E Zhihuan：Characteristics of the RMB Internationalization and Its Prospects for the SDR

2015-06-09 IMI

E Zhihuan: Deputy General Manager, Economics & Strategic Planning Department, Bank of China (Hong Kong) The RMB is not yet fully convertible and China still imposes capital controls, but the internationalization of the RMB has made tremendous progress in the past 10 years. The RMB has taken the lead globally in terms of its function in payment, foreign exchange transaction, settlement and reserve holding. This year, the Yuan is on the verge of being included in the SDR basket. The success of the RMB internationalization is an exceptional case and is worth further examining. I. The RMB Internationalization is dually driven by policy and markets Based on its development pattern in the past decade, the RMB internationalization has been driven by policy in the early stage and by markets in the later. Since the People's Bank of China (PBOC) promoted offshore RMB business in 2003, every milestone of offshore RMB market development was closely related to the loosening regulatory controls in the Mainland. For example, in January 2007, the PBOC approved of RMB bond issuance in Hong Kong by eligible Mainland financial institutions. The Central Government has been issuing RMB bonds in Hong Kong since 2009, which further developed the offshore dim sum bond market. From July 2009 to August 2011, RMB cross-border trade settlement has expanded from pilots to all provinces and cities in Mainland. Hong Kong’s RMB businesses have grown from individual services to corporate ones with enterprises and institutions. The market size increased and the RMB internationalization sped up. From 2011 to March 2013, the Central Government launched the RMB qualified foreign institutional investors (RQFII) program, which extended to all the financial institutions that register or mainly operate in Hong Kong. The design concept and mechanism of Hong Kong's offshore RMB market evolved from one-way cash repatriation back to the Mainland to the two-way flows. The offshore market thus became the founder and hub for developing RMB products and spreading the use of the RMB elsewhere in the world. Recently, the Shanghai Free Trade Zone, Shanghai-Hong Kong Stock Connect and even the "One Belt, One Road" strategy are adding new growth impetus to the RMB internationalization. Apart from policy factors, market demands are the key to the development of offshore RMB businesses. China’s real economy, especially trade and investment growth, provides a solid foundation for the RMB internationalization. In 2014, the size of China’s economy has reached USD10.38 trillion, second only to the US. In the meantime, China is the largest exporter of goods and the fifth largest exporter of services worldwide. Additionally, in recent years, the foreign direct investment (FDI) China attracts is also second only to the US, and China’s outbound direct investment (ODI) countries is right behind Japan and the US amongst G20. The dollar amount has been basically at par with that of FDI. With the support of China’s real economy and financial activities, the RMB internationalization goes hand in hand with market demands. In other words, there is tremendous room for the RMB internationalization to grow before it is compatible with China’s economic clout. In the past several years, the market force has been playing a bigger role as demands for RMB products and trading surged, in particular in the financial industry. As the world's largest offshore RMB hub, Hong Kong's first mover advantage is reflected in the depth and breadth of the market. The increasingly active trading activities and an extensive selection of RMB products give birth to a virtuous cycle of demand and supply, meeting market demands and expanding the Hong Kong market itself. The RMB cross-border trade settlement processed by Hong Kong banks grew from RMB369.2 billion in 2010 to RMB6.2583 trillion in 2014, an increase of more than 15 times and accounted for the vast majority of the Mainland’s RMB trade settlement. At the end of 2014, Hong Kong's RMB liquidity pool totaled RMB1.1583 trillion (including RMB154.7 billion of certificates of deposit), which accounted for 43% of global offshore RMB deposits. Outstanding Dim Sum bonds in Hong Kong soared from RMB55.8 billion at the end of 2010 to RMB380.5 billion at the end of 2014, a 5.8 times jump and allowed Hong Kong to stand out as the leading offshore RMB bond market. As cross-border financial integration between pilot free trade zones and offshore markets gradually deepens, more financing needs and opportunities for cooperation have emerged. Since the Shanghai Free Trade Zone (FTZ) came up with innovative financial business solutions, there have been considerable demands for cross-border RMB services from Mainland pilot FTZs. The Qianhai-Shenzhen Hong Kong Modern Service Industry Cooperation Zone kicked off the first cross-border RMB loan program. After the Shanghai FTZ was officially launched, the PBOC started cross-border RMB pilot program in both the Suzhou Industrial Park and the Tianjin Eco-city. Guangdong, Fujian and Tianjin FTZ have also been set up. The pilot areas have strong links to offshore RMB business, generating large demands for cross border financing, and serving as an important growth engine for investment and financing activities in Hong Kong’s offshore market. It is believed that the success of Shanghai