China’s economy and the renminbi (RMB)
The emergence of China as a global economic powerhouse has been the result of consistently strong growth over the past three decades combined with a booming export industry that today is the world’s largest. While the domestic economy is yet to open its current account and allow for free capital flows, there have been significant efforts by the authorities to internationalise and promote the use of the RMB outside China. It is clear that China’s goal of becoming the world’s largest economy by 2020 and the internationalisation of the RMB are two initiatives that are symbiotic in nature. At the recent Asian Banker RenminbiWorld 2015 conference in Beijing, much of China’s strategy to internationalise the RMB by building offshore centres and linking these to development projects outside China such as One Belt One Road, was discussed by speakers and amongst panel members that included the likes of Hans Eichel, former finance minister of Germany, Sherry Madera, Minister-Counsellor & Director, China - Financial Services and Technology at UK Trade & Investment (UKTI) and Tay Hwee Ling, chief representative of the Monetary Authority of Singapore in Beijing.

A three-prong approach
Since 2009, the Chinese government has implemented a host of policies to internationalise the RMB. These have included three specific measures; promoting trade finance in RMB, encouraging the use of RMB as an investment currency and persuading central banks to include the RMB in the basket of reserve currencies.

The first initiative of encouraging cross border trade settlement and payments to take place in RMB has already been paying dividends, with the RMB leapfrogging from 35th place in 2010 to fourth place in 2015, by value of payments according to SWIFT. The RMB currently ranks behind the US dollar, the euro and the British pound and is the fastest growing currency globally. According to a recent SWIFT report, by 2015 Chinese companies expect one-third of Chinese external trade to be renminbi-denominated, and more than half of China’s trade with emerging markets, amounting to $2 trillion, likely to be settled in RMB.

The second policy of stimulating the RMB as an investment currency has been less fruitful. Much of the reason for this can be attributed to the lack of free convertibility of the currency as well as restrictions on moving RMB across borders, both of which are essential characteristics when it comes to gaining the confidence of global investors.

Additionally, the surprise devaluation of the RMB’s exchange rate by the central bank in mid-2015, raised questions about the country’s commitment to liberalising its capital markets and elevated further concerns about whether the RMB can be relied upon as a long term store of value.
The third policy of using RMB as a global reserve currency has recently met with success following approval by the IMF for the RMB’s inclusion as the fifth currency in the IMF’s special drawing rights (SDR) currency basket alongside the US dollar, the Japanese yen, sterling and the euro. This has come after intense lobbying by the Chinese authorities over the past two years. At the RenminbiWorld 2015 conference in Beijing, Jurgen Conrad, of the Asian Development Bank said that the IMF’s inclusion of the RMB into the SDR basket was a more symbolic gesture as “total volume of the SDR represents around 2% of the total international reserve holdings” and hence the impact on RMB volumes will be marginal. Moreover, Conrad added that it was “up to the treasury management of central banks to decide how much SDR or even RMB to hold as a part of their reserve policy”.

Liquidity and new offshore hubs
The three-prong policy of internationalising the RMB would have had limited effectiveness unless a mechanism to provide liquidity to the offshore institutions was also developed to afford all investors access to the RMB. Given that China’s liberalisation of its capital account has been cautious and will likely take time, the strategy to develop offshore RMB markets has been of paramount importance both to drive the internationalisation of the RMB as well as to create accessibility to deep liquid pools of RMB outside China.

Currently and for the foreseeable future, the goal therefore is to create unrestricted offshore access to RMB for trading, hedging and financing, all of which leads to lower transaction costs for foreign companies engaged in trade finance as well as foreign investors looking for yield opportunities with RMB products. Recent statistics from June 2014 indicate that RMB offshore deposits have exceeded RMB1.7 trillion.

The initial model of an offshore RMB centre started with Hong Kong in 2004 and permitted foreign investors access to RMB deposits and liquidity outside China for the first time. Shortly after launch, demand for the offshore RMB surged in Hong Kong and was equally matched by growing volumes of CNH FX trades. “The offshore RMB market in Hong Kong has already developed with reasonable depth and breadth,” said a spokesperson from the Hong Kong Monetary Authority (HKMA) during the RenminbiWorld 2015 conference.

