China plays currency "long game"

20 May 2014

China is keen to end its dependence on the US dollar, but internationalising the renminbi can't be rushed, says David Mayes. 

When China's currency unexpectedly began weakening earlier this year, the country came under pressure from the United States and others to do something about it. Undervalued currencies are seen to give exporters an unfair advantage in foreign markets and since 2005 the Chinese government has been committed – officially, at least – to letting the renminbi (RMB) appreciate.

Given China's fast-growing economy and its healthy trade surplus, there seemed little reason for the renminbi to drop – even by a modest amount. Analysts suggested that its 3% fall since January 2014 in part reflected a desire by China's central bank to punish currency speculators. The exchange rate of the renminbi is currently set not by currency exchange markets but by the People's Bank of China, which defines the extent it can fluctuate in relation to the dollar.

There is also increasing talk of the renminbi eventually taking its place alongside the US dollar, the yen and the euro as a global currency, in keeping with China's position as the world's second-largest economy. At present the country accounts for about 12 % of world trade and 12% of global GDP but the renminbi comprises just 1% of global currency trading.

However, Professor David Mayes, of the Business School's Department of Accounting and Finance, says China's ultimate currency goal remains unclear.

"China has been arguing in favour of a composite world currency, but my guess is that they don't quite know where they should go. What they clearly don't want is a continuing dependence on the US dollar," says Professor Mayes.

China would like more pricing control over commodities globally to reduce exchange-rate risk because trading in US dollars shackles it to US monetary policy, he says. There are also persuasive domestic reasons for internationalising