International role for renminbi more important than revaluation

What do you think people should be focused on right now with regard to potential exchange rate policy in China?
Market attention is now focused on the timing of a change in China's exchange rate policy and the potential size of appreciation of the renminbi when that happens. In the medium-to-long term, however, capital account convertibility and a greater role for the renminbi as an international currency are much more important developments to China and the world than whether the renminbi revalues by 2% to 5%.

We see two "anomalies" in China's economic and financial relationships with the rest of the world, and correcting these anomalies will be the main driving forces for a gradual liberalisation of capital controls in China and an increasing role for the renminbi as an international currency.

What are those anomalies?
First, there is a striking asymmetry between China's role as a major economic and trading power and its limited integration into global financial markets. China is already the world's largest exporter and is likely to become the largest importer in the next couple of years. However, cross-border capital movements, which naturally rise along with an increase in trade, are still restricted in important ways, particularly in relation to portfolio and banking flows. As a result, a large part of the capital outflows from China has been via the official sector, in the form of foreign exchange reserves, which account for about two-thirds of the country's total external assets. The official reserves are invested mostly in fixed income assets, leading to an imbalance in the risk-return profile of China's external assets.

Also, owing to the concentration of external assets in the government's hands, China's $2.45 trillion in FX reserves overstate the strength of the country's external capital; external assets are largely held by the private sector in most other countries. The Chinese government has started to diversify its external capital position by promoting direct investments and lending by the corporate sector. We believe more broad-based liberalisation is likely to gather pace over time as pressure from continued FX reserve accumulation builds.

Second, in contrast to China's importance in global trade and economy, the renminbi plays a very limited role in international trade and finance, and, hence, in the global monetary system. Among the four largest economies -- the US, the EU, Japan and China -- only China has almost all of its foreign trade denominated and settled in foreign currencies. The international use of a currency is ultimately determined by market forces, but in the case of the renminbi, policy restrictions on convertibility play a role. Once these restrictions are lifted, the renminbi is likely to become a significant international currency owing to the size of the Chinese economy. A large domestic economy allows economies of scale to be exploited and reinforced, broadening the scope for using a currency over a wider domain. Also, large-scale trade activities usually generate a large volume of foreign exchange transactions with at least one leg in the domestic currency.

China has taken some steps, particularly with regard to Hong Kong, to "internationalise" its currency...
Absolutely. The Chinese authorities have shifted from a cautious approach to an increasingly proactive stance in promoting the international role of the renminbi. The policy efforts started in 2004 by allowing Hong Kong banks to offer the Special Administrative Region's (SAR) residents renminbi services, including deposit-taking, exchange, remittance, and renminbi-denominated cards. The initial purpose was primarily to facilitate personal expenditures by Hong Kong residents on the mainland. Over time, with the close cooperation between the People's Bank of China (PBoC) and the Hong Kong Monetary Authority (HKMA), the scope of Hong Kong banks' renminbi business has expanded, and the objective of promoting the use of the renminbi outside China has become increasingly clear.

In 2007, financial institutions from mainland China started to issue renminbi bonds in Hong Kong, and in October 2009, China's Ministry of Finance sold sovereign bonds denominated in renminbi in the SAR -- the first sovereign renminbi issuance outside the mainland. In April 2009, the Chinese authorities announced an initiative to allow exporters and importers in a number of cities to settle cross-border trade in renminbi. And in February 2010, the HKMA announced further liberalisation measures designed to develop an offshore renminbi market. In particular, local banks were allowed to extend their business to all local companies, including the provision of renminbi credit. Also, restrictions are lifted on issuer, investor and amount of renminbi bond issuance in Hong Kong, provided no cross-border renminbi flows are involved.

Cumulatively, these measures will become increasingly significant. However, the pace of growth is restricted by the remaining controls on renminbi convertibility. Indeed, without full convertibility, it is difficult to see the renminbi becoming a significant international currency. Put another way, we believe renminbi internationalisation will be the main driving force for capital account opening and increasing convertibility of the renminbi.

What are other important drivers for convertibility of the currency?
The size of the financial market also matters. International currencies are usually associated with large, liquid and open financial markets. China's domestic financial market has grown rapidly in recent years, with its stock market capitalisation having exceeded that of Japan to become the largest in Asia. In the process of financial market development and liberalisation in China, Hong Kong plays an important role as a highly developed and very open international financial centre. The two markets will likely become increasingly integrated as capital account opening on the Mainland proceeds.

Overall, we expect significant progress to be made in achieving renminbi convertibility in the next 10 years. As that happens, and as China's economic clout grows, we are likely to see the renminbi become a significant international currency. That will have a wide range of implications for China, Asia and the world. One immediate implication is that the renminbi exchange rate will become increasingly flexible, likely moving to a truly floating regime. Internationalisation by itself does not entail a strong or weak currency, in our view. China's financial sector will play a much bigger role in the global monetary and financial system than today. Also, Hong Kong will likely grow rapidly to become a major international financial centre.