The early success of Hong Kong as a single RMB regional hub encouraged other financial centres to engage and build their their own centres. Thus a single regional RMB hub soon evolved into multiple global RMB offshore centres with markets in Hong Kong, Singapore, Taiwan, London, and Macau all building their own RMB clearing centres. Currently more than 14 RMB centres have been created worldwide. HK is the largest offshore RMB centre mainly due to its history and proximity with mainland China. Other centres have developed their RMB hubs by applying their own comparative advantage. One such example is Singapore that is strategically placed between China and the rest of South East Asia. Tay said that “A large part of the trade volume between China and South East Asia is transacted through Singapore,” before noting with respect to Singapore’s RMB centre that, “our trading volumes account for a quarter of global clearing RMB volumes which is second only to Hong Kong”.

Madera offered a different perspective by suggesting that while trade and foreign exchange were all factors that lead to the growth in volumes for offshore RMB centres, the real growth will come in the longer term if the RMB is used as an investment currency. For that to happen she believes that a build out of a robust RMB market is essential through the offerings of “debt instruments, derivatives products, hedging mechanisms and other products that will build liquidity along the yield curve. This is what we are doing in London”.

One notable feature of the offshore RMB centres is that there are positive signs of collaboration initiatives between the centres even as competition between centres remains intense. The underlying reason can be attributed to the fact that each centre has its own unique comparative advantage and strengths and will need to rely on the other to complete its offerings.

For example, Singapore is traditionally a hub for foreign exchange and fixed income transactions. Taiwan, on the other hand, has performed exceptionally well in attracting offshore RMB deposits. Combining a high volume hub with a strong depository base was seen like a logical move and thus Singapore’s decision in 2014 to include Taiwan in its initial offering of RMB Bonds (Lion City). This was the first dual cross-border listing initiative of its kind and is a further testament that offshore RMB centres need not adopt a zero-sum game approach and instead can mutually benefit from each other’s strengths.

Infrastructure and operations
Collaboration between offshore centres is also instrumental to ensuring operational streamlining and interoperability of transactions. Aside from liquidity, a key objective of the Chinese authorities in ensuring the success of RMB internationalisation has been to provide a foundation for an underlying operational infrastructure. With this in mind, the People’s Bank of China (PBOC) initially established a link between the offshore RMB centres through corresponding banking nostro platforms linking European centres to Asian ones and subsequently successfully rolled out sophisticated real time gross settlement (RTGS) systems in Hong Kong and Taiwan. In March 2015, the PBOC announced that it intended to launch a “payments super-highway” linking all offshore centres to each other, as well as to the mainland with full connectivity, using a platform commonly known in China as the Cross-border Inter-bank Payments System or CIPS.

The PBOC’s dual strategy to enhance liquidity outside China through the build out of offshore RMB centres is a brilliant plan, but one that also requires an efficient, interoperable and accessible platform connecting all hubs to the mainland. This combination of increased liquidity with the support of a robust operational infrastructure is vital for enabling the RMB to become a credible international currency.

Sustaining demand
While there have been direct efforts to promote the RMB as an international currency, it is important to factor in other strategic initiatives undertaken by the Chinese authorities to spur growth and investment that have had secondary benefits for its currency.

One proof of this is the Shanghai-Hong Kong Stock Connect, which was established in November 2014 to remove restrictions on foreign investors looking to buy Chinese A-shares listed in Shanghai as well as to allow for the inclusion of Chinese stocks in global benchmark stock indices. Although not a primary goal, the Chinese authorities were nevertheless cognizant that this link would allow for a broadening of the offshore RMB’s use and thereby support Hong Kong’s offshore RMB business. The critical impact the Stock Connect has had with respect to RMB internationalisation is a result of the mandatory policy of restricting the collateral eligibility parameters to only RMB. Clearing participants in the Shanghai-Hong Kong Stock Connect are required to post a deposit equivalent to 20% of their trading value and only RMB cash deposits have thus far been approved as collateral. For this reason, demand for the CNH (offshore RMB) picked up ahead of the launch of the Stock Connect in November 2014.

