China has taken enormous steps towards internationalising its economy over the past five years, heralding significant advantages for the global economy and the potential for improved international relations, writes Michael Vrontamitis, Head of Trade, Product Management at Standard Chartered Bank.
To realise its potential, China will need to improve governance and market supervision, embrace private sector involvement and invite stronger international co-ordination. Corporate businesses and institutional investors that access expert advice and early advantage of emerging opportunities created by trade, currency and capital account liberalisation have the opportunity to create competitive advantage, diversify risk and maximise returns.
The journey towards internationalisation
The past five years have marked a remarkable period of progress towards RMB internationalisation as both a trade and investment currency. The offshore RMB market, with major centres in Hong Kong, Taiwan, Korea, Singapore, London and others, has few capital account restrictions, and companies are now permitted to sweep money on and offshore between affiliates. From an investment perspective, targeted investment schemes into the country, with specific country and individual quotas through QFII (Qualified Foreign Institutional Investor) and RFQII channels, the Mutual Recognition of Funds and Shanghai-Hong Kong Stock Connect programme, allow access to China’s securities markets. This access allows investors the opportunity to diversify risks and optimise returns.
Although there is still considerable progress to be made, the journey towards internationalisation is irreversible. The government has stated its objective that Shanghai will be a major international financial centre by 2020, and remains on course to achieve this, subject to managed convertibility of the RMB and further liberalisation of capital account restrictions. Within only five years, the RMB has already become one of the top five currencies globally for international trade, according to a Swift report published in July 2015, and second for trade finance. As a result, it is widely expected that the RMB will become a G3 currency by around 2020 when China’s economy is set to equal that of the US.
China’s journey has not been without its obstacles, as the recent slowdown in growth and the shocks to its stock and currency markets have emphasised. They have also demonstrated how international China has become with domestic economic issues impacting global markets. Although these have resulted in uncertainty and potentially disrupted short-term investment plans, they have demonstrated the resilience of the market. While the potential impact of these events on the speed and priority of ongoing reform is unclear at this stage, what is more certain is that these market shocks and lower growth figures are unlikely to dissuade foreign asset owners and asset managers from investing in China. This is due to China’s economic fundamentals and future potential remaining strong, but also in anticipation of the inclusion of A-Shares into benchmark indices and the IMF’s addition of the RMB into the special drawing rights (SDR) basket. Recent events demonstrate, however, that corporate and institutional investors need to adopt the same degree of risk oversight in China as in other regions and currencies, and ensure routine access to expert advice.
The next five years
Some of the next steps that we are likely to see in China’s liberalisation journey are likely to include a series of pilot capital account initiatives, initially in free trade zones and then potentially more widely. As with previous pilot projects, these are expected to be limited in scope initially, such as the introduction of two-way sweeping for corporations based in the Shanghai Free Trade Zone (SFTZ) in 2014. The ability to include onshore RMB in regional and global cash pools and repatriate Chinese earnings has removed a major obstacle to corporate liquidity management. The ability to achieve two-way sweeping has since been expanded beyond the SFTZ, and recently the eligibility requirements have been lowered, enabling more corporates to be able to participate in this pan-China scheme, and the net inflow quota has also been enlarged to five times bigger. In the future, some of these eligibility requirements and quota requirements could be further lifted up.
Key to China’s success in becoming a leader in global financial markets will not only be the liberalisation agenda, but domestic reforms to underpin it: strengthening governance and supervision, increasing investor protection and improving financial sector transparency. These reforms will need to include clear lines of accountability and support for key RMB payment mechanisms, and enhancing the credibility of ‘gatekeepers’ of governance and supervision, such as accountancy firms, auditors and credit rating agencies. For example, bankruptcy courts need to be entrenched into the legal system, rules for debtor-in-possession (DIP) financing laid out, stress test protocols defined for investment funds, and equal treatment of foreign creditors in bankruptcy situations articulated. To allow a healthy derivatives market to develop, a master agreement needs to be in place that is interoperable with the International Swaps and Derivatives Association (ISDA) to provide greater certainty over netting and encourage investor trust and liquidity.
