The Rise Of The Renminbi: Will China’s Yuan Become A Global Reserve Currency? by Mark Mobius, Franklin Templeton Investments
In recent months, China has stepped up a longstanding campaign for its currency (officially called the renminbi [RMB] but also referred to as the yuan), to be included as a part of the composition of the International Monetary Fund’s (IMF’s) Special Drawing Rights (SDR). While the media is abuzz with the potential market implications of China’s currency achieving status as an international reserve currency—one which can be held by central banks and other major financial institutions to pay off international debt obligations—at one level, the issue is somewhat arcane. SDRs are a synthetic quasi-currency made up of a basket of widely traded currencies. They are used by the IMF for accounting purposes and as a medium for allocating assets among member countries. They play almost no role in private trade and finance. They do, however, provide the IMF’s approval that a currency has the qualities necessary to be an international reserve currency. Indeed, SDR currencies are automatically regarded as acceptable reserve currencies, whereas other currencies have to meet criteria for full convertibility to have the same status.
Until recently, the Chinese government placed major restrictions on the use of the RMB. The authorities appeared to consider the control that an insulated currency conferred on domestic monetary and fiscal policy to be more important than the potential benefits from full participation in global financial markets. In recent years, however, the government attitude has changed, with market-oriented economic reforms and a more outward-looking foreign policy including measures to encourage wide RMB usage.
The four currencies with SDR status—the US dollar, the euro, the UK pound sterling and the Japanese yen—currently make up the overwhelming majority of global international currency reserves. As a knock-on effect, they dominate international bond markets and global financial transactions. In recent years, the rising share of global trade accounted for by emerging markets, and by China in particular, has left this state of affairs looking somewhat anachronistic. The Chinese government had campaigned for RMB inclusion in SDRs in 2010, at the most recent of the IMF’s reviews of the SDR structure, but at that time, the bid was rejected. In our view, prospects for success at the meeting scheduled for October 2015 appear high.
The Potential Benefits for China
Reserve currency status and RMB internationalization could confer a number of significant benefits on China, including potentially lowering borrowing costs and facilitating overseas expansion by Chinese companies, allowing cross-border contracts in major commodities such as iron ore to be priced in RMB, thereby easing foreign exchange risks arising from pricing in US dollars, and above all, opening the way for a portion of China’s enormous foreign exchange reserves to be redeployed in more economically productive directions. The latter measure could conceivably stimulate economic growth at the margin both in China and on a global scale. Other reserve currency countries have much lower reserves relative to their gross domestic product than China does—the United States is able effectively to operate without reserves at present— while overseas investment projects such as China’s ambitious “one belt, one road” and “New Silk Road” initiatives to build trading infrastructure with neighboring states, as well as private initiatives, would represent potentially attractive new uses for resources that are at present tied up in currency deposits and Treasury bills.
For a currency to be included in SDRs, the IMF primarily requires that it be important in terms of its share in global trade, but also that it is “freely used,” a term further broken down into “widely used” and “widely traded.” In 2010, the RMB already featured widely in global trade, but the IMF decided that the currency did not meet the “freely used” criterion. At that time, the RMB was not an internationally convertible currency. Its exchange rate against other currencies was tightly controlled by the Chinese government at a level believed by many commentators to represent a significant undervaluation, while an unsophisticated local banking system lacked the ability to provide many of the instruments required by international companies to manage their currency exposures. A form of the RMB, called “offshore RMB” was available through a few Hong Kong-based banks, but it was cumbersome to trade in compared with other currencies, and its value differed from that of the onshore RMB on foreign exchange markets.
A good deal has changed since 2010, and the process of change has been accelerating. The number of offshore centers where RMB is traded has proliferated, while in the Shanghai Free Trade Zone (FTZ), currency transactions can be executed between mainland and associated offshore companies with few restrictions. Meanwhile, the People’s Bank of China (PBOC) has been moving toward reforms in the country’s banking system by freeing interest rates and by introducing a deposit insurance system, two important milestones on the road to creating a system fully able to participate in international financial flows. Importantly, many authorities, including the IMF, believe that the RMB is fairly valued. Reserve currency status would imply abandoning the current RMB-dollar peg.
A New Currency Connection
The opening of the Shanghai-Hong Kong Stock Connect in the latter part of 2014, allowing foreign investors to freely invest in eligible Chinese A shares previously restricted to only Chinese citizens or foreigners with special permits, was seen as a major move in internationalizing the RMB through allowing mainland investors to acquire stocks on the internationally traded Hong Kong markets. The initial impact was lower than expected, however, with only small percentages of permitted daily trading quotas being utilized. The situation changed in April 2015 with the announcement of measures to permit mainland mutual fund managers to buy into Hong Kong stocks (that were trading at markedly lower valuations). Restrictions on use of the Stock Connect by individuals were also eased. As details of the move filtered out, use of the Stock Connect rose sharply, such that trading quotas were exceeded on some occasions and remained well above prior levels. In May, we also saw the announcement of a planned “Mutual Recognition” program that would open the way for mainland and Hong Kong mutual fund managers to offer their funds in each other’s markets. As mutual recognition comes into operation, we believe Chinese mainland investors would be most impacted, given wider investment choices. These recent developments could also help the Shanghai stock market become much more closely integrated into global financial markets, markedly expanding the effective global use of RMB.
Some remaining areas of uncertainty surrounding direct investment in China—in particular, lingering fears that a “suspended” capital gains tax could be reinstated and the possibility that a “short swing” law could potentially lead to capital gains from larger investor positions in individual companies being expropriated—are tempering our enthusiasm for utilizing the new freedoms at present. In addition, recent government intervention in the stock market and suspension of stocks during a sharp market downturn could have an impact on the reform process and the progress made toward RMB gaining international reserve currency status. However, we do feel there is political will toward economic reform in China, so such issues may not persist.
Going forward, the PBOC is offering a move to full “managed convertibility” over the remainder of