China gets back to work on RMBi

China’s substantial liberalisation of its onshore capital market has given a new lease of life to the internationalisation of the RMB. But if the RMB is to succeed as a truly global currency, China must reverse measures introduced three years ago, provide access to hedging as well as liquidity and risk-management instruments, and eventually allow its currency to float. Paolo Danese reports.

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China’s goal of turning the RMB into a global currency appeared well on track in the first half of this decade, with the appointment of nearly two dozen global RMB clearing banks, the promotion of an offshore bond market and the expansion of quotas for foreign investors entering China. Offshore RMB (CNH) deposits in Hong Kong hit Rmb1tr by the end of 2014, the CNH bond market took off and investors started to get a real taste for onshore equities which, by early 2015, were on a tear. But by August, it was a very differ­ent story.

When the People’s Bank of China changed its way of determining the daily fixing of the RMB against foreign currencies, it inadvertently triggered a 16-month-long battle against the yuan bears. The latter argued that the 2%, one-off devaluation of the fix caused by the policy tweak was a signal that China was preparing for an economic hard landing, and that a competitive devaluation of the currency would be necessary.

Fast forward to 2018 and it is clear that China has beaten the bears, many of whom suffered heavy losses and had to unwind their short positions. But while the former PBoC governor, Zhou Xiaoc­huan, spent ten years trying to build up the RMB as a global currency, the deval­uation interrupted the currency’s ascent and has set its internationalisation back by several years. Since August 2015, the RMB has dropped off the list of the top five global payments currencies, as tracked by infrastructure provider Swift, and CNH deposit-holders quickly shifted out of the currency. In Hong Kong, for example, the CNH pool has halved in size from the highs reached at the end of 2014, and issuance in the offshore RMB bond market dried up almost entirely in both 2016 and 2017.

“At present, the RMB’s international status is significantly lower than China’s,” Yin Yong, the former deputy governor of PBoC, said in a paper pub­lished in July by the influential Chinese think tank China Finance 40 Forum.

Take a longer view, however, and things look rosier. The fundamental drivers for a global RMB remain in place. China represents more than 15% of the world’s GDP, 11% of its total imports and exports, and 11% of its net international investment positions as of last year, according to Yin. Given China’s growing importance as a global economic power, it is inevitable that the status of the RMB will improve; but can it raise its profile enough to challenge the dollar as the global currency?

As this report goes to press, the cur­rency is once again retreating against the dollar and creeping close to the noto­rious “line in the sand”, an exchange rate of around 7 RMB per dollar. The A-share market is also under pressure; the Shanghai Composite index has fallen about 30% from the highs of early 2018. But in some areas, at least, there have been positive developments. Morgan Stanley Capital International (MSCI) included A-shares in its emerging mar­kets (EM) indices in June, while the Bond Connect has, as discussed elsewhere in this report, provided the trigger for sub­stantial inflows to onshore RMB bonds, with trillions more dollars expected to follow. Provided the Chinese authorities do not meddle in the market and allow access to hedging and other tools, there is room for some optimism.

“I do not expect to see ad hoc measures being taken, I believe the volatility in the RMB is normal,” says Ken Chiu, head of the RMB competence centre at French lender BNP Paribas. “Chinese officials have been talking about allowing more two-way volatility in the market. The official line is that the RMB exchange rate should be able to move. And if you look at the appetite, offshore investors are still very keen. While in June we observed substantial weakening in the FX rate, it was still one of the most active months for purchases over the Bond Connect.”

In terms of RMB allocations, foreign investor sentiment has turned a corner, partly because they have more choice. There are now four different cross-bor­der schemes for fixed income investors, namely qualified foreign institutional investor (QFII), RMB QFII (or RQFII), Bond Connect and, for mutual funds, Mutual Recognition of Funds (MRF).

“Having alternative methods just means that people use different ways to slice and dice that access,” says Andrew McGinty, a Shanghai-based senior partner in the China corporate practice of inter­national law firm Hogan Lovells.

“We have seen a fund that does invest­ment via derivatives like participatory notes in Chinese A-shares, but that also uses Stock Connect. People want to have exposure to this market: you have the growth story, a highly educated work­force, a massive consumer market,” McGinty tells GlobalRMB.

Foreign ownership of Chinese bonds as a share of outstanding securities hit an all-time high of 3% in July, according to data from Hong Kong Exchanges and Clearing.

RMB watchers have long maintained that index inclusion is the key to unlock­ing currency internationalisation.

“For the past 20 years we have seen the corporates going into China, the next wave will be the investment flows from institutional investors,” says Rose Kay, head of RMB solutions for Hong Kong and Taiwan at Standard Chartered. “We already see the central banks actively investing in China, the RMB is already a reserve currency now with around 1% of central banks’ global portfolios. We also expect a significant increase in foreign investment inflow by private sector investors as both major equity and bond indices start to include China markets.”

