The Internationalisation of the Renminbi (Interview with Dan Steinbock)

By Dan Steinbock     

According to Dan Steinbock, the internationalisation of the renminbi is accelerating. The inclusion of the yuan in the IMF basket of reserves is now a matter of time.

On August 11, the People’s Bank of China (PBOC) adjusted the exchange-rate of the Chinese renminbi (RMB) against the US dollar to better reflect market conditions. The net effect was a devaluation of 1.9% relative to the dollar.

The adjustment was an effort to comply with the requirements of the International Monetary Fund (IMF) to include the yuan in the reserve currency basket. The move towards a more market-determined rate is what the IMF and the US Treasury, along with European financial authorities, have been asking for.1

It is well-aligned with Beijing’s effort to speed up the RMB internationalisation.

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The Renminbi Goes International

Today, China is the world’s biggest exporter and the second-largest economy in the world in absolute terms. At the end of last year, the RMB moved into the fifth position in global payments, but still accounts barely over 2% of the international payments total. However, its explosive potential is reflected by its rise as a settlement currency for China’s global trade to 23% by early 2015.

Until the global financial crisis, the RMB had little exposure to international markets because of government controls that prohibited almost all exports of the currency, or its use in international transactions. In the era of Xi Jinping and Li Keqiang, China is rebalancing toward consumption and innovation, and Beijing is fostering the RMB’s rise in international finance.

RMB’s explosive potential is reflected by its rise as a settlement currency for China’s global trade to 23% by early 2015.

After China joined the World Trade Organization (WTO) in 2001 and exports truly took off, the RMB has evolved as an international currency for paying for goods and services. In this era – roughly the 2000s until the global crisis – foreign multinationals invested in China, but Chinese foreign investment was minimal.

In the second stage – the first half of the 2010s – China consolidated its role as the world’s trading engine. As Chinese capital is increasingly going out, leading Chinese brands – from ICT (Lenovo, Huawei, Tencent, Alibaba, China Mobile) to financial institutions (ICBC, China Construction Bank, Agricultural Bank of China, Bank of China) to oil and gas (Sinopec, PetroChina) – are becoming familiar abroad and the RMB’s role is expanding as a currency for global investment.2 Concurrently, the number of Chinese traveling overseas has soared to 117 million.

In the third stage, the RMB seeks to achieve a new status as a reserve currency with sovereign governments. That’s where we are today. The transition will not occur without friction. All major international currencies – the US dollar, Euro, British sterling and Japanese yen – have experienced their share of growth pains.

The summer turmoil in the Chinese equity markets reflects these transitional challenges. In early 2013, I predicted the impending boom in the Chinese markets. In mid-June, that boom resulted in a severe correction. Despite volatility, the potential of Chinese market prevails.3

 

 

RMB Financial Channels

The internationalisation of the RMB also benefits from the steady expansion of new RMB clearing banks, which provide direct access to RMB liquidity in China, while contributing to the expansion of offshore RMB.

The launch of the Shanghai-Hong Kong Stock Connect – the cross-boundary investment channel that connects the two markets – has boosted the growth of trading volumes, along with Shanghai’s Free Trade Zone (FTZ), which is paving way to new FTZ reforms in other cities.

Despite initial technical challenges and the Chinese stock market correction, the China International Payment System (CIPS) is expected to be introduced in the fall. Scaled down, it will be used only for cross-border yuan trade deals.

There are almost an estimated $500 billion of RMB bilateral currency swaps – agreements between two countries to ensure access to each other’s currency if needed – in China and more than 30 countries.

These efforts are complemented by the launch of the massive “One Belt, One Road” regional initiatives in China’s regional proximity and internationally.

After years of hollow reform pledges by the G7 nations, China is also taking a more proactive role in global finance, through the BRICS New Development Bank and the Asian Infrastructure Investment Bank (AIIB). Despite initial US opposition, the AIIB took off dramatically last spring, especially after the UK joined the bank, which paved the way for other EU economies.4

 

 

Emergence of RMB Commodity Trading

While the dollar still remains the dominant currency for most commodities, China’s role in international commodity trade has increased dramatically.

Intriguingly, the dominant role of the dollar in global commodity pricing evolved in the 1970s when the US dominance began to erode. When America became an energy importer, it grew more reliant on the leading oil producers. As the Middle East’s oil economies opted for the dollar as payment currency, the petrodollar era came to rest on economic and strategic relations (oil for US dollars and military aid).

Until recently, these arrangements have enhanced US geopolitical might in the Middle East, including Washington’s ties with Saudi Arabia. However, as the US shale revolution took off and China’s role as the largest buyer has steadily increased in the region, the old status quo is gradually eroding.

