highlighted their concerns about the activities in these centers and have pushed them towards greater transparency by publishing a black list. These offshore centers had been tolerated by authorities from onshore jurisdictions as long as the activity of non-residents did not disrupt onshore monetary and financial stability. These reports highlighted the characteristics of OFCs. The IMF report focuses on the size of their financial sectors compared with the rest of the economy, their emphasis on business with non-residents, and the incentives to provide financial services off-shore, such as low or zero taxation, moderate or light financial regulation and banking secrecy and anonymity. The FSB report elaborates further on these incentives. Both reports come to the conclusion that OFC can be tolerated from an official point of view as long as they are transparent and play by international rules. Against this backdrop, it is surprising that Chinese authorities would intend using OFC as a major pillar in the process of the internationalization of RMB. Even the title of this session, “offshore market construction” implies some sort of engineering put in place by the Chinese authorities. It would therefore be useful to separate various points of interest. It is not surprising that international financial markets would like to trade RMB offshore, as onshore RMB trading is severely restricted by foreign exchange regulations. The offshore centers themselves are more than happy to acquire a major share of this booming RMB business. Chinese banks see future business opportunities by playing a pivotal role in the liquidity management of offshore RMB business. All this is supported by a surge in public sentiment, supporting the replacement of USD by RMB as the dominant world currency as quickly as possible. 2.Theory and reality of Offshore markets The theory stipulates that two separate markets, onshore and offshore with a price differential can coexist as long as there is no arbitrage. Chinese authorities also seem to follow these assumptions, as access for Chinese entities dealing on the offshore markets is tightly controlled as is the liquidity management of RMB in the offshore centers. According to the construction of offshore RMB markets, supply of offshore RMB is provided by Chinese importers as well as Chinese FDI. Demand for offshore RMB is provided by non-residents buying Chinese exports as well as issuers of RMB denominated securities. The RMB lending to foreigners to purchase Chinese exports can be provided by the China Export Import Bank or any other Chinese commercial bank. Borrowing offshore RMB has been tighly restricted with individual permits issued by the Minstry of Finance. Supply and demand can only be balanced when both components, RMB import and RMB export financing grow at equal speeds, thus leaving a net minimum for investment purposes. In reality, however, an RMB imbalance has emerged in each individual OFC, or even taking all OFCs together. As expected, this has resulted in interest and exchange rate differentials compared with onshore rates. Presently, interest rates and exchange rates are lower than onshore rates (see Dong He and R McCauley 2010, 2012). These continue to exist as long as no arbitrage business is allowed, neither for non-residents (who have no access to the domestic RMB market) nor for residents, the majority of which is barred from this market. As arbitrage has been excluded as an equaliser, balances have to be 'engineered'. If a deficit arises, the PBoC has to pump liquidity into the OFC, either through the Chinese agent bank, which has access to the domestic money supply or through swap operations with the national central bank. These safeguards are in place. If surpluses arise, designated Chinese entities have been allowed to borrow in the offshore RMB market. This activity has been tightly controlled and as a result the emerging 'Dim Sum' market activity has been below expectations. A major reason is that rising exchange rate expectations have led market participants to go long in RMB. By allowing RMB trade settlement and creating RMB “recycling mechanism” the Chinese authorities effectively eased the restrictions on short-term cross border capital flows (see Yu Yongding 2013). In reality, however, these differentials have led to Chinese residents borrowing in offshore markets to take advantage of lower interest rates and to evade a tightening of domestic monetary policy, an unintended consequence of offshore activities. The second unintended consequence will be the monetary implication for China as well as offshore centers, such as Hong Kong. Assuming that all of China's foreign trade will be conducted in RMB, the volumes traded on the offshore market (close to RMB 24trillion) could become a sizable component of the total onshore and offshore RMB money supply (M2 presently RMB 120trillion). The PBoC will be faced with the same dilemma of the US FED in the 1980s, to include the offshore holdings of RMB in the money supply or not? The impact on Hong Kong's monetary policy could be even more dire. If HK residents continue to convert their HKD holdings into RMB, acting on continued low interest rates and expected RMB appreciation the whole HK money supply (M2 of RMB 7trillion) could be dwarfed by the growing size of the RMB offshore market. 