Scenario two – managed internationalisation
In the second scenario, China never fully opens its capital account. Instead, it spurs the creation of a new monetary system, in which the Chinese state re-asserts itself more than the market.
It is unlikely that China will simply slot into the existing monetary system. Historically, great powers have changed the nature of the financial system into which they have integrated. It is not a coincidence that the Bretton Woods system of fixed exchange rates was created after the United States emerged from the second world war as the main ordering power. Today, if China has its way, the renminbi may never become fully convertible.
This is consistent with China’s highly discretionary approach to capital management to date. In April 2015, former central bank governor Zhou Xiaochuan stated that the “capital account convertibility China is seeking to achieve is not based on the traditional concept of being fully or freely convertible … instead China will adopt a concept of managed convertibility.”5
Since then, managed convertibility has meant asymmetric intervention, where global investor inflows are permitted much more (via QFII, QDII, R-ODI, or QDLP schemes) than domestic outflows. At the end of 2015, for instance, Chinese residents were subject to tighter capital controls, while international investors were free to take funds out. China’s policy of managed convertibility would only have been amplified in late 2015 and early 2016 when hedge funds began shorting the offshore renminbi, which then produced a devaluation signal to other market participants.6
In any case, China’s preference for managed convertibility should not be too surprising. After all, it is not so long ago that the US had capital controls. For instance, the US Interest Equalisation Tax of 1963 was meant to make it less profitable for US investors to invest abroad to protect the balance of payments. This involved imposing a tax on foreign shares and bonds up to 15% of their purchase price.
What can we learn from the sterling bloc?
The last sustained example of an international currency with major capital controls was the sterling bloc centered on the United Kingdom between the 1930s and the 1960s. This came about following the economic crisis after 1929, when several countries pegged their currencies to the pound sterling to reduce volatility. By 1933, members of the sterling bloc included most of the British empire but also Denmark, Egypt, Estonia, Finland, Iraq, Iran, Latvia, Lithuania, Sweden, Norway, Portugal, Thailand, and others.
The parallel is inexact. China today is a rising power. The sterling bloc was created when the UK was in decline. Furthermore, the sterling bloc was established to manage and even hide British weakness, whereas renminbi regionalisation is designed to project China’s strength. Nevertheless, there are three potential similarities with the sterling bloc.
1. A reserve currency with capital controls
Most obviously, sterling was a reserve currency with capital controls, precisely the aim of Chinese policy. Sterling was not convertible outside the bloc. Countries were required to exert careful control on exchange within the sterling area, and payment of non-sterling exports was closely tracked.
Percentage share of sterling in total reserves (1950-1958)
Source: Schenk, Britain and the Sterling Area, p. 30
2. Strong trade relationships
The bloc was underpinned by strong and complementary trade relationships. Throughout the 1950s, Iraq, India, Burma and South Africa – all of which were at this point politically independent of the UK – continued to conduct over 40% of their trade with the UK. The sterling area was a complementary system where the producers of food and raw materials would supply British industry in return for manufactured goods from British factories.
In a similar vein, China enjoys strong trade relations with its Asian neighbours. Chinese imports from Asia (Hong Kong, Japan, South Korea, India, and Southeast Asia) already account for 38% of its total trade. In sharp contrast, China’s trade with Latin America and Australia amounts to just 10% in total.7 Distance is still relevant to trade costs, and transport costs are still significant despite containerisation.
Regional composition of China's imports, 2017
Source: The Observatory of Economic Complexity, MIT, 2018
Moreover, China has been running persistent deficits with some countries in Asia, including South Korea, Thailand and Malaysia. This has enabled some Asian countries to accumulate the renminbi-denominated reserves needed to operate a renminbi-based system, another similarity to the sterling bloc.8
Chinese demographics also naturally favour a step change in trade relations with its Asian neighbours. As China ages, unskilled labour is becoming increasingly scarce relative to countries like Indonesia, India and Bangladesh. China will therefore export capital and goods that require skilled and semi-skilled labour, and import goods using raw materials, energy and unskilled labour – making those Asian countries natural trading partners. Consistent with this presumption, trade among the economies in question has been growing more rapidly than global trade, and faster than China’s trade overall.9
3. A complementary financial relationship
A complementary financial relationship managed by the central country is the third potential characteristic that the sterling bloc and a regional renminbi system might share. Capital controls helped the sterling area survive the second world war. During this period the UK borrowed heavily by using the commodity exports of its colonies to acquire dollars. In turn, the UK provided the colonies with foreign exchange via quotas. The sterling area bolstered British foreign exchange reserves and reduced the risk of a run on the pound for the UK.
However, the dependent countries also enjoyed some benefits. The sterling area provided access to the London capital markets for other members at a time of general capital controls that restricted access to other lenders. It also reduced exchange rate risk for most of the sterling transactions between partners during the 1950s.
The dynamics of this relationship may share some similarities to the current Belt and Road initiative, which allows China to project power overseas while promising countries trade and investment.
Not plain sailing
China’s policy of renminbi regionalisation will not happen overnight. For one thing, China’s efforts to restructure its economy mean it may be in for a difficult few years. Meanwhile, China will also need to overcome its neighbours’ distrust. A recent survey of 1000 government, academic, civil society and media elites in Southeast Asia found that only 10% thought China to be a “benign and benevolent power.”10 These factors will certainly affect the speed of any currency transition.
The second scenario is effectively the status quo. Continued renminbi internationalisation within a partially closed capital account is our base case, as the Chinese authorities have clearly stated their aim is managed internationalisation.
Under a scenario of Chinese regionalisation, there will likely be a decline in risk premia in China’s trade partners due to a shift in China’s outbound investment. Investors should monitor signs of increasing regionalisation, as reflected in Chinese policy initiatives like the Belt and Road and the expansion of the People’s Bank of China swap lines. The Chinese central bank has already signed more than 30 swap agreements with emerging market countries to facilitate trade and offer downside protection in times of crisis.11
Such regional initiatives could lead to a general decline in risk premia in emerging Asia and reduce the boom and bust of the dollar funding cycle. A relevant parallel is perhaps Western European involvement in Eastern Europe, which has boosted overall investment and financial connections. It has been a gradual process that evolved after the fall of the Soviet Union. Initiatives include the establishment of infrastructure funds, portfolio investment and trade deals. The spread between nominal German and Hungarian 10-year bonds fell by 380 basis points in the 20 years to the first quarter of 2019, though the crisis in between also suggests that if unmanaged, the de-risking process can go too far.
The second broad impact to asset allocation is a transformation of Asian emerging market economic cycles. Dollar dominance is partly predicated on the fact that the dollar is still the default currency for trade, with 80% of dollar-denominated imports never entering the US. Economists have found strong invoicing effects from the dollar, where overseas economies’ trade, inflation rates and asset values exhibit great sensitivity to movements in the dollar.12 Increased invoicing in renminbi will cause other economies to trade more in line with China’s economic and financial cycles, boosting investment strategies that are aligned with this transformation.