CASH IN, MAYBE CASH OUT

The Panda bond market – for RMB-de­nominated bonds issued by non-Chinese entities in China – has picked up this year; issuance in the first half of 2018 amounted to Rmb51bn, or nearly double the amount for the same period in 2017. There is also more activity in the dim sum market, where bonds are denomi­nated in RMB but issued outside China, with Rmb36bn of such bonds issued in the first half, up from Rmb10bn in the first half of 2017.

But the Panda market has been held back by delays in the announcement of official regulations regarding the repatria­tion of proceeds. This is a serious concern because, in the wake of the PBoC’s moves in August 2015, the authorities raised a new Great Wall, this time as a defence against most forms of capital outflow. As a result, many foreign companies experi­enced delays in moving funds offshore or were prevented from doing so.

McGinty notes that PBoC sought to reassure firms that it was business as usual for issues such as the dividends paid by foreign companies operating in China, despite the general clampdown.

“But if you have a large amount of div­idends, payments were still being held up, we heard anecdotally,” he says.

“Now China feels it can loosen some of the controls except in certain designated ‘sensitive industries’,” McGinty adds. “Foreign investors still have the impres­sion you can’t take money out of the country. You can, but you need to make sure you do the right things, that you have the right paperwork in place and, where required, such as on outbound transactions, that you have a record filed with, or obtained approvals from, the right authorities before closing the deal. You can take money out, it just takes a lot longer.”

But at last, potential Panda issuers have reason to be optimistic.

“PBoC has already announced they will issue a detailed guideline soon,” says Kay. “Issuers will have the choice of where to deploy the proceeds, and they will be allowed to bring the RMB funds out of China and convert them to foreign currencies.”

POINTLESS HUBS?

One topic that has been largely ignored in the broader RMBi conversation is that of the offshore RMB hubs. These were previously hailed as a critical component of the RMB internationalisation strat­egy, but the Chinese authorities seem to have either forgotten about the concept entirely or else decided that the mission had been accomplished given that at the tail end of the Obama presidency, the US and China agreed to add New York to the list. Bank of China New York (BOCNY) was added as a clearing bank in Septem­ber 2016, when an RQFII quota was also assigned to US-based investors for the first time.

Not much has moved since then, however. Even though China granted JP Morgan the privilege of becoming the first non-Chinese clearing bank, joining BOCNY in February 2018, GlobalRMB understands that as of the middle of this year, clearing activities by the two insti­tutions have yet to begin. Beyond the US there is also little in the way of concrete data on how these hubs, launched with great fanfare, are helping the RMBi strategy.

“China will really need to develop a much broader base of offshore RMB centres,” says McGinty. “We have a few now, but I think China will carry on expanding that hub network, given that the expansion of the use of the RMB offshore is seen as a pre-condition to RMB internationalisation.”

There are hints of activity; the New York Federal Reserve reports that, for the first quarter of 2018, RMB FX trad­ing reached a combined average daily volume of just over $10bn, compared to $87bn in Hong Kong, which is the largest offshore RMB trading centre.

“They need the hubs to build the CNH pool and to smooth RMB liquidity across time zones,” says BNPP’s Chiu. “They also need the hubs to bridge activities onshore and offshore around the clock. That’s also important for cross-border initiatives like the upcoming Lon­don-Shanghai Stock Connect. You need that liquidity to make it a success.”

The fundamental issue remains one of demand.

“Is there a need to have a hub in 25 countries? I do not see it as cru­cial,” says Candy Ho, global head of RMB business development at HSBC. “The FX market is already a 24-hour market globally. As a bank, we are able to support clients in FX and hedging from Hong Kong, London and New York already. You do not necessarily need to have a hub in every country.”

China’s launch of a cross-border interbank payment system, which helps to process RMB payments from anywhere in the world during its almost-around-the-clock operating hours, has also made clearing banks and hubs obsolete. Yet so far, these var­ious channels – hubs, clearing banks and payment systems – have failed to attract the sort of volumes to justify the related government-driven publicity and investment.

“When the payment volumes pick up, then the infrastructure will be impor­tant,” Kay says. “We are still waiting for the tipping point. We still need to see increased usage of RMB for trade invoicing and investment.”

WHERE TO START

Former central banker Zhou did himself few favours. After going around the globe for a decade proclaiming that China was ready to make the RMB a global currency, he then allowed the government to not only retreat from that agenda, but to reverse it by impos­ing heavy restrictions on capital inflows and outflows starting in the middle of 2015.

So even though the RMBi agenda has scored some big wins – namely the inclusion of the RMB in the special drawing rights (SDR) basket and of Chinese equities in the MSCI EM index – there is a substantial to-do list.

Now that access to cash stocks and bonds has been liberalised, hedging and liquidity management are the top priorities for the market, given that many barriers are still in place. Active and passive foreign investors in A-shares, for example, need access to index futures to hedge and take a view on that market’s direction, especially as MSCI will be increasing the weighting of those stocks in its indices.

But confronted with the second equities bear market in three years, the Chinese authorities have given no indication that they would be willing to open up equity derivatives in the near future.

One topic that frequently comes up in conversation is the need to allow foreign investors access to the onshore repo market, as it could radically trans­form RMB liquidity.

