Six Questions Regarding the Internationalisation of the Renminbi
HKEx Chief Executive Charles Li has written an article in Chinese that covers six key questions about the internationalisation of the renminbi (RMB). The internationalisation of Mainland’s currency has become one of the most widely discussed topics in Hong Kong’s finance industry. As a result, Mr Li wanted to offer his views on the subject and explain why he thinks the internationalisation of the RMB is an important issue for the industry and Hong Kong. The following is a summary of the article (the article has been posted in the Chinese-language section of the HKEx website).
Six Questions Regarding the Internationalisation of the Renminbi
HKEx Chief Executive Charles Li
21 September 2010
Internationalisation of the RMB has been one of the hottest topics in Hong Kong’s financial press recently. It is also a major component of HKEx’s 2010-2012 Strategic Plan. Through the following discussion, we hope to provide some perspective to this important development particularly in relation to how it is relevant to our markets. We try to address the following six questions:
1. Why is there a need to internationalise the RMB?
2. Is RMB internationalisation feasible and realistic in the current environment?
3. What is the likely roadmap of development?
4. Why Hong Kong can be an offshore RMB centre in this development?
5. What are the commercial opportunities potentially available to Hong Kong?
6. What does Hong Kong need to do to prepare itself?
Question I: Why is there a need to internationalise the RMB?
1. It will help China preserve the fruits of its development to date
There is a need for the Mainland to reduce the size of its foreign exchange reserves to minimise the impact of international financial market volatility on its economy. If the RMB assumes a broader role as a currency for trade settlement between the Mainland and other countries and regions, Mainland enterprises will have less foreign exchange exposure, and the Central Government will face less pressure in managing its foreign exchange reserves.
2. It will help China balance its growth, particularly relating to its trade
There is indeed an imbalance between investment and consumption in the Mainland economy, and between exports and domestic demand. The RMB internationalisation will not directly remove the imbalance, but it has a significant role to play in controlling the growth of the foreign exchange reserves, easing the revaluation pressure on the RMB and increasing coordinated development in economic and trade balance between the Mainland and its major regional partners and resources providers from outside the region.
3. It will help China achieve greater influence in global political and economic affairs
As the world’s second largest economy, China does not have proportional say and influence in international economics and finance. To a large extent, this is the result of a currency that lacks international standing.
The Mainland’s trading partners’ acceptance of the RMB as settlement currency will expand the Mainland’s influence in international trade and increase the autonomy and flexibility of the Mainland’s currency policy. Every move towards making the RMB an international reserve currency results in a greater say for China in the geopolitical arena.
Question II: Is RMB internationalisation feasible and realistic in the current environment?
The internationalisation of the RMB is likely to evolve in three stages in gaining international acceptance gradually to become a currency of trade (5-10 years), a currency of investment (10+ years) and ultimately a reserve currency (20+ years). The RMB internationalisation discussed here is exclusively for the first phase. As of today, trade settlement in RMB has amounted to RMB91.6 billion and it continues to grow rapidly, despite the current capital account and convertibility constraints. So the issue is not whether the RMB will become an international trade currency. The question is how fast we can achieve it.
The consensus is that the increasing internationalisation of the RMB is feasible and can be achieved without the opening of the capital account as long as it is implemented along the following three lines: (i) limited and gradual, (2) controlled and through pilot experiment; and (3) offshore. The primary objective is to push the initiatives steadily, with minimum impact on the onshore capital markets and capital account control.
Question III: What is the likely roadmap of development?
It is important to bear in mind that the RMB internationalisation we are focusing on is only for the medium-to-long term objective of the RMB becoming a trade settlement currency (5-10 years). The issue is how to push for the very limited opening of the capital account, not for its own sake, but for the purpose of stimulating use of the channels already open for RMB inflows and outflows for trade settlement. We are likely to see three key developmental stages (please see the attached diagram).
