China Levels the Global Playing Field by Hayden Briscoe, AllianceBernstein
It’s a powerful vision for the world’s future. The US and China: two growth powerhouses; two major currencies.
At the heart of China’s much-publicized economic reforms are the internationalization of its currency—the yuan renminbi (RMB)—and the liberalization of its capital markets. It’s no exaggeration to say that these changes will affect not only China, but the world.
When China succeeds, the result is likely to be a more balanced global economy and a more level playing field in terms of choice of currency for trade settlement.
The RMB is likely to achieve reserve currency status in Asia and, potentially, Latin America. The People’s Bank of China (PBC) should become a major liquidity provider to global business. In this respect the PBC would challenge the Federal Reserve and European Central Bank. The Fed’s global dominance would be checked in another way, as the RMB’s rise would mean that the US dollar would no longer transmit the Fed’s monetary policy decisions as pervasively as in the past.
The key to assessing the likelihood of these scenarios becoming reality lies in understanding the dynamics that drive China’s reform agenda.
From World’s Factory to World’s Banker
Like many emerging countries, China has traditionally conducted its international trade in US dollars. That era effectively came to an end at the height of the global financial crisis in September 2008, with the collapse of US investment bank Lehman Brothers. The event caused dysfunction in global credit markets and a sharp drop in world trade, as exporters and importers experienced difficulty in sourcing US-dollar funding. The experience brought home to Chinese government officials, business people and the general public the risks of being so dependent on the US dollar.
The government’s first response, through the PBC, was to establish bilateral currency agreements with some of the country’s largest trading partners, including Australia and Brazil. In 2010, it took a first step toward internationalization of the RMB by agreeing with the Hong Kong Monetary Authority to make the currency deliverable into Hong Kong. The offshore currency was designated CNH (to distinguish it from its onshore counterpart, CNY), gave rise to the CNH bond market and began to make RMB settlement possible for those involved in trade with China.
By the second quarter of 2012—just two years after its inception—the CNH had become the settlement currency for 10% of China’s global trade. A year and a half later, the proportion had doubled to 20% (Display). We see potential for it to double again or even reach 50% in the next few years. The RMB already accounts for 9% of the global letter-of-credit market, ahead of the euro and yen.
This momentum is helped by China’s state-owned banks, which provide liquidity for CNH settlement in global financial centers in Asia, Europe, the UK and Australia. Since January 2013, the RMB has progressed from being the 13th-biggest world payments currency to fifth biggest, in value terms.
Before the financial crisis, when the manufactured exports sector was China’s main driver of growth, the country was routinely referred to as the world’s factory. These recent developments already point to China becoming one of the world’s great bankers.
US Treasury Holdings Are a Risk
China’s reasons for reducing the exposure of its international trade to the US dollar include geopolitical and macroeconomic motives, too. Based on the accumulation of foreign-exchange (FX) reserves, China has simply grown too big for the world economy. The country’s FX reserves are fast approaching US$4 trillion, helped by a return to record current account surpluses.
Inevitably, a large portion of these funds is invested in the US Treasury market—the one bond market with sufficient liquidity to absorb such an amount. This has proved to be something of a political embarrassment for China, which the US government suggests is buying US-dollar assets in order to keep the RMB undervalued. According to the US Department of the Treasury, China held US$1.3 trillion of US Treasury securities in September 2014, making it the largest foreign holder.
We expect these tensions to ease over time. By internationalizing its currency, China would no longer need to sterilize US-dollar inflows by investing in US Treasuries. And, by encouraging a two-way flow of capital across its borders, more foreign entities would look to borrow in RMB. The liberalization of China’s capital markets will be the subject of my next post.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Hayden Briscoe is Director of Asia-Pacific Fixed Income at AllianceBernstein.