FTZ could be replicated and promoted to a greater extent, and reforms be further implemented, creating more financing needs and more room for cooperation. The connection between capital markets in the Mainland and Hong Kong has been rapidly established. The Shanghai-Hong Kong Connect was the first trial to link the two stock markets. Regulators and market players are now discussing the option of extending the framework to products other than stocks, such as commodities, bonds, fund products, just to name a few major asset classes, and applying the current model to other markets and regions. Besides the Shanghai Stock Exchange, according to the Hong Kong Stock Exchange, it plans to cooperate with Shenzhen Stock Exchange, China Financial Futures Exchange Dalian Commodities Exchange, Shanghai Futures Exchange and the Zhengzhou Mercantile Exchange, etc., in the future. The rapid expansion of this model is conducive to the connection of capital markets in HK and the Mainland on a large scale and will expedite the RMB internationalization. As the "One Belt, One Road" strategy moves forward, regional cooperation will yield more opportunities for offshore RMB financing. The "One Belt, One Road" is a crucial part of China’s opening strategy. China will build a complex investment cooperative network with relevant/neighborhood countries through extensive trade links, promote the circulation and transactions of offshore RMB with international strategic alliances, just like what the US did with the Marshall Plan. These RMB-based cooperative projects will generate large demands for RMB trade settlement and financing. As the world's largest RMB settlement platform, Hong Kong will be at the core to meet settlement needs from the "One Belt, One Road' strategy. Hong Kong's financial institutions could finance infrastructure projects along "One Belt, One Road" through syndicated loans and debt securities. They could also undertake a number of RMB-based ODI projects and promote the circulation and cross-border transactions of the RMB in the offshore market. II. Recent developments of the RMB internationalization 1. The RMB internationalization has made headway on the global stage, with an emerging worldwide settlement framework comprised of multiple coexisting markets After the PBOC appointed RMB clearing banks in Singapore and Taiwan in 2013, RMB clearing banks in London, Paris, Frankfurt, Qatar, Toronto, Kuala Lumpur, Bangkok, and Seoul were subsequently appointed in 2014. A 24-hour global offshore RMB market system thus emerged, covering countries and time zones in Asia, Europe, the Americas, and the Middle East. The global RMB settlement system has evolved from being reliant on Hong Kong as a hub to a network of multiple coexisting markets. In Asia Pacific, a number of offshore RMB centers such as Taiwan and Singapore have grown to a certain scale that allows for differentiation in market structure and positioning. Taiwan now boasts the second largest offshore capital pool after Hong Kong, with RMB310.2 billion of deposits at the end of 2014. Singapore is another important market for offshore RMB businesses in Asia Pacific. As of September, 2014, RMB deposits in Singapore amounted to RMB257 billion, following only Hong Kong and Taiwan. Thanks to its enthusiasm in boosting offshore RMB businesses and its position as a hub of ASEAN, Singapore has made considerable progress in RMB settlement, RMB-denominated commodity transactions, and RMB asset management. 2. Trading activities outside of Hong Kong in bonds, foreign exchange, and RQFII have become increasingly active The offshore RMB bond market has rapidly expanded from Hong Kong to other jurisdictions. According to the HKMA, Dim Sum bond issuance (excluding CD’s) in 2014 amounted to RMB190 billion, nearly double that in 2013. Although Hong Kong remains the biggest offshore RMB bond market worldwide, other markets have emerged. In 2014, there were 31 Formosa bond issuances totaling RMB20.8 billion in Taiwan. In Singapore, a total of six banks have issued Lion City bonds amounting to RMB11.5 billion. Meanwhile, London witnessed a number of groundbreaking RMB bond issuances. The U.K. government successfully issued RMB-denominated sovereign bonds and became the first foreign sovereign issuer of RMB bonds. Moreover, IFC of the World Bank has issued a total of RMB3.25 billion of Yuan bonds in London and became the largest RMB bond issuer on the London Stock Exchange. RMB bond issuance has also emerged in Frankfurt, Paris, and Luxemburg, while emerging markets such as Brazil and Dubai have begun to issue RMB bonds. Offshore RMB bond issuance outside of Hong Kong has reached a cumulative total of RMB150 billion. As for foreign exchange transactions, according to Reuters, London has surpassed Hong Kong and accounts for 44% of global RMB transaction volume. Transactions of deliverable futures in London rose 127% to average USD42.4 billion per day. Besides Hong Kong Exchanges and Clearing, RMB futures contracts have been launched on the CME, Singapore Exchange, and Brazil’s BM&FBOVESPA. As for RQFII products, 10 jurisdictions outside of Hong Kong have been allotted a total of RMB 650 billion for investments. As of the end of February, 2015, institutions in markets such as Singapore, the U.K., France, and Korea had applied for an RQFII quota of RMB41.5 billion. Meanwhile, the NYSE and LSE have listed RQFII-ETF products, providing investors with an important avenue to invest in A shares and the Chinese bond market. 