To understand the different challenges in these three stages, the following analogy might be of some help. If we see RMB flows as water and RMB products as fish, the logic will be clear. Fish do not exist where there is no water and they cannot survive if the water is stagnant. Without nutrients in the water, fish don’t grow. The nutrients, representing returns on RMB products, can only come from the home market. That’s why the offshore RMB must be allowed to flow back, at least at the initial stage.
Right now, RMB can flow out of and back into the Mainland on a massive scale with little restriction as long as they are for trade settlement purposes. However, few people or companies are willing to take RMB as few investment opportunities exist offshore. Without a substantial outflow of RMB through trade, there will be no substantial inflows of RMB either. There are now only tricklings or even semi-arid outflows and inflows under the trade account. The interim objective before the capital account is fully open is how to stimulate these outflows and inflows.
Stage 1: Formation of the offshore RMB market
The RMB began to trickle out of the Mainland since early 2004, largely through the daily permitted conversion of RMB20,000 by Hong Kong residents, resulting in an overall accumulation of approximately RMB80 billion by the middle of this year. During this early period, the “water” was largely stagnant and the products were small, made up mainly of savings deposits, remittances, and exchange and credit card services. These products offer relatively low yields. The accumulation was driven largely by anticipated RMB appreciation.
A breakthrough only came in July this year, when the signing of the Supplementary Memorandum of Cooperation on the Expansion of the RMB Trade Settlement Scheme enabled the free circulation of the RMB outside the Mainland. Recognising the need for RMB products to access the domestic yield base, efforts were made to allow the RMB to flow back to the Mainland. Initial measures included permission for offshore banks to invest their offshore RMB holdings in the onshore inter-bank bond markets, providing the offshore RMB products potentially higher yields. The widely-anticipated mini-QFII programme is a further example of such flow-backs being actively considered.
In sum, 2010 is the formation phase of the offshore RMB market. During this phase, products are largely retail in nature, offer lower yield, and are mostly bank, insurance and mutual funds related. Permitting offshore banks’ greater access to domestic yield sources will allow offshore banks to offer products with more favorable terms which will in turn attract even greater demand for RMB offshore.
Stage 2: Growth of the offshore RMB market
In the growth stage, the primary objective is to develop sufficient quantities of products that are of sufficient size, generating sufficient returns to support much more active secondary market trading that will serve to increase the attractiveness of the RMB to the Mainland’s trading partners so that flows of RMB under the trade account can grow substantially.
High-yield products, such as equities, are essential because they tend to trade more in the secondary markets. This is important as trading will help produce a much greater multiplying effect of the RMB already offshore. One RMB in a held-to-maturity product creates only one RMB of liquidity offshore; one RMB in a product that trades 6-7 times during its life will create much more RMB liquidity offshore. In the age when RMB liquidity offshore is limited to start with, more actively traded RMB products generate critical leverage for the growth of the offshore RMB liquidity.
To ensure the successful launch and trading of such higher-yield products, two special arrangements might be needed to ensure at least initial success: (i) liquidity support and (ii) un-restricted flows-back to the Mainland.
(1) Liquidity Support
Before the market gains momentum, existing offshore RMB liquidity will be a constraining factor for any high-yielding products. Before launching such product, an issuer must ensure that neither the launch nor the trading would be negatively affected by the lack of RMB liquidity. Policy makers need to consider providing the offshore market with a critical mass of initial RMB liquidity support product launches. Possible sources of liquidity include:
1. Easier corporate access to RMB swap arrangements between the People’s Bank of China and central banks of the Mainland’s trading partners;
2. Larger RMB trade financings by Mainland commercial banks;
3. Permitting Mainland banks to use on-shore inter-bank lending to facilitate temporary RMB liquidity needs offshore;
4. Permitting greater RMB outflows by Mainland companies;
5. Permitting the Mainland insurers and asset managers to invest RMB offshore on a pilot programme; and
6. Permitting Qualified Domestic Institutional Investors to invest RMB offshore.
In addition, special-purpose liquidity pools could be created to provide necessary RMB liquidity for the launch and trading of designated products on a pilot basis. Essentially, investors already with RMB could directly subscribe for or trade products in RMB; while investors who did not have RMB at the time but wished to immediately subscribe or trade could tap into the RMB liquidity pool with Hong Kong dollars, provided that when they trade out of the position, they exited the pool with Hong Kong dollars, returning the pool to its original size, thus avoiding the pool becoming an unlimited drain of RMB liquidity from the source of the pool. Such an arrangement would ensure that public offering or trading of products would not be affected by the potential shortage of available RMB.