While the dollar still remains the dominant currency for most commodities, China’s role in international commodity trade has increased dramatically. It is the largest consumer of iron ore, zinc, lead and copper. In the coming years, increasing share of commodity trade is likely to be priced in RMB, as evidenced by the emergence of RMB-denominated contracts on exchanges in Chinese cities.

As the world’s largest consumer and producer of gold, China also hopes to play a role in determining gold prices. Only three years ago, Hong Kong Exchanges and Clearing bought the London Metals Exchange, while Shanghai is about to launch an RMB-denominated gold-index.

In the future, commodity prices are likely to gravitate toward the RMB and other large emerging-economy currencies.5

 

 

The $1 Trillion Dollar Reserve-currency Decision

The RMB’s road to a major reserve currency comes with economic and geopolitical challenges. In the past, the value of the currency has caused major debates. These came to an end in May, when the IMF reported that the RMB was fairly valued, while urging Beijing to develop a floating exchange rate within three years.

Nevertheless, US Congress and the Treasury continue to argue that the RMB should be trading at higher levels against the dollar, due to China’s trade surplus, the plunge of oil prices, and rising Chinese productivity. These arguments are no longer persuasive, however.

The fall of the oil prices was triggered by the US shale revolution and the Middle East’s overcapacity. The US has had regional trade deficits for decades with East Asia (first with Japan, then with the Asian tiger economies, and more recently with China). And in the decade prior to recent turmoil, the RMB appreciated 30% against the dollar.

According to China’s central bank, foreign central banks held over $110 billion in RMB-denominated assets in April. Despite rapid RMB expansion, the starting-point is low. In 2014 total foreign exchange reserves amounted to more than $6 trillion.

Today, the RMB fulfills most basic preconditions of a reserve currency. China has become the second-largest economy in the world. Second, the RMB has evolved in an environment of low inflation, small budget deficits and stable growth. Third, the rise of the RMB as major reserve currency relies on strong institutional support. The fourth condition requires deep, open and well-regulated capital markets, which is why China is accelerating financial reforms. In April, Beijing pledged that the capital account liberalisation will occur by the end of the year.

China had hoped the RMB could be added in the IMF’s basket by January 1, 2016. However, in early August, the IMF was asked to delay its RMB inclusion until September 2016. The timing matters. Before the summer, Standard Chartered and AXA Investment Managers estimated that at least $1 trillion of global reserves will switch into Chinese assets when the IMF endorses the RMB as a reserve currency.

 

 

Toward Multiple-currency Reserves

In nominal terms, the size of the Chinese economy is likely to exceed that of the US in the 2020s. But size is not everything. While the US economy surpassed that of Britain in the late 19th century, sterling remained the preferred currency in international commerce and the dominant instrument for investments and sovereign reserves well into the early 20th century.

Things began to change after World War I, when the dollar surged in trade finance. As investors began to move from sterling to dollar and central banks started to expand their dollar reserves, the stage was set for a transition.

Before the summer, Standard Chartered and AXA Investment Managers estimated that at least $1 trillion of global reserves will switch into Chinese assets when the IMF endorses the RMB as a reserve currency.

In the past half a decade, the RMB has achieved dramatic progress in commodities, trade, investment and sovereign reserves. It is increasingly central to commodity trading. The RMB’s catch-up with the Japanese yen and the British pound will take longer – and even longer to gain parity with the dollar and the euro, which still represent 45% and 28% of international payments, respectively.

Nevertheless, the RMB’s role as a major reserve currency is now a matter of time. In the short-term, the transition means increasing market volatility. In the medium-term, it has potential to support China’s rebalancing and thus growth prospects globally.

The RMB will be the first emerging-economy currency that will join the sovereign reserves. In that role, it will pave way to other major emerging-economy currencies in the future.

 

Interview with Dan Steinbock

TWFR: What are the ramifications of the demise of the petro dollar and why has it been kept so secret?

DS: Reportedly, there have been such talks involving finance ministers and central bankers. In 2009, when the US economy was still very fragile, the Gulf states reportedly were planning to end dollar dealings for oil, along with China, Russia, Japan and France. Another wave of reports about the demise of the petro dollar regime surfaced in spring 2014 with the 30-year, $400 billion Russia-China energy deal. And in 2014/15 came the collapse of the oil prices, which boosted dramatically the value of the dollar.

The demise of the petro dollar regime has been fuelled by the US shale gas revolution, overcapacity in the Middle East, Western sanctions against Russia and Iran and destabilisation of the Middle East since the Iraq War.

 

TWFR: Has the devaluation of the RMB triggered a currency war?