3. Currency swaps and policy banks have been the main drivers of RMB businesses in emerging markets Currency swaps have provided a number of jurisdictions with RMB funds for trade settlement purposes. For instance, the Bank of Korea activated the currency swap mechanism to facilitate trade settlement between Korean and Chinese enterprises. In 2014, the Central Bank of Argentina drew down its RMB swap quota to settle trade between Argentine and Chinese companies. Meanwhile, the Monetary Authority of Singapore used currency swaps to provide financial institutions with a comprehensive suite of RMB lending mechanisms, promoting RMB’s role in trade and direct investments in Singapore. In addition to official cooperation between governments, policy banks and cross-border investments also boosted offshore RMB businesses in emerging markets such as Latin America and South Africa. Since 2013, major Chinese policy banks have provided countries including Venezuela and Jamaica with RMB loans to facilitate investments in resources and infrastructure. Meanwhile, major South African insurers have concluded foreign direct investments in China with RMB funds. As bilateral trade between China and emerging markets grows steadily and currency cooperation between governments picks up pace, more and more emerging economies outside of Asia will become new offshore RMB markets. In Hong Kong, the largest offshore RMB market worldwide that experienced rapid growth in the past 10 years, there have been a number of new developments. Firstly, RMB clearing rose considerably and surpassed Hong Kong dollar clearing. In 2014, RMB RTGS clearing reached RMB170.3 trillion for a year-over-year increase of 112.6% compared with RMB80.1 trillion in 2013. In the same period, Hong Kong dollar RTGS clearing amounted to HKD184.2 trillion $, or RMB147.7 trillion. Since April 2014, monthly transaction volume of RMB RTGS has surpassed that of Hong Kong dollar and emerged as one of the most prominent currencies in Hong Kong’s clearing market. Secondly, the growth of cross-border RMB transactions under the capital account accelerated and has become a new driving force of Hong Kong’s offshore RMB market development. Recently, growth of cross-border RMB businesses under the capital account has been noticeably faster than that of the merchandize trade account. In 2014, cross-border RMB trade settlement increased 41% to RMB6.55 trillion, with 18.6% of merchandize trade being settled in RMB. Meanwhile, cross-border direct investment (ODI and FDI combined) rose 97% to RMB1.05 trillion. Obviously, growth of RMB transactions under the capital account outpaced that under the merchandize trade account. In this regard, capital account businesses may become a new driving force of Hong Kong’s offshore RMB market. Furthermore, foreign exchange activities are becoming increasingly important in Hong Kong’s offshore RMB market. In 2013, RMB foreign exchange transactions amounted to USD17.2 trillion, while RMB payments totaled USD11.16 trillion. As the pace of China’s capital account opening accelerates, market demand for currency derivative products will strengthen. Therefore, foreign exchange derivative transactions will play a prominent role in promoting offshore RMB products. In addition, Hong Kong’s offshore RMB funds, to some extent, have been allocated worldwide. Hong Kong is currently the most important center of offshore RMB deposits. RMB deposits in Hong Kong totaled over RMB1 trillion in 2014. Including certificates of deposits, Hong Kong’s RMB capital pool has exceeded RMB1.16 trillion, which was mainly used for loans and Dim Sum bonds. According to the HKMA, as of the end of 2014, outstanding RMB loans in Hong Kong amounted to RMB188 billion, while issuance and outstanding value of Dim Sum bonds came in at RMB196.8 billion and RMB380.5 billion, respectively. At RMB568.5 billion, RMB loans and outstanding Dim Sum bonds combined accounts for only 49% of Hong Kong’s offshore RMB capital pool. For the time being, obviously, Hong Kong alone cannot fully absorb the stock of RMB funds, some of which are used by overseas financial institutions for interbank liquidity and swaps and thus contribute to the development of other offshore markets. Recently, RMB loans in other offshore markets soared and may have exceeded those in Hong Kong. Therefore, Hong Kong’s RMB funds are being allocated globally. III. SRD, the new building block for the RMB internationalization The International Monetary Fund (IMF) will unofficially begin its quintuple review of the SDR basket this May, with official result to be expected in October, and implementation at the beginning of 2016. Taking into account of the progress made in China’s financial reforms and the RMB’s internationalization in the past several years, the market is generally optimistic about the RMB’s chance to make it into the SDR basket this time around. If successful, the implications are significant. It is essentially an endorsement by the IMF of the RMB’s international reserve currency status, putting it at par to the likes of the US dollar, Euro, Yen and British Pound. With this endorsement, global central banks are clear to hold RMB assets. Such an achievement is significant considering the RMB is not yet fully convertible, and China still imposes capital controls. It will corroborate the correct path China’s reform and opening are on, and will push for further actions such as the RMB’s convertibility and China’s capital account opening. However, the RMB will have to qualify as a freely usable currency as defined by the IMF, and overcome the possible veto from the US Government/Congress. 