(2) Foreign Direct Investment (FDI) flow-back to the Mainland
Offshore issuers of any higher-yielding RMB products need their proceeds to be able to flow back to the Mainland in order to access the returns they need. Efforts are needed to convince the policy makers to treat RMB FDI from offshore product issuers differently as the inflow itself would not create any incremental pressure on onshore foreign reserve accumulation. An entirely different regulatory regime needs to be adopted for the RMB inflow.
Most of the suggested approaches discussed above will require, on the surface, adjustments on the capital accounts. The key distinctions are that: (i) the primary objective is not to seek the opening of the capital account per se, but the increased use of the already open channel for RMB inflows under the trade account; (ii) all the measures proposed can be undertaken under a limited scope and on an experimental basis; (iii) the policy makers maintain management of all the “tabs” of the various flows and can monitor and adjust them anyway they see fit; and (iv) once the RMB is offshore, whatever activities take place there have very limited impact on the domestic currency and capital markets.
The most important point is that higher-yield and more actively traded products are essential tools of leverage to stimulate RMB flows through the two large, open and yet dry canals of trade settlement.
Stage 3: Maturity of the RMB offshore market
Once Hong Kong’s offshore RMB investment markets reaches a critical mass in terms of size, liquidity and product diversity, the number of the Mainland’s trading counterparties choosing to settle their trades in RMB is likely reach a critical mass as well, creating substantial amounts of RMB outflows and inflows. Out of such natural trade-driven RMB flows, sufficient RMB liquidity could settle on a more permanent basis in Hong Kong, thus rendering many of the liquidity-stimulating measures discussed in Stage 2 largely unnecessary and irrelevant. All of these will be achieved, one must be reminded, without a substantial opening of the capital account.
Question IV: Why Hong Kong can be an offshore RMB centre in this development?
Hong Kong has three unique characteristics, making it the ideal place for this historic experiment: (i) it is “One Country”, (ii) it is “Two System” and (iii) it is already one of the most important international financial centres.
First, it is under Chinese sovereignty and is trusted by the Central Government. It is best to start and try out new things in a political system and geographical region where risks are more easily monitored and managed without undue geopolitical concerns. Over the past 20 years, Hong Kong and the Mainland have maintained a high degree of financial cooperation and have thus established a comprehensive system for regulatory coordination that is built on mutual trust, mutual aid and mutual benefit.
Second, “Two Systems” means that the experiment is undertaken in a politically separate, economically different and geographically segregated environment. Such separation is needed to largely maintain the current status quo on the capital account and to ensure that any possible negative impact of the experiment can be successfully “walled” off from the domestic market.
Third, Hong Kong has been serving as the Mainland’s gateway of trade for decades and it is already a leading international financial centre, thus providing the Mainland’s trading partners the political, economic and legal infrastructure and credibility to experiment with the use of the RMB offshore.
Hong Kong may be the best place for this grand experiment, but we shouldn’t be assuming we are the only place. Confidence, we should have; complacency, we must avoid.
Question V: What are the commercial opportunities potentially available to Hong Kong?
The business opportunities are expected to come in stages.
The earliest beneficiaries of RMB internationalisation will be the banks, insurers and asset managers; products will begin with these institutions as well. This is essentially the redenomination of Hong Kong dollar assets into RMB.
As more flows-back to the Mainland are established, more higher-yield products will emerge, such as treasury bonds and investment grade corporate bonds. The RMB-readiness programmes will initially mean costs for financial institutions, but as infrastructure begins to be built, more products will find their way into the markets. By and large, however, commercial benefits from RMB internationalisation will still be relatively limited.
