By Mark Evans, Analyst and Wilfred Wee, Portfolio Manager
Implications for global asset allocation as the renminbi emerges as a reserve currency
One of the key investment themes we highlighted in our China New Year Viewpoint1 was 'The emergence of the renminbi (RMB or CNY) as a reserve currency'. In this paper, we outline the roadmap we believe China will need to take to achieve this, and in doing so, solidify confidence in the renminbi’s status as a global medium of exchange, store of value, and unit of account. This progression forms the basis of our long-term constructive view on the economy and our belief that strategic portfolio allocations to China are set to structurally increase.
Where to from here?
The renminbi technically achieved ‘reserve currency’ status by being inducted as the fifth constituent in the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) basket on 1 October 2016, along with the US dollar (USD), euro (EUR), yen (JPY) and sterling (GBP). Indeed, it became the third largest constituent in the basket with a 10.92% weight. This move is consistent with China’s increasingly global presence, particularly in terms of merchandise trade, where the country’s combined imports and exports are at comparable levels to the US and euro-zone area.
Figure 1: Renminbi – third largest constituent in SDR basket
Source: Haver Analytics, International Monetary Fund, Bloomberg, Investec Asset Management calculations. Trade is calculated as the 12-month moving average of merchandise trade as a percentage of global merchandise trade. As at 30.11.17.
However, global reserve managers are only just starting to rebalance the currency composition of foreign exchange reserves (COFER). IMF data as at 31 December 2017, pegs the stock of global foreign currency reserves at US$11,425 billion, with the renminbi making up just U$122 billion (1.23%) of the total. Furthermore, data from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) shows that the renminbi still accounts for less than 2% of total foreign currency transactions.
Figure 2: Majority of foreign currency reserves in US dollars
Sources: IMF, Bloomberg, Society for Worldwide Interbank Financial Telecommunication, Investec Asset Management calculations. Swift payments calculated on a 12-month moving average basis. As at 31.12.17.
Given reserve managers’ substantial overweight holdings in US dollars, we believe there is significant scope to rebalance their COFER towards the renminbi as its standing in the global financial system becomes entrenched. The speed and extent to which this happens will likely follow the contours of China’s broad financial reform which we see evolving along three key aspects:
- Domestic financial market reform
- Capital account liberalisation
- Renminbi internationalisation.
We consider each of these three elements in more detail to help shed light on the speed and extent to which the renminbi establishes itself as a globally accepted medium of exchange, store of wealth and fully-fledged reserve currency.
1. Domestic financial market reform
While the ultimate objective of achieving reserve currency status and internationalising the renminbi is clear, we believe that the sequencing of reforms is vital to achieving this goal. On hindsight, the authorities’ attempt to move to a more free-floating renminbi in 2015 backfired as this was done abruptly and ahead of thorough domestic financial market reforms. Sharp measures were required to contain capital outflow pressures, reversing somewhat the broader financial reform push. Nevertheless, we believe the authorities have done an impressive job in arresting this outflow. The balance of payments has returned to surplus again, giving the authorities more freedom to re-start broader financial reforms.
There has been significant domestic financial market reform over the last decade:
- The financial system has become less reliant on state-owned-bank loan funding.
There are initiatives to move to more innovative forms of capital funding, for example, private equity and venture capital funds. We expect this trend to continue; a move to greater use of equity financing is consistent with the clearly stated objective of financial system deleveraging.
- The People’s Bank of China (PBoC) has built up a significant stock of high-quality liquid domestic assets (government bonds).
This can be attributed to various re-lending programmes, such as the Medium Term Lending Facility and Pledged Supplementary Lending, in addition to PBoC’s daily open market operations. Consequently, these strategies have given rise to a more liquid, stable and deeper bond market – important features for global reserve managers.
- Credit demand from state-owned enterprises (SOEs) has been curbed through SEO reform and supply-side structural reform.
This has helped to concentrate lending to the more profitable and productive areas of the economy.
- Deposit and lending rates have been liberalised.
The authorities have also introduced bank deposit insurance. These measures all help to make the financial system more robust.
- Local governments have been swapping bank loans issued to Local Government Financing Vehicles (LGFVs) into municipal bonds.