1.The RMB meets the basic requirements To qualify for SDR inclusion, a currency has to meet two criteria, the first being that its exports of goods and services during the five-year period ending 12 months before the effective date of the revision have the largest value. China already met this criterion in 2010, as it was the world’s third largest exporter of goods and services at that time. And according to SWIFT, the RMB has become the second most used currency in trade finance, and the fifth largest currency in payments, positioning right behind the four SDR currencies. The second criterion is that it has to be determined by the IMF under Article XXX (f) to be a freely usable (FU) currency. In 2010, the IMF concluded that the RMB had not met this requirement, and thus decided to maintain status quote. It is worth noticing that the IMF, in its own report, clearly states that the concept of a freely usable currency concerns the actual international use and trading of currencies, and is distinct from whether a currency is either freely floating or fully convertible. In other words, the facts that the RMB is not yet fully convertible, China still imposes capital controls, and the related RMB exchange rate mechanism shall not be considered obstacles to the RMB’s path into the SDR. To determine whether a currency is widely used for international payments or widely traded, the IMF refers to four quantitative indicators. The first indicator is the Currency Composition of Official Foreign Exchange Reserves (COFER) complied by the IMF itself. So far, COFER has not been able to single out the RMB in its statistics. Judging from the fact that when COFER began to report the Canadian dollar and Australian dollar individually in 2013, they accounted for about 1.5% each of the world’s allocated forex reserves holdings, the RMB has yet to reach such a threshold. It was included in other currencies that accounted for 3.1% of the total in 4Q14. The second indicator is the international banking liabilities compiled by the Bank of International Settlements (BIS). Again, the RMB is not yet identified individually. Since the data series refer to offshore deposits, based on China’s own releases, offshore RMB deposits at the end of 2014 amounted to RMB2.8 trillion or USD440 billion, making it the fifth largest currency right behind the four SDR currencies. The third indicator is the international debt securities statistics also compiled by BIS. Now that BIS does not list RMB individually, cross comparison using the offshore RMB bond market’s size of RMB480 billion at the end of 2014 results in a small share of 0.4% of the total. The fourth indicator being used is global forex markets turnovers captured by BIS’ Triennial Central Bank Survey. It shows that the RMB is ranked the ninth with a market share of 2.2/200. Overall, the RMB’s strength lies in exports, trade finance and payment, and it is gaining significantly in terms of offshore deposits and forex trading. Its weakness is in central banks holdings and the RMB international bond market. Regarding central banks holdings, it is reciprocal with whether the RMB makes it into the SDR, which IMF should take into account. In mid 2013, IMF expanded the coverage of its COFER to list the Canadian dollar and Australian dollar individually, adding to the original five currencies of the US dollar, Euro, Yen, Pound Sterling and Swiss Franc. The statistics were traced back to 4Q12, when the Canadian dollar and Australian dollar accounted for 1.4% and 1.5% respectively of the world’s allocated forex reserves holdings. Using 1.5% as a threshold, it amounted to about USD91.3 billion out of the USD6.09 trillion of the total allocated official forex reserves holdings at 4Q14. Using the prevailing exchange rate of 1 US dollar to 6.20 Yuan, it equals to RMB570 billion. There is good reason to believe that such a threshold could be quickly reached considering there are reportedly more than 40 central banks around the world who have already or planned to hold RMB assets in their forex reserves. They can add to the exposure through offshore markets, QFII, RQFII and China’s interbank bond market. With regard to the latter, so far there are more than 20 central banks including Switzerland, France, Japan, Austria, Australia, and Singapore, etc., who are granted quota for China’s interbank bond market investment. On the other hand, both the onshore and offshore RMB bond markets have continued to register rapid growth. Moreover, those indicators are not meant to be used mechanically. IMF also emphasizes that the Executive Board’s judgment is necessary. Combined with Christine Lagarde’s latest comment that it is a matter of when, not if, the RMB makes it into the SDR, and the RMB internationalization’s progress in the past several years, the RMB stands a fairly good chance to pass IMF’s internal assessment of being freely usable in this year’s review. 