At this stage, Hong Kong’s financial market will began to see visible accumulation of RMB liquidity, with growth in product range, product sizes and yield profiles. Trading in the secondary market will also become more active. Products in two key areas will be worth watching for: trade finance and exchange traded products.
As overseas RMB is allowed to be invested in the Mainland’s inter-bank bond market, overseas banks can immediately introduce trade finance services that are larger in scale and more attractive in terms. This will accelerate the process in which the Mainland’s trading counterparties begin to use RMB. This will not only bring new vitality to the Hong Kong banking sector but more importantly, it will begin to bring incremental RMB flows from the trade settlement accounts, not the capital accounts.
With liquidity support in place and easy RMB FDI passage back to the onshore market, exchange-traded products are likely to emerge both in terms of number of issues and size. Corporate bonds, equities, and even derivatives could be listed gradually. These products will trade much more actively, producing strong multiplier effect, generating even more RMB liquidity. Hong Kong’s capital market will also become beneficiaries of this experiment.
In summary, acceleration will be the key theme, with the central objective focused on pushing trade settlement in RMB toward critical mass. The earlier we reach the “tipping point” of offshore RMB liquidity, the earlier we will begin to enjoy a full-blown offshore RMB markets without the artificial support or boosting measures discussed above.
How large the benefits of the RMB internationalisation can be for Hong Kong at this stage will be anybody’s guess. One thing we know for sure: the benefits will be big. Last year, only about 1 per cent of the Mainland total trade volume was settled in RMB. If 10 per cent of that could be settled in RMB, with the anticipated RMB inflows from other channels, the scale of Hong Kong’s offshore RMB market could exceed RMB 2 trillion in the not too distant future. According to a recent Goldman Sachs report, the amount of RMB in Hong Kong will reach US$521 billion (i.e., RMB3.5 trillion) in the next five years. This will account for 31.6 per cent of the total deposits of the Hong Kong banking system.
In short, this is a business opportunity that is calculated in trillions.
Question VI: What does Hong Kong need to do to prepare itself?
In HKEx’s Strategic Plan 2010 – 2012, we recognise that “the opportunities available to us from our nexus with the Mainland are global, not just regional, in scale and scope.”
As such, what should we do now? Very simple, we need to be confident and we need to be prepared.
We need to be confident about ourselves, about Hong Kong’s core competitive strengths and we need to be confident in good times and bad. When we are confident, we will not become overly concerned that developments in Shanghai, Shenzhen or other parts of the Mainland will become dilutive to us. The more China’s onshore markets develop, the better it is for Hong Kong.
We need to be confident in the internationalisation of RMB. It is true that this experiment will likely to be highly complex, challenging and completely without precedent. But China is already at a historic crossroads and this bridge will need to be crossed one way or another.
Some argue that this whole experiment is something in the distance, with very little tangible benefits in the short run. True. But we should not lose sight of the fact that by presenting China a strategic value proposition for the longer-term, Hong Kong will likely be able to lock up all the key short-term economic “collateral benefits”. Therefore, even a short-sighted businessman should find solid reasons to be excited about this opportunity.
As we consider the enormous potential business opportunities, each and every person in the financial services sector should ask themselves: “Am I ready?”
Many things need to be done: investing in IT infrastructure, improving market structures, enhancing the competitiveness and robustness of our rules and procedures, and developing new asset classes and capabilities. Investing is like building a road, something you have to do to get the traffic, you cannot wait for the traffic before acting.
RMB internationalisation is a massive undertaking which will probably take two generations to complete. It will be complex, challenging and unpredictable. The six questions we ask ourselves now are only the beginning of a long journey.
Hong Kong offers China a unique opportunity and place to undertake this great experiment. In that sense, Hong Kong is a blessing for China. By the same token, this opportunity is a blessing for Hong Kong.
Our collective goal is to begin this historic experiment in earnest. We need to do it right, as failure will set us back. We also need to do it at the right time, and that time is now. China needs this to work and we need to make it work. This is a great responsibility for our generation; we do it right, there will be great opportunities for generations to come.