This has improved transparency of local government debt, brought down borrowing costs and reduced duration mismatch risks between local government liabilities and assets.
- The authorities have taken significant strides in dealing with gaps in the financial system regulatory framework.
This is a strong pre-requisite for capital account liberalisation.
We expect further improvement in the regulatory framework following the consolidation of the banking and insurance regulators. They now fall under the purview of the newly created Financial Stability and Development Committee, which should also result in less regulatory arbitrage. The palpable slowdown in bank lending to non-bank financial institutions is evidence of the tighter regulatory framework taking effect.
Figure 3: Bank claims on non-bank financial institutions (year-on-year change)
Source: Haver, People’s Bank of China, Investec Asset Management calculations. As at 28.02.18
Nevertheless, further reform is still needed. The stock of shadow banking assets has become a significant part of the overall financial system. Bank lending and deposit rates are liberalised but not yet fully market-driven, blunting the authorities’ ability to deal with the proliferation of shadow banking. Implicit guarantees remain inherent in the system which continue to distort market pricing. Local ratings are heavily skewed towards ‘A and above’; such bunching limits their efficacy as measures of credit differentiation. Even though the PBoC’s ownership of domestic assets has increased, China’s bond markets lack secondary market depth and liquidity. These are also challenges that other emerging markets face. We believe the authorities are cognisant of these priorities, and realise the need to make progress over time.
2. Capital account liberalisation
Over the last 15-20 years, China has liberalised its current account but has only part liberalised its capital account, with portfolio investment flows tightly controlled. Stringent capital controls can stymie the supply and demand of the renminbi offshore. Until recently, a shortage of available avenues for holders of renminbi offshore to invest back into renminbi assets reduced the appeal of holding the Chinese currency offshore. Balance of payment surpluses have also limited the ability of the renminbi to find its way offshore. Hence, capital account liberalisation is a necessary step towards the internationalisation of the renminbi. Other effects of capital controls include financial repression, mispricing of financial assets and reduced incentives for users of capital to professionalise, limiting China’s long-run growth potential.
Capital account liberalisation and increased competition can help to advance domestic financial market reforms. Hence, we believe China favours global bond index inclusion – not for the foreign capital inflows as such – but more for the pricing efficiencies that increased foreign participation can bring. Progress on this front can make way for significant productivity gains.
We have seen an array of measures to promote capital account inflows. The establishment of offshore renminbi centres in Hong Kong and various other global financial hubs, and the birth of the offshore dim sum bond market greatly increased the appeal of holding the Chinese currency overseas. Various schemes have been established to encourage inflows into China’s onshore bond and equity markets, with the stock and bond connect programmes the most obvious and recent examples of such initiatives. The inclusion of Chinese equity and bond markets into key global benchmark indices makes portfolio inflows inevitable, a theme which will certainly gather pace over the months and years to come.
Capital outflow liberalisation is far trickier; it is an extremely important policy to get right in terms of calibration and sequencing. Despite the existence of capital controls, the capital account has become increasingly porous, raising the spectre of capital flight. This explains the asymmetry in capital account liberalisation over the last few years. The pool of local savings is huge, and as wealth increases, it is only natural that savers in China look to diversify their assets into other markets. This is a normal and healthy development, but the size of domestic savings onshore complicates the process of outflow liberalisation. Too large an outflow at any given time can create unwelcome capital flow volatility, impacting the broader economy and investor sentiment. To illustrate, the stock of broad money supply (M2) in China now exceeds US$27 trillion, more than double the size of China’s GDP, nearly nine times its foreign exchange reserves and over seven times its non-reserve foreign assets. So while China has no problems encouraging outflows, it has to ensure that outflows are not too abrupt.
Figure 4: M2 to total Reserves Ratio
Source: Bloomberg, Investec Asset Management calculations. As at 28.02.18.
Various schemes have been established to encourage portfolio outflows, but until recently a number of these were suspended when it became apparent that capital outflows had intensified. From an outward direct investment (ODI) perspective, the authorities welcome outflows which are related to strategic investments, particularly those related to the ‘One Belt One Road’ initiative. At the same time, we have seen a tightening of controls on private sector-related ODI, particularly investments deemed not to serve national interests such as the purchase of hotels and football clubs.
