Originally published in The Deal Magazine (November 2, 2009)
Earlier this year, Chinese Central Bank Gov. Zhou Xiaochuancreated a stir by suggesting that there needed to be an alternative to the U.S. dollar as the world's reserve currency and that the International Monetary Fund special drawing rights be considered for this role. However, it quickly became clear that this was really a "head fake" and what Zhou really meant was that the renminbi should eventually play this role. Zhou was not bluffing -- it seems likely that the renminbi will, over the next few years, become one of the key international currencies and play an increasingly important role in international commerce and finance.
It was probably in 2006 when China reached the tipping point and became a country with more foreign exchange reserves than it knew what to do with. That year, China became more concerned with inbound flows of "hot money" than outbound leakage of foreign currency, and when China started to become more focused on encouraging outbound M&A than attracting foreign investors. In 2006, China's foreign exchange reserves surpassed those of Japan and became the largest in the world. With foreign exchange reserves at $2.273 trillion at the end of September, China is the world's largest creditor country, and of course, that has great significance for the future of the renminbi.
With China's rapid ascent as a global economic and financial power, Chinese policymakers have been asking themselves, why can't the renminbi play the role of an international currency similar to the U.S. dollar? China sees how the dollar's role as an international reserve currency has permitted the U.S. economy great flexibility in financing its trade and budget deficits. China also noted with alarm how, during the financial crisis, dollar-denominated trade finance dried up, hurting Chinese exports and prompting Chinese policymakers to consider whether the renminbi shouldn't also be allowed to play a greater role in international trade. And of course, there is no doubt a general feeling in China that with great power status there should also come a commensurate level of prestige for its national currency. China now even has a government official in charge of this effort: Hu Xiaolian, formerly the head of the State Administration of Foreign Exchange, was appointed in July to the new special monetary policy office of the People's Bank of China (China's central bank) to promote internationalization of the renminbi.
All of this thinking about the renminbi is manifesting itself in various ways in Chinese official policy. First, China has designated Hong Kong as the place where experimentation with offshore renminbi transactions will initially occur. Since 1997, Hong Kong has been part of China again, but it retains a unique status as an offshore center, with free capital flows and a largely independent financial regulatory framework. Beginning in 2004, Hong Kong banks have been permitted to provide local individual residents and retailers with renminbi bank accounts for personal and retail transactions, and for which a renminbi clearing system between Hong Kong and mainland Chinese banks was established. This made a lot of sense, since the huge influx of mainland Chinese tourists to Hong Kong has caused a mountain of renminbi cash to build up in Hong Kong. In 2007, a few mainland Chinese banks were permitted to begin selling renminbi-denominated bonds to Hong Kong residents, offering interest rates higher than those offered on renminbi bank deposits in Hong Kong. More recently, the Chinese government has issued sovereign renminbi bonds in Hong Kong, the first such issue outside of the Chinese mainland. It should not be long before a menu of renminbi-denominated financial products will be offered in Hong Kong, giving it a competitive edge as an international financial center.
Ba Shusong, deputy director of the Financial Research Institute, Development Research Center of the Chinese State Council, recently opined that "RMB-denominated trading transactions account for a very small portion of international trade, which is not commensurate with China's status as one of the top three economies in the world." Early this year, Ma Rentao and Zhou Yongkun, researchers at the Graduate School of the People's Bank of China, expressed the view in a leading Chinese financial journal that China, with its massive foreign exchange reserves, should provide liquidity to its major trading partners through central bank currency swap agreements in order to stabilize the market disruptions and revive sluggish trading brought on by the financial crisis. They argued that this would also promote the regionalization and, ultimately, globalization of the renminbi by increasing the pool of the currency outside of China and encouraging settlement of trade in the currency. And in fact, the Chinese government has been trying to create offshore pools of renminbi in many trading partner countries and regions around the world by entering into central bank currency swap agreements. Since the start of the financial crisis, Rmb650 billion ($95 billion) of such agreements had been entered into with Malaysia, South Korea, Hong Kong, Belarus, Indonesia and Argentina to encourage the use of renminbi for trade settlement with or funding operations in China. It is still unclear how much of a real impact these government-to-government arrangements will have on the actual volume of renminbi-denominated commercial transactions.