DS: Currency friction began with record-low interest rates and quantitative easing in the West. In the emerging markets, those policies translated to “hot money” inflows; i.e., asset bubbles, imported inflation and currency appreciation. As the ECB opted for similar instruments, the friction was amplified. Then came the plunge of oil prices, which strengthened the dollar dramatically.

Currency friction will be amplified by rate hikes in the West.  Before the crisis year of 2008, the US rate still exceeded 4 percent. That level is not likely to be restored until 2018-2020 (and the final level may be lower than before the crisis). What may prove equally challenging is the anticipated reduction of the Fed’s balance sheet, which has soared to more than $4 trillion, thanks to rounds of QE. That reduction will affect interest rates and foreign-exchange markets – and not always in intended ways.

 

TWFR: How come the market is so susceptible to the devaluation of RMB, is this the real cause or does it indicate a  real weakness in the stock market thanks to quantitative easing in Europe, Japan and America?

DS: Beijing’s adjustment was not the cause of the market turmoil, but a step in efforts to comply with the IMF requirements to include the RMB in the reserve currency basket. Fuelled by media, markets over-reacted.

And yet, Wall Street had anticipated correction because US markets have been very expensive, as evidenced by the CAPE (cyclically-adjusted price-earnings ratio), which had climbed back to over 26, close to its peak before the global recession in 2007. Among other critics, Nobel laureate economist Robert Shiller has warned about the “new normal bubble” in the US equity markets. Indeed, high valuations may not be viable after zero-bound rates, rounds of QE, and US sovereign debt that now amounts to $18.4 trillion. Weakened by stagnation, markets in Europe and Japan could not avoid comparable turmoil.

 

TWFR: What is the reason that China and Russia are hoarding so much gold?

DS: It is true that, in the past half a decade, China’s gold holdings have soared by 50%. However, these figures should be set in the context. According to IMF’s officially reported gold holdings, US has over 8,100 tonnes and Germany almost 3,400 tonnes. The IMF, Italy and France each have 2,400-2,800 tonnes. China’s gold reserves remain less than 1,700 tonnes and Russia’s about 1,300 tonnes.

China’s motive for gold purchases is mainly diversification. In a year, China’s foreign-exchange reserves have been reduced from $4 trillion to $3.6 trillion. As China’s dollar assets remain extensive, Beijing has an interest in a smooth transition, however.

 

TWFR: What will the effect on the world economy be  when China finally floats the renminbi?

DS: Before the summer, at least $1 trillion of global reserves were expected to switch into Chinese assets when the IMF endorses the RMB as a reserve currency. On the other hand, if Beijing will float the RMB by the year-end, as promised, and the IMF will defer its decision to fall 2016, as current reports suggest, then both actions may occur after the Fed’s first rate hikes. That means greater economic uncertainty and market volatility in the short-term. Capital account liberalisation remains Beijing’s longer-term policy challenge.

 

TWFR: What does China’s surprise currency devaluation means for its economy and the world?

DS: The adjustment reflects China’s broader efforts to rebalance its economy and speed up reforms in financial markets. In the Xi-Li era, China’s growth model can no longer rely on net exports and investment. Consequently, Beijing is pushing rebalancing toward consumption and innovation, which is likely to take well into the 2020s. In the medium-term, this transition will ensure more balanced and sustained growth. In the short-term, these changes are not likely to occur without some friction abdominal volatility.

About the Author
dan-steinbock-webDr. Dan Steinbock
 is an internationally recognized expert of the nascent multipolar world. In addition to advisory activities, he is Research Director of International Business at India China and America Institute (USA) and Visiting Fellow at Shanghai Institutes for International Studies (China) and the EU Center (Singapore). He was born in Europe, resides in the US and spends much time in China and Asia. For more, see www.differencegroup.net

 

References
All references are the author’s past commentaries:

1. On the presumed and real reasons behind the RMB adjustment, see “What caused U.S.-Chinese market turmoil?” China-US Focus, August 26, 2015.
2. On the emergence of Chinese foreign direct investment, see “The Rise of the Chinese Multinationals,” The National Interest, Fall 2005 Asia Supplement; “New Innovation Challengers,” The National Interest, Jan-Feb 2007.
3. “The Chinese Market Mystery,” Project Syndicate, Jan. 10, 2013; “China’s $10 Trillion Market Explosion,” Roubini Global/EconoMonitor, June 24, 2015.
4. “The beginning of the AIIB epoch,” China Daily, June 29, 2015.
5. “Fears of impending interest-rate hike tarnish gold,” Shanghai Daily, Aug. 12, 2015

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