Given the long-term benefits of capital market efficiency, we believe that capital account liberalisation will progress gradually over time in a carefully calibrated and well-sequenced manner to minimise disruptive capital flow volatility.
3. Internationalisation of the renminbi
The internationalisation of the Chinese currency can be seen as the last step in the sequence, given it cannot really happen without significant progress on domestic financial market reform and capital account liberalisation. Reflections on the global role of the renminbi come at a time when serious questions are being asked about the status of the US dollar as the global reserve currency. The US runs large current account and fiscal deficits, which has sparked the currency reserve debate. While the renminbi will not displace the US dollar as the world’s reserve currency anytime soon, the sands are certainly shifting.
China has made considerable headway on the internationalisation of the renminbi, a key milestone being the induction of its currency into the SDR basket. Developing appropriate financial architecture to facilitate internationalisation has been progressing at a fairly rapid pace over the last decade, albeit from a very low base. For example, the use of the renminbi for China’s balance of payments transactions grew from close to zero at the start of the decade to around 30% by the middle of 2015.
Figure 5: Bank foreign receipts and payments
Source: Haver Analytics/State Administration of Foreign Exchange, Investec Asset Management calculations. As at 28.02.18.
While we saw some moderation in the usage of the renminbi following the attempted currency reform in August 2015, volumes have been steadily rising again since the start of 2017 as confidence in its value has returned. Similarly, renminbi deposits in the various offshore financial hubs, grew steadily from zero at the start of the decade, peaking in 2015. Since the sizeable drawdown at the beginning of 2017, we have seen a solid accumulation of offshore renminbi deposits again.
Figure 6: Offshore renminbi deposits
Source: Bloomberg, Investec Asset Management calculations. Offshore RMB deposits held in Hong Kong, Singapore, Taiwan, South Korea and United Kingdom. As at 28.02.18.
In the previous section we discussed the renminbi offshore supply challenges as a result of persistent balance of payments surpluses. One way the authorities have been promoting the supply of the renminbi offshore is through bilateral currency swap agreements with global central banks. The value of these swap agreements has now reached CNY 3.34 trillion, up from zero ten years ago. We expect this trend to continue as swap deals are rolled over and increased while new swap deals are agreed. Establishing a bilateral swap agreement with the US Federal Reserve, would be a significant milestone and a logical development, but political considerations may delay this development.
Figure 7: Outstanding bilateral currency swaps
Source: Bloomberg, Investec Asset Management calculations. As at 31.07.17.
Furthermore, to enable offshore settlement and the clearing of renminbi transactions, China has established offshore clearing banks across a number of key countries, including the United States. We believe this is an important development in promoting the internationalisation of the renminbi. In March 2018, China launched renminbi-denominated crude oil futures contracts at the Shanghai International Energy Exchange. These are the first futures listed on China's mainland catering to foreign investors. Onshore market players now have the opportunity to either gain portfolio exposure to oil or hedge their exposures without having to convert renminbi into US dollars, cementing the Chinese currency as a medium of exchange.
Finally, the establishment of multilateral agencies such as the Asia Infrastructure Investment Bank, New Development Bank and the Silk Road Infrastructure Fund should all help promote the internationalisation of the renminbi over the medium to long term.
China has laid many of the foundations to facilitate the internationalisation of the renminbi. While the long-term objective is to establish a globally accepted reserve currency, the immediate evolution would be to start turning the renminbi into a reserve currency for the Asian region, where the US dollar currently dominates. Chinese exports and imports to the Asian continent exceeded US$2 trillion in 2017; conducting more cross-border transactions in the renminbi would be a natural step. Thanks to a significant improvement in the quality of policymaking over the last few years, we believe that confidence in the renminbi as a store of value has been significantly bolstered.
China has made significant strides in implementing necessary reforms to promote the internationalisation of the renminbi and work towards achieving reserve currency status. Progress has been impressive but there is more to be done. We have highlighted the roadmap that China will likely follow, in the areas of domestic financial market reform, capital account liberalisation and the internationalisation of the renminbi. In the process, these steps taken should solidify confidence in the renminbi’s status as a global medium of exchange, store of value, unit of account, and a globally accepted reserve currency.
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1 Chinese New Year: Five investment themes for the ‘Year of the Dog’, 16.02.18