Thursday, 18 July 2019

Convertibility hurdles

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China’s State Council has called for a plan for the full convertibility of the renminbi, raising hopes that the currency may be about to take its rightful place on the international stage. Authorities, however, have so far been cautious about opening up the capital account.

China's Liu Xiang grabs the last hurdle in his lane after crashing and failing to finish his men's 110m hurdles Round 1 heat of the 2012 Olympic Games at the Olympic Stadium in London.

Source: Reuters/David Gray

China’s Liu Xiang grabs the last hurdle in his lane after crashing and failing to finish his men’s 110m hurdles Round 1 heat of the 2012 Olympic Games at the Olympic Stadium in London.

With so many of the world’s consumer products made in China, the country’s currency is noticeable for its absence in the global markets. While China has emerged as a major driver of global trade and growth – even overtaking the US in world trade volumes for the very first time this February – the renminbi has yet to be seen as a global unit.

The Chinese leadership has big plans to change that, but the currency is still not on par with the rise in stature of the PRC economy. That, in turn, is crimping the development of China’s capital markets.

China has currency controls to prevent easy trading of the renminbi around the world. The country has not opened its economy to the free flow of capital, and its exchange rate is not flexible. The renminbi is convertible under the current account, but the capital account covering portfolio investment and borrowing is carefully managed.

There is no doubt, however, that the world’s second-largest economy wants the renminbi to be a major global currency, to boost its role in international trade and finance. China is taking steps to increase the use of the renminbi in global trade and investment, and to persuade other countries to include the currency in their own foreign exchange reserves.

In 2005, in an attempt to trim the trade gap with the US, China allowed its currency to move higher against the dollar. This move towards the internationalisation of the renminbi will mean further easing of capital controls on inbound and outbound investments and, eventually, lead to full convertibility. Many analysts, however, have been disappointed with the pace of that development.

“I don’t think it has lived up to the expectations that were widespread in 2005 (when they first de-pegged it) that it would be a major global currency in 10 years’ time. We’re almost there now,” said Adrian Foster, head of financial markets research, Asia-Pacific, at Rabobank International in Hong Kong.

“The reason it isn’t the major driver some people thought it would become is because the authorities have kept a tight rein on it since then, and day-to-day moves have been small and reform announcements modest.”

China has certainly moved at its own pace in currency reforms. In 2005, the Chinese authorities began a period of gradual renminbi appreciation against other major currencies, including the dollar and the sterling. The US dollar/renminbi exchange rate in the years since has fallen to a new low of around 6.1420, compared with 8.2765 before the move.

China has also allowed greater foreign investor exposure to renminbi-denominated assets through financial instruments, such as offshore Dim Sum bonds, as well as the introduction of the Qualified Foreign Institutional Investor and Renminbi Qualified Institutional Investor schemes.

Evolution, not revolution

In early May, the State Council, China’s cabinet, finally called for the drafting of detailed plans to help achieve full convertibility, lifting hopes of an acceleration of the internationalisation process.

“This suggests that portfolio investment and borrowing will be liberalised significantly in the next few years, with fewer restrictions on foreigners investing in Chinese markets and Chinese residents investing in foreign markets,” said Brian Jackson, Coutts’ Global FX Strategist, in a recent note.

While short on specific details or a timetable for the opening of the capital account, the State Council’s statement called for measures to allow individuals in China to make overseas investments, improve risk controls of local government debt and regulate the development of the renminbi bond, equity and trust markets. The government’s announcement only reiterated the commitment of the new Chinese leadership to free up the currency eventually. So, what is holding the country back from full convertibility?

“(It is) an unwillingness on the part of China’s authorities to allow free capital flows in and out of China’s economy,” Rabobank’s Foster said. “I sense they distrust capital flows to reflect rational things and worry about the propensity for capital flows to move in herd-like direction and to become de-stabilising. It’s hard to argue against them, given the global financial crisis.”

Nevertheless, the case for further renminbi appreciation remains strong, according to Coutts’ Jackson.

China has limited the movements in its exchange rate against the US dollar to no more than 1%. “Officials, however, have hinted that this range may be widened in coming months, providing greater scope for appreciation,” he said.

Some recent developments have again led to higher expectations of appreciation this year. Among the developments is the Reserve Bank of Australia’s decision to allocate around 5% of its foreign reserves to renminbi-denominated assets, signalling confidence in the Chinese unit as a potential reserve currency. Hong Kong authorities are also relaxing local rules relating to renminbi capital flows.

Recent appreciation “is likely to have been regarded with some caution by Chinese policymakers, who have shown in recent years a preference for exchange-rate reform to progress at a gradual and steady pace,” Jackson said. “Officials have also been keen to avoid giving the impression that yuan appreciation is a ‘one-way bet’ – a suggestion that would encourage speculative activity and attract hot-money flows into Chinese financial markets, providing further impetus to yuan gains.”

Jackson added the prospect of quick renminbi appreciation could also distort incentives for Chinese banks and companies.

A sharp pick-up in foreign currency lending in the Chinese banking system suggested that banks were lending and firms were borrowing foreign currency, based on expectations that a stronger renminbi would yield them quick profits, rather than for business-related uses, such as to fund foreign investments or provide trade finance, he said. “This type of activity is always frowned upon by Chinese authorities.”

Accordingly, the State Administration of Foreign Exchange, or Safe, tightened rules to limit the size of banks’ foreign currency loans relative to sizes of their foreign currency deposits. Some estimates have the foreign currency loan-to-deposit ratio in the Chinese banking system at as high as 170%. Safe is tightening scrutiny and enforcement and aims to bring that figure down to 75% for Chinese banks and 100% for foreign banks.

“Officials will also be doing more to make sure that companies’ demand for foreign currency is based on trade flows and business-related purposes rather than driven by speculation on yuan appreciation,” Jackson said. “Longer-term policy objective, including the need to boost domestic consumption and reduce China’s dependence on external demand as a source of economic growth, continue to point to the need for a stronger currency in coming years.”

With inflationary pressures easing and the producer price index for manufactured goods falling, Chinese leaders have more time to focus on long-term task of rebalancing the economy towards a more sustainable growth path.

Currently, a large portion of savings in China is in the form of the retained earnings of the corporate sector, mostly state-owned enterprises. Instead of giving out dividends that can lift household incomes and boost consumption, many of these companies have channelled profits into capital accumulation and excess capacity.

The Chinese leaders also know that a more flexible exchange rate regime would serve the country well in the long run, giving the central bank a freer hand to adjust interest rates. Higher deposit rates will also give households a better rate of return on their savings.

Although the endgame is clear, full convertibility is not likely to be achieved any time soon, said Rabobank’s Foster.

“I think full convertibility is years away, not on the investment horizon as I see it. There will be further liberalisation, but no ‘Big Bang’ and the pace will be evolutionary rather than revolutionary,” he said. “In five years’ time, I guess you’ll ask the same questions about convertibility of the yuan.”

To see the digital version of this report, please click here.

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