As a further measure to encourage commercial use of the renminbi, on April 8 the Standing Committee of the State Council approved a plan to allow the renminbi to be used for pricing and settlement of international trade. The stated goals were to "boost China's trade with other trading partners, improve trading conditions, provide liquidity that had been severely curtailed by the financial crisis, lower exposure to foreign exchange fluctuations and maintain a high rate of growth in the trading sector." After some mis-starts, regulations in July were promulgated to provide for a pilot project pursuant to which qualified companies in five cities in China (Dongguan, Guangzhou, Shanghai, Shenzhen and Zhuhai) can price and settle in renminbi their international trade transactions with counterparties in Hong Kong, Macao and Association of Southeast Asian Nations countries. The government expects this program to gain momentum over the coming months.
With China's vast foreign exchange reserves, the government has become much less concerned about outflows of capital. In 2007, China allowed for the first time qualified Chinese domestic mutual funds (so-called qualified domestic institutional investors, or QDIIs) to make portfolio investments abroad. As of the end of August, 56 QDIIs had been approved, with an aggregate investment quota of $55.95 billion and a cumulative overseas investment of $28.71 billion. The drop in worldwide stock markets during the financial crisis caused the Chinese government to suspend approval of new QDII funds, but recently the Chinese government has resumed such approvals.
Furthermore, the Chinese government has recently made it much easier for Chinese companies to invest offshore, either through M&A or establishment of offshore manufacturing facilities. The foreign exchange regulations have been liberalized to simplify approval process for offshore investments and to delegate greater authority to provincial foreign exchange authorities to administer and approve smaller outbound investments. Recent regulations also make it easier for Chinese companies to provide financing to their offshore affiliates. Thus, Chinese corporate outbound investment will be an additional channel to recycle China's savings offshore. The numbers reflect this liberalization -- in 2008, China's direct outbound investments increased by 111%, to $55.91 billion.
Ironically, at the same time as capital outflows are being encouraged, China is clamping down on "hot money" inflows into China. There are tighter controls over conversion of foreign exchange received by Chinese exporters into renminbi because the government wants to stop trade income sneaking back into the country as investments. Recent regulations make it harder now for foreigners to acquire renminbi to invest in real estate and for foreign company subsidiaries in China to make equity investments in domestic companies.
Foreign investment in the domestic stock markets is still off limits to foreigners except for a limited number of "qualified foreign institutional investors." Nevertheless, "hot money" inflows into China for the second quarter of this year (measured by deducting foreign direct investments and trade surplus from the country's foreign exchange reserves increase) are estimated at more than $100 billion by Zeng Gang, director of the Banking Research Office of the Chinese Academy of Social Sciences. The Chinese government is concerned that unrestricted flows of capital into China will trigger additional inflationary pressures in China, and also place pressure on China to appreciate the renminbi, something that policymakers only want to do gradually.
For the renminbi to become an international reserve currency, it will need to be fully convertible for capital account transactions, and many skeptics do not believe that the Chinese government will permit this any time soon. The theory is that the Chinese government is too worried about the stability of the Chinese financial system and maintaining a strong control of its monetary policy to allow full convertibility of the renminbi. The State Council's call for Shanghai to become an "international financial center by the year 2020," interpreted by the Chinese as an indication that the renminbi must be fully convertible by that year, seems like a pretty slow track. However, this is a conservative date, and convertibility will happen much faster. The Chinese have shown themselves to be masters at implementing incremental but rapid policy changes, whether it was privatization of rural cooperatives in the early '80s, the lifting of price controls in the late '80s, the lifting of trade tariffs in connection with China's entry into the World Trade Organization or listings of state-owned enterprises in the late '90s and this decade. Full convertibility and internationalization of the renminbi will creep up on us before we know it.
Howard Chao heads the Asia practice of O'Melveny & Myers LLP, and Sean Tai is a counsel in the firm's Shanghai office. Yuan Yuan and Zhao Rongjing, legal consultants in the firm's Shanghai office, contributed to this article.