3.Choices for China A currency is internationalised when markets participants, residents and non-residents alike, conveniently use it to trade, to invest, to borrow and to invoice it outside the the currency's home market (“offshore”). The RMB has just begun the process of becoming an international currency (McCauley 2011). The present system of promoting internationalisation of RMB through offshore centres (OFC model) looks like a controlled experiment as we have seen during the period of Special Economic Zones (SEZ) with “free” trade of offshore RMB for non-residents and selected domestic residents. The resulting interest rates and exchange rates will be studied carefully by Chinese decision makers as well as the introduction of hedging instruments and other financial products, which are not available for participants in the onshore RMB market. The current payment and settlement system is rather cumbersome as balances have to be 'engineered' in each offshore RMB market. This requires the intermediary role of agent banks (such as BOC in HK) to provide liquidity or to channel excess back to the dometic system. Alternatively, currency swaps between the PBoC and the local central banks could be activated. Trading partners have also complained that the present RMB clearing is more costly than through the established channels. If RMB balances in the various offshore centres were to be traded round the globe, either existing structures could be utilised (such as the Countinuously Linked Settlement Bank CLS) or designated banks could be allowed to trade RMB balances globally between OFC, in what could be called an emerging RMB interbank market. The question was raised how long this OFC model experiment can continue and what are the pre-requisites to bring the process of internationalisation of RMB onshore, such as to the Shanghai Free Trade Zone (SFTZ)? The following steps would have to be taken to centralise the RMB offshore market and to bring it closer to home thus abolishing the locational dimension of regulation. Authorised banks in SFTZ, Chinese as well as foreign owned would be asked to keep separate accounts, onshore and offshore RMB accounts. Historically there have been numberous examples, including the UK before the abolishment of exchange controls in 1979. Present day Singapore handles such a double SGD accounting system. The Monetary Authority of Singapore issued clear guidelines as to what offshore banks are allowed to do. These banks, dealing in onshore as well as offshore RMB are well supervised and have to report their business frequently. Foreign banks could be asked to set up subsidiaries rather than branches to allow more leverage by the China Banking Regulatory Commission. Authorised banks should be allowed to onlend balances to each other in an emerging RMB interbank market. As long as payments are mostly for international trade and services and FDI, which are basically liberalised, there should not be too many complications. Domestic RMB are made available to domestic entities, who pay or receive domestic RMB only through authorised banks. These in turn would be allowed to transfer payments between the onshore and offshore RMB accounts. A foreign partner, such as an African state receiving FDI in RMB would keep these balances with one of the authorised RMB banks. This bank in turn could make the RMB available to an importer of Chinese exports, lend the funds in the emerging RMB interbank market or to a designated RMB borrower. Financial transactions, which are still subject to exchange controls need more scrutiny but can be managed. The flow from non-resident accounts into onshore accounts through authorised banks would continue to be controlled. The main burden would lie on correct classification of payment purposes. A due payment date of 90 days would qualify as normal export payment, whereas if extended for longer periods this would be classified as credit and thus be subject to exchange control. The advantages for China for bringing the offshore RMB business onshore would be the close monitoring of transactions, a single payment and settlement system, handling both sides, domestic RMB payments through CNAPS and international RMB payments through CIPS. Shortfalls or surpluses of international RMB could be automaticlly compensated from the CNAPS payment system, thus gradually reducing the interest and foreign exchange differencials between domestic and offshore RMB markets. Finally, the timeframe for replacing the present OFC based system by a “centralised” offshore system depends on whether the process will be market driven or regulated. Markets will most likely favour the OFC model whereas a more controlled process should favour offshore RMB trading in SFTZ. As foreign exchange controls need to be in place for the foreseeable future (see Yu Yongding 2013 and 2014) the coexistance of OFC RMB trading with SFTZ offshore RMB trading should nevertheless begin. This requires the setting up of an offshore RMB trading centre in SFTZ, such as constructing the market infrastructure (CIPS) and authorising Chinese and foreign banks who in turn open non-resident RMB trading accounts. Guidelines for offshore RMB trading activity should be issued as well as a sound reporting framework. Foreigners as well as designated Chinese entities will be allowed to operate through non-resident RMB accounts. The ensuing competition between OFC centres and SFTZ (similar to USD trading in NY) will determine the eventual unified RMB trading, once domestic financial reforms have been implemented and the remaining exchange controls have been removed.

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Herbert Poenisch: RMB Offshore Market Construction

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