2.It is unclear whether the US will resort to its veto Other than the freely usable requirement, the RMB’s SDR prospects will also hinge upon the US Government and the US Congress’ stances, with the former being more prone to be won over than the latter. Currently, the IMF’s decisions have three thresholds. Decisions requiring a 50% majority of the votes cast include those pertaining to the Fund’s daily function such as approval of specific lending programs. Special majorities of 70% of total voting power are required for decisions that fundamentally alter the IMF’s operational practices such as the design of IMF facilities, changes to the interest rates on IMF loans/SDR, the budget of the IMF, etc. The 85% threshold applies mainly to decisions on the Fund’s governance structure such as amending the IMF’s Article of Agreement, changing the number of Executive Directors, new membership, quota increase, reallocation of SDR, etc. The US currently has a voting share of 16.75%, meaning it has the veto power on the most important IMF decisions. As the inclusion of the RMB into the SDR basket will trigger many rules changes of the SDR, it is believed to need 85% of voting shares, making the US decision critical. Under separation of power, the US President has the authority to appoint the US Governor, Alternate Governor, Executive Director, and Alternate Executive Director to the IMF. The Department of the Treasury has been delegated responsibility to direct US representatives at the IMF and to take a range of actions with respect to the IMF. The Secretary of Treasury, as a matter of practice, is nominated to serve as the US Governor at the IMF, while the Chairman of the Federal Reserve as the Alternate US Governor. According to the US Law, the US Congress is responsible for authorizing and appropriating all US financial commitments to the IMF, including the US quota and voting share, etc. In this year’s review, providing the US representatives in the IMF go along with IMF’s recommendation to add the RMB to SDR, it may still need the US Congress’ approval to be effective. At the time being, this proves to be quite a challenge. In March this year, China’s Premier Li urged the US to support the IMF reform initiatives of 2011. They include doubling the IMF quota, transferring 6% of the expanded quota to emerging markets, selecting all Executive Directors by election, not by appointment in some cases, and transferring two Executive Directors posts from Europe to emerging markets. The reforms will make China the third largest shareholders of the IMF, and make all BRIC countries into top ten shareholders. Moreover, China’s voting share will increase from 3.81% to 6.0%, while the US’ declining slightly from 16.75% to 16.5%, but still maintaining its veto power. These reforms are also the consensus of G20, which the US Government also supports. However, according to the US Law, it needs the US Congress’ authorization, which it has failed to grant in all these years, exposing the rift between the administrative and legislative arms of the US to the dissatisfaction of even the US allies. Judging from this example, it is not unreasonable to speculate that the US Congress might block the RMB’s inclusion into the SDR even though the US Government gives the green light, which is essentially the same as the US casting its veto. 3.It is a matter of time Even if the US Congress stands in the way, it will be reduced to technical obstacle given that the IMF, most of its members, and even the US Government give their blessings. It will do little harm to the RMB’s international reserve currency status, as China’s reform efforts are for all to see. It is thus believed that investment in RMB assets will be little affected. The next IMF review will be five years away in 2020. By then the RMB’s internationalization and China’s financial opening are likely to surpass the SDR requirements by wide margins. The SDR recognition will be long overdue. Hence, the 2015 review is also a window of opportunity for the IMF, failing to capture which will in turn hurt the SDR’s credibility. Furthermore, failure to resolve the issue this year may spur the IMF to find another window before 2020 to finalize the RMB’s inclusion into the SDR. 4.SDR, the new building block for the RMB internationalization If the RMB successfully makes it into the SDR, it will certainly help solidify its international reserve currency status, making it a true international currency. Firstly, it will remove the obstacles standing in the way of many central banks in their decisions whether to hold the RMB due to its lack of status as an international reserve currency. This in turn will trigger a buying spree by central banks and sovereign wealth funds alike. As calculated above, 1.5% of disclosed allocated official forex reserves equals about RMB570 billion, which is sizable asset reallocation. Secondly, it will further facilitate the use of the RMB in cross border trade, investment, settlement, etc. And China is in the advantage when negotiating pricing commodities such as crude oil and iron ores in the RMB. Thirdly, it will help lower the borrowing costs by Chinese corporation overseas in their execution of the Go Abroad strategy. And even if China runs into current account deficits, financing it will not be a problem given the RMB being an international reserve currency. Lastly, it will help promote further financial reform and opening such as the exchange rate mechanism reform, and capital account convertibility.

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E Zhihuan：Characteristics of the RMB Internationalization and Its Prospects for the SDR

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