China’s regulators need to deepen renminbi internationalisation beyond just trade settlement by lifting restrictions on cross-border flows of the Chinese currency for capital account purposes.
Without an open capital account, renminbi internationalisation can only achieve 10% of its full potential, indicating that limiting outflows through the current account is unsustainable, according to a research report released by Deutsche Bank on January 9.
“Renminbi trade settlement is unlikely to drive strong growth in offshore renminbi liquidity and the asymmetric nature of the policy design – which seems to favour renminbi remittance to the onshore market under the capital account...has increasingly become the primary policy constraint to further renminbi internationalisation,” said Linan Liu, strategist at Deutsche Bank.
For example, the use of the Chinese currency for investment purposes is severely limited when the capital account is controlled. This is because foreign residents can only receive renminbi – also known as the yuan – through trade channels, which implies that the amount of liquidity made available will only be a small fraction of the potential demand for renminbi-denominated investments.
Additionally, a controlled capital account also hinders central banks from using the Chinese currency as a reserve currency.
“If renminbi outflow is only through the trade channel in the next few years and assuming most offshore renminbi assets are held by reserve managers, the size of offshore renminbi liquidity will be no more than 2% of global foreign reserves,” said Liu.
From a macro perspective, the deepening of the internationalisation of the Chinese currency has to be accompanied by an increase in the trade deficit. However, a high trade deficit will lead to a devaluation of the renminbi, which may lead to a decline in global demand for the currency, highlights Deutsche.
RMB vs JPY and USD
Based on the experience of the internationalisation of the Japanese yen and assuming that renminbi outflow is only available through trade and settlement, then renminbi settled trades may account for up to 40% of China’s total foreign trade, which is about four times the current level.
This implies that global offshore deposits in the Chinese currency could increase from the current Rmb860 billion (US$138.2 billion) to Rmb2-Rmb3 trillion, notes Deutsche.
However, if the capital account is liberalised as in the case of the US dollar’s internationalisation, non-residents’ holdings of renminbi assets could rise to 80% of gross domestic product (GDP) when the Chinese currency becomes fully internationalised, which is approximately Rmb30 trillion in absolute terms, estimates the bank.
This is why Chinese authorities should consider liberalising more renminbi cross-border transactions under the capital account otherwise offshore renminbi market development could stall.
“Essentially, lifting restrictions on cross-border renminbi flows for capital account purposes and capital account liberalisation or convertibility between the renminbi and other currencies are two reforms that are mutually substitutable,” said Liu. “Lifting restrictions on one of them will make restrictions on the other invalid.”
Policy measures
In order to preserve the momentum of China’s capital account liberalisation, Deutsche has come up with a number of reform measures to further relax controls on cross-border renminbi capital flows for short-term and medium-to-longer-term funding needs. Also, the bank emphasises the need to develop the offshore renminbi market.
Firstly, offshore banks should be allowed to issue renminbi-denominated banker’s acceptance including letters of credit (LCs) which can be pledged as collateral to borrow from the onshore interbank market.
This is a trend which has already occurred in China, where onshore commercial banks issue these instruments and offshore trade suppliers use them to obtain funding in the offshore market.
“With offshore short-term funding costs not only converging with the onshore market, but potentially rising above onshore funding, we think it is important to permit onshore renminbi short-term liquidity access to offshore end-users through collateralised borrowing, to meet demand for trade financing and other real economic activities,” said Liu.
Secondly, the expansion of already existing pilot programmes is crucial to spur further interest, including the scheme to allow renminbi cross-border lending by onshore multinational corporations (MNCs) to offshore parent companies or related subsidiaries within the same group.
Also, relaxing restrictions on individual and corporate foreign exchange (FX) conversion and on renminbi outward remittance would help in capital account liberalisation. Currently, individuals and corporations can remit US$50,000 and US$1 million per annum respectively to the offshore market.
Deutsche recommends allowing the ability to permit remittance to the offshore market under the quota. Additionally, the authorities should consider raising the unrestricted FX conversion quota – for renminbi to other hard currencies - for individuals to US$200,000 per year and permitting FX conversion of US$2 million per annum.
“Some regulators have been concerned that offshore renminbi or foreign capital inflows would increase FX reserves, and thereby increase domestic liquidity and sterilisation costs. If US dollar or renminbi outflow is made easier, it would help address these concerns,” said Liu. “The permission for FX outflow would also provide additional scope for increasing the foreign institutional investments in China’s interbank bond market and stock markets.”
Offshore renminbi participating banks should also be allowed to gain more access to the onshore market for financing. For example, offshore financial institutions seeking funding from the onshore interbank market, obtaining collateralised financing by putting bond investments under repo transactions or even issuing a Panda bond.
Such funds obtained should be remitted to offshore market, adds Deutsche.