“Repos will help the liquidity man­agement of offshore portfolio managers, making it so that they do not need to sell the bonds when they need liquid­ity,” says Chiu. “They will be able to tap the repo from offshore and be able to get short-term liquidity whenever they want.”

One source close to the regulators tells GlobalRMB these may be opened sooner rather than later, as the success of the Bond Connect – and its focus on institutional rather than retail investors – gives the pro-reformers within China’s onshore regulatory bodies more clout.

As for risk management, credit default swaps are another of those little-mentioned products within China that could make a big impact.

“The discussion is still not very active on [CDS] products,” says Chiu. “For now, you only have domestic institutions as protection writers, but if you allowed offshore investors to issue that protection, it could help mitigate the risks in the market. Right now, a Chinese protection writer does not nec­essarily want a Chinese counterpart.”

Rates hedging is also on the wish list of many an investor, and it seems the onshore authorities are willing to fix that in the short term, especially given that this market is already open to investors under the China interbank bond market (or CIBM) Direct scheme.

“As part of a broader harmonisation between access programmes, there are already plans for Bond Connect investors to be eligible to enter the rates hedging market, just like for CIBM Direct where you could always hedge interest rate volatility of the underlying bond market,” says HSBC’s Ho.

One positive outcome of the Bond Connect launch, overall, is that it eased concerns around the ability for CNH markets to cope with increasing demand. That was addressed by allowing inves­tors authorised under the Stock Connect, Bond Connect and CIBM Direct schemes to access onshore liquidity through authorised Hong Kong banks. Kay notes that this will also have repercussions for corporates, because even treasurers overseeing Chinese operations typically manage their FX exposures through a regional treasury centre (RTC) in Hong Kong, Singapore or directly from an over­seas headquarters.

“In the past, it was difficult for them to access onshore rates from HQ or the RTC, while with a recent PBoC relaxation they can comfortably move the cash out, get the RMB receivables or dividend in Hong Kong, and then hedge using the onshore rate from here through their bank,” says Kay.

THE SILKY WAY TO INTERNATIONALISATION

One of the most important ways of im­proving the RMB’s internationalisation, namely the Belt and Road Initiative (BRI), is already well under way.

“We have talked about usage of the RMB on the BRI, and it is on the rise,” says HSBC’s Ho. “We are seeing ASEAN, Middle Eastern, and Eastern European corporates all becoming more receptive to using RMB or using RMB financing for BRI projects. The initiative can be one of the catalysts for RMBi, especially if future financing on BRI projects will be denomi­nated in RMB.”

The Chinese authorities seem to be making that bet as well.

“The Belt and Road Initiative provides an important strategic opportunity for the internationalisation of RMB,” writes former PBoC deputy governor Yin in another paper published in July.

Yin notes that across 64 BRI countries and regions, RMB payments made up 14% of total trade with China, still below the 25% average for China’s total trade. For 55 of these countries, RMB usage is below 5%.

“If we could expand the use of RMB, it could be exported in the form of capital, which can be used to buy Chinese goods and services,” he writes.

StanChart’s Kay thinks this could indeed be the key to unlocking the next phase of growth.

“The foundation is the trade flows,” she says. “That will pick up if the BRI succeeds. Once that link is built you will have more goods trade between China and the BRI countries in RMB. We also expect to see more financing for BRI countries done in RMB.”

THE END-GAME

If China really wants the RMB interna­tionalisation plan to be credible, the obvious step is to float the currency. There is no scenario in which a managed currency could be adopted for trade or investment far and wide around the world.

“China maintains its policy-speak of full liberalisation in the medium to long term,” says McGinty of Hogan Lovells. “My prediction is that China can’t pre-announce when that will be and tell the market its intentions. If it did, everybody would pile into RMB assets. You would have an influx of capital into most asset classes and the risk of signif­icant speculation.”

He points out that the Chinese author­ities paid close heed to the lessons of the Asian Financial Crisis of 1997 and the defeat of the Bank of England in defending the pound in 1992.

“China has a very long memory, and the lessons from those crises have been absorbed and digested,” he says. “It does not want to be in the position of being exposed to speculative pressures on the RMB. That being said, there would be a huge upside for them to remove barriers, which would announce that the RMB has truly become a world reserve currency. It would be a strong assertion of China’s new economic status in the world.”

Chiu agrees.

“In terms of capital account liberali­sation, there are plenty of examples in other jurisdictions of the kind of market volatility that can come with it. To make the opening a success, it requires a lot of monetary policy support, the right FX regime, you need to have a safety net. China will not open up just for the sake of opening up.”

All in all, a liberalisation by 2020, which had been floated as a possibility by the Chinese authorities as recently as 2016, now seems unlikely.

“A full liberalisation in the short term may not be possible given that 2020 is less than two years away,” StanChart’s Kay says. “I do think China has already and will continue to open up its cap­ital, FX and derivatives markets. But there will still be measures to manage the flows. I don’t see the onshore RMB becoming fully convertible all of a sudden. It is not that realistic.”

Chiu holds on to at least one certainty:

“They will never reverse and close the door again.”