Michael Cripps (Shanghai) and Philip Prowse (London), partners with international commercial law firm, Clyde & Co, explore the growing potential for the renminbi in international trade.
Recent events and regulatory changes suggest that China has both the opportunity and the willingness to pursue renminbi currency liberalisation more actively, with the ultimate goal of creating fully convertible renminbi that occupies a position of international importance commensurate with China’s role in global trade.
Part of the opportunity for currency liberalisation is provided by Chinese perceptions that the renminbi is currently closer to an ‘equilibrium’ level than in the past. At the National People’s Congress, Wen Jiabao noted both that China’s current account surplus has shrunk – 2.7% of GDP in 2011 compared with 5.1% in 2010 – and that expectations of future renminbi appreciation have diminished, gauged by prices in the non-deliverable forwards market.
The authorities also appear to be permitting greater currency flexibility. In the first quarter of 2012, volatility increased in the daily currency fixes against the US dollar and there is an expectation that the daily trading band may be widened from +/-0.5% to 0.75% or even 1%.
In addition to the economic opportunity, there is also a political imperative to pursue more proactive liberalisation. In 2009 China launched a pilot scheme for renminbi settlement of cross-border trade between five Chinese cities and Hong Kong and Macao. The scheme has been subsequently extended to cover the import of goods into China between any foreign and domestic companies and the settlement of exports of goods by Chinese companies with mainland designated enterprise status.
As a result, the proportion of Chinese trade settled in renminbi is growing rapidly – from 0.7% in the first half of 2010, to 9% a year later. Recent estimates place the current proportion close to 13% and HSBC has estimated that this could reach as much as 50% by 2015.
The volume of offshore renminbi trading has reached a critical mass where it is now in the Chinese regulators’ interest to proactively manage the liberalisation process. Otherwise they risk losing control of the market to overseas operators, such as western investment banks, seeking to profit from the arbitrage between offshore and onshore markets.
The development of the Hong Kong renminbi-denominated bond market, known as the “Dim Sum”, is one example of how overseas banks seek to innovate to exploit arbitrage possibilities. The desire to maintain control should ensure that the liberalisation agenda continues to be pursued in some form, irrespective of how reformist or conservative the complexion of the new Chinese leadership.
What will reform look like?
The form this reform agenda might take was outlined in February 2012 in a report from the statistics department of the People’s Bank of China (PBoC), the central bank.
The report was authored by a middle ranking official, which lends it the air of a “trial balloon”, which could subsequently be backed away from if circumstances changed, but nevertheless provides a window on current official thinking.
The report outlines a three-phase programme towards loosening capital controls. In the first step, envisaged to take place over the next three years, Chinese banks are expected to take more business from Western banks, which are constrained in their ability to lend in the wake of the global financial crisis.
In the second phase, with a three to five-year timeframe, there is an acceleration of overseas renminbi lending, particularly in support of trade deals. In the third phase, over a five to 10- year time horizon foreigners will be allowed greater freedom to invest in Chinese stocks, bonds and property.
While the pace of reform envisaged in the report is sedate, events on the ground are unfolding far more quickly. There is already evidence of Chinese banks expanding, for example, the assets of the Middle East arm of Industrial and Commercial Bank of China (ICBC), which was established in 2008 at the height of financial crisis, have grown almost 40-fold in the last three years.
Recent regulatory changes also illustrate progress on the third phase of liberalisation – to allow foreigners greater freedom to invest in China, using offshore renminbi funds. Offshore use of renminbi officially started in Hong Kong in 2004, to facilitate cross-border tourist spending and subsequently expanded to allow the issuance of renminbi denominated bonds in Hong Kong in 2007. The problem for holders of offshore renminbi deposits historically has been that there were no channels to repatriate the funds into China for investment, because of Chinese fears over hot money inflows.
Pace of change accelerating
In October 2011, two regulations from the PBoC and the Ministry of Commerce simplified and standardised the process of repatriating offshore renminbi for foreign direct investment purposes, which previously required prior permission from the PBoC.
Then, in December 2011, the Renminbi Qualified Foreign Institutional Investor Scheme (RQFII) was launched, which is an extension of the existing US dollar-denominated Qualified Foreign Institutional Investor programme, which permits investment in the Chinese A Share market. Once they have been authorised, RQFII funds may invest in certain approved types of onshore RMB financial instruments, including shares, bonds and warrants listed on stock exchanges and securities investment funds.
Further steps are also underway to establish new offshore trading centres for renminbi in addition to Hong Kong. London and Singapore are applying for designation as offshore centres and it is expected that London will receive official authorisation this year.
As part of this process, in January UK chancellor George Osborne signed an agreement with the Hong Kong Monetary Authority to look at clearing and settlement systems, market liquidity and the development of new renminbi-denominated products. London benefits from its position as the world’s biggest foreign currency trading centre, positioned in the European time zone, but outside the eurozone we expect that it will probably become the most important location for offshore renminbi trading.