While reforms to current cross-border investment channels are underway, foreign investors continue to be able to leverage proxy schemes including Stock Connect, the Mutual Recognition of Funds and RQFII, with Hong Kong continuing to develop as the offshore asset management centre and gateway to China. Similarly, corporate businesses have considerable opportunity both to leverage but also contribute to the liberalisation and reform agenda when working with a banking partner that has trusted relationships with regulators and the full spectrum of market participants.
Whatever the pace of liberalisation and the priority that is placed on each element of the reform agenda, the next five years as China moves towards its 2020 objectives will undoubtedly see enormous changes, creating uncertainty on one hand, and opportunity on the other for both domestic and foreign corporations and investors.
Treasurers and investors need to anticipate the intended and unintended consequences of a reform that will impact on how they manage working capital and plan their investment strategy. For example, a growing number of items, including commodities, are priced and settled in RMB. The Shanghai Gold Exchange announced in June 2015 that a RMB-denominated gold fix would be launched by the end of this year, or even sooner. This is a key development given that China is the largest producer and consumer of gold. Furthermore, the London Metals Exchange (LME), which has been acquired by Hong Kong Exchanges and Clearing Ltd (HKEX), is anticipating the future shift in the commodities market and now accepts cash collateral in RMB.
The true measure of the RMB as an international currency will be its use to settle transactions between counterparties where both are outside Greater China, such as between Singapore and South Africa.
While the growth of the RMB for trade and investment are essential steps in becoming a world currency, the third key element is its role as a reserve currency. While total RMB reserve allocations remain small at this stage at around 1.1% of the world reserves as of end 2014, the RMB is already held as a reserve currency by over 60 governments and sovereign wealth funds according to the PBOC, with both Asian and African central banks in particular recently announcing plans to increase RMB holdings. The UK government has also issued RMB-denominated debt to fund reserves.
The inclusion of the RMB in the International Monetary Fund (IMF)’s Special Drawing Rights (SDR), the credit accounts on which countries can draw in the event of financial stress is due to be discussed at the IMF meeting later in 2015, with a widespread expectation that the RMB will be included in the SDR basket by 2016.
In July 2015, the PBOC released a groundbreaking circular that liberalises central banks’, sovereign wealth funds’ and multilateral institutions’ access to the China interbank bond market. At the end of September, the PBOC further announced that these public sector investors may access the China interbank foreign exchange market. The combination of these developments makes the RMB an easier choice for public sector investment.
In reality the RMB is already being treated as a reserve currency and the real question one should ask of the inclusion of the RMB as an SDR currency is not whether it will be included, but what weighting it will receive.
Despite short term challenges, such as the recent devaluation and reverberations across global markets, the RMB internationalisation process and the opening of China’s capital account are fundamental to a rebalanced global economy and more sustainable growth. These developments will also help facilitate a more competitive, consumer-oriented economy. Overseas corporations and investors that take advantage of opportunities today, whilst taking a longer-term view, could gain potential competitive advantage, whilst benefiting from risk and investment diversification. Earnings on Chinese investments and other cash that has previously been “trapped” is increasingly becoming more readily transferrable, while income generated from other regions can be invested more easily in China.
Even so, there are inevitably barriers to the opening up of China’s capital account and the market and regulatory reforms that underpin it. The first is practical, given the size and complexity of the Chinese market and the number of competing priorities. The second is ideological, in that reformists need to continue to win support from more traditional party members to press ahead with reforms, as well as engaging transatlantic partners.
However, adopting credible institutional reform, non-discrimination and robust market supervision will be a key test of China’s ability and willingness to become a leader, rather than a participant, in global financial markets. By achieving domestic reforms, however, China has the opportunity to enhance stability in the financial system and build confidence amongst both domestic and international participants.
In this environment, Standard Chartered Bank plays a vital role in educating both Chinese and non-Chinese clients on emerging opportunities and working closely with authorities to understand and input to new rules and their practical implementation. Even five years ago, treasurers had few choices for cash and treasury management in China.
Today, informed decisions that leverage existing opportunities and anticipate future change can create financial and operational efficiency, and increase value for shareholders or investor clients. To achieve this, treasurers and finance managers need a clear short, medium and long-term strategy in China as the country moves up the value curve and consumer markets continue to grow.
Furthermore, by being proactive in engaging with leading banks and regulators, treasurers and investors have the ability to offer input to the detail and priority of reforms, and be part of early pilot schemes to gain early advantage.