Beijing’s first step to internationalise the renminbi (RMB) by promoting its role in foreign trade settlement has been successful so far. The next step is to deepen the internationalisation process by creating non-trade demand for RMB. This will involve enlarging the offshore RMB market and creating RMB-denominated assets and hedging tools supported by onshore financial liberalisation. Empirical evidence shows this next step still to be in its infancy. Even the rapid expansion of offshore RMB financial transactions is essentially trade-driven.
This means that offshore centres, notably Hong Kong, that have a natural advantage in accumulating RMB through trading with China will continue to dominate in the medium-term.The game changer will be full capital account convertibility, but don’t bet on it happening in the short-term.
A successful first step
Despite the recent expansion of the offshore RMB market, which has generated all the fuss about fast currency convertibility, the most important mechanismbehind the expansion of offshore RMB-denominated assets has been the ability of Chinese importers and exporters to settle their foreign transactions in RMB. Non-trade demand for RMB has yet to be fully developed. In other words, RMB internationalisation remains a function of foreign trade; offshore RMB financial transactions are only a derivative of it at this stage. This needs to change if the internationalisation process is to be deepened.
RMB-denominated trade settlement has soared (Chart 1) since Beijing started allowing Chinese companies to settle foreign trade in the currency in mid-2009. These RMB funds have flowed offshore and have been trapped mostly in Hong Kong, where 90% of RMB trade settlement takes place, leading to a significant build-up in RMB deposits (Chart 2).
However, China’s current account surplus is not conducive to deepening the internationalisation processbecause, when all current account transactions are settled in RMB, a surplus means more RMB flows back to China than flows out (as China exports more than it imports). With a closed capital account, where non-trade capital flows are blocked, a current account surplus will only shrink the offshore RMB pool, frustrating the internationalisation effort. So what else can China do?
RMB and the demand for money theory
The demand for money theory sheds some light on the next step for RMB internationalisation. There are three motives for demand for money: transactional, precautionary and speculative. Promoting the RMB as a foreign trade settlement currencyis the first step in that it captures the transactional demand motive. The next step involves deepeninginternationalisation by capturing the precautionary demand (from central banks as one of their reserve currencies and from the foreign private sector as one form of foreign currency savings) and the speculative demand for RMB (as an investment currency in an international portfolio).
These other two RMB demand motives are closely related to the availability of a deep and mature Chinese capital market, with Chinese financial products and hedging tools made available to foreign players.Such development remains slow due to the deep-rooted structural and institutional reforms needed, and most of the offshore non-trade demand for RMBat this stage remains, arguably, speculative (this is not to be confused with the speculative demand for RMB). This can be seen in the behaviour of RMB deposits in the Hong Kong banking system.
Non-trade RMB demand remains speculative
Despite the big jump in RMB deposits in the Hong Kong banking system, its share is still around 12% of total. It is noteworthy that the sharp rise between 2009 and 2011 came mainly at the expense of a fall in the share of other foreign currency deposits (Chart 3), as investors speculatedon RMB appreciation.
When the market started to bet on RMB depreciation in the second half of 2011 and again in late 2014 and early 2015, RMB deposits in Hong Kong also started to drop. Granted, as Beijing gradually liberalises capital inflows, more avenues for offshore RMB to flow back to China have also prompted the decline . But speculation on RMB depreciation wasthe major reason for investors abandoning the RMB between 2011 and 2002 and in late 2014-early 2015.The fact that the rise in the share of RMB deposits in Hong Kong came at the expense of other foreign currency deposits, especially in the “go-go” months between 2009 and 2011, reflected investors’ portfolio reallocation within their foreign currency holding. There was no long-term demand for RMB by switching out of the Hong Kong dollar. As soon as market expectations turned towards RMB depreciation (see Chart 3), deposits flowed out of RMB and back into other foreign currency and Hong Kong dollar deposits.
Such erratic behaviour in RMB-deposit growth is nota sustainable way to internationalise the currency. To deepen internationalisation, Beijing must create an incentive for foreigners to use and hold RMB other than for trading good and services.
Internationalisation stuck in first gear
Arguably, most of the increase in offshore RMB financial transactions in Hong Kong, the largest offshore RMB centre, is still driven by international trade activity. Free convertibility of offshore RMB, or CNH, has caused its exchange rate to deviate from the onshore rate, or CNY. When foreigners are bullish on the RMB, they push up CNH so that it trades at a premium to CNY. This gives Chinese importers an incentive to pay for their imports offshore with RMB as they can convert CNY into CNH at par, yet CNH buys more foreign exchange. CNH supply/deposits increases in the process.
On the other hand, when foreigners are bearish on the RMB, they sell CNH and depress its exchange rate so that CNH trades at a discount to CNY. This gives Chinese exporters an incentive to accept payment in RMB offshore since they get more CNH for any given amount of foreign exchange and can convert CNH into CNY at par. CNH supply/deposits falls as a result. But this phenomenon is not common until late 2014 because CNH seldom trades at a discount to CNY (Chart 4).
Thus, there was mostly an excess of CNH settlement in imports over exports in response to the prevalent CNH premium. This phenomenon is in stark contrast to evidence in other countries where exporters tend to settle in their home currency more often than importers do. The excess CNH import settlement is the main driver of offshore RMB-supply growth. It also helps offset the negative effect of China’s current account surplus on the offshore RMB pool.
In other words, CNH supply responds endogenously through the import settlement channel which, in turn, is a function of the CNH-CNY premium. The larger the CNH-CNY premium, the bigger is the incentive for Chinese importersto settle in RMB, boosting CNH supply and, hence, the size of offshore RMB deposits.
Empirical evidence shows that that growth of the CNH market is largely driven by trade (via the Chinese importers’ RMB settlement) not by capital flows.Since China has yet to deepen the second step for RMB internationalisation, there remains much potential for financial activity to develop in the offshore market.
However, before China opens its capital account, offshore centres, notably Hong Kong, which have a natural advantage in accumulating large amounts of offshore RMB through trading with China will remain the main beneficiaries of CNH activities. Other centres will have to compete for CNH from Hong Kong and other centres since offshore RMB is fungible. The game changer will be full capital account convertibility, which will take some years to unfold.
Senior Economist, BNPP Asset Management (Asia) Ltd., and author of “Demystifying China’s Megatrends: The Driving Forces That Will Shake Up China and the World”, Emerald Publishing 2017, and ten other books on the renminbi, China and Asian economic development. Lo was listed on the International Who's Who Professionals in 2000 and 2011, and has many years of international research experience in economics, financial markets and public policy and standards development, covering North American and Asian economies.