Another initiative that China is working on that may have a material impact on the internationalisation of the RMB is the “One Belt, One Road” (OBOR) initiative. An underlying foundation of the scheme is the creation of an economic corridor to be built from China to central Asia and then ultimately stretch to European cities as far as Moscow, Rotterdam and Venice. The primary aim of this initiative is to develop much needed infrastructure connecting China to Europe and parts of Asia through highways and rail routes as well as to implement infrastructure for the movement of resources such as oil and natural gas pipelines. The secondary aim carries a lot more weight for the longer term sustainability of China’s growth. According to Premiere Xi Jinping, this initiative should stimulate trade and investment between China and countries along the route. Speaking at the Boao Forum in Hainan province, Xi told international industry representatives that “the annual trade volume between China and these countries should surpass $2.5 trillion in a decade or so.”

If launched and implemented in the correct manner, the benefits to China’s growth that stand to be reaped from the OBOR initiative is immense. Positive externalities in other sectors such as tourism, agriculture and mining, are also to be expected. However as the current wave of infrastructure development unrolls across Asia, the spin-off effects on the growth of its currency are also notable.

Chinese authorities are fully aware that a project of this magnitude cannot be undertaken until significant financing has been made available to all participating nations involved in building the corridor. So far China has pledged $40 billion to finance projects under the initiative from a silk road fund. In addition, local Chinese business publication Caixin has confirmed that China will draw upon its substantial foreign exchange reserves to inject $62 billion of capital into banks such as the China Development Bank and China Exim Bank, which have been mandated as the prime financiers of the OBOR initiative.

What is critical for the Chinese authorities to ensure is that the majority of financing that goes into the OBOR initiative, (be it through direct loans or debt issuance) is pledged to countries in RMB as the first choice currency, instead of in US dollars.

This will not be the first time that the Chinese have promoted large cross-border initiatives without the use of the US dollar. A page could be borrowed from the Gazprom deal in 2014 where the bulk of the $400 billion long-term supply deal between Russia and China was done using RMB.

At the end of the day, the introduction of an alternative global currency that can be used in both Europe and Asia need not necessarily be detrimental for global markets. Eichel categorically stated in his opening speech that a “second currency is necessary to counter the global hegemony imposed by the US dollar”.

The steeper road
The RMB’s journey towards internationalisation has unfolded at such a staggering pace over the past five years that even the staunchest of its critics have been confounded. The RMB as a trade, investment, and reserve currency has, to varying degrees, met incontestable success. More importantly, the dual initiatives of developing offshore hubs and infrastructure platforms has provided the currency with the necessary offshore liquidity and operational support.

Going forward, it is increasingly evident that the legacy Chinese model of domestic production and export led growth will gradually shift to offshore external investment. It is therefore key that as China uses its mature manufacturing industry and excess domestic capacity to aggressively expand westwards into central Asia and Europe, the RMB is used to drive all underlying financing transactions. This will be imperative if China wishes to sustain demand in its currency well beyond trade financing and payments.

The final step in internationalising the RMB would be to establish much needed foreign investor credibility in the currency. Credibility for the RMB will not be established overnight but reflected in the long term efforts that the Chinese authorities undertake in a few key areas. Primarily China needs to show progress in its longer term goal of liberalising its capital account. Equally importantly, the Chinese must show restraint when it comes to using any artificial measures to manipulate the value of the RMB and instead allow for market forces to dictate the currency.

On a broader note, China must also undertake measures that would lead to stronger supervisory standards in auditing companies, improving credit rating methodologies and implement regulatory standards on its vast shadow banking industry.

China’s journey along the path of internationalisation has been a success in terms of promoting the RMB by creating the necessary international demand, establishing liquidity and building the right infrastructure. However as a next step, China needs to build international credibility and confidence. The road to RMB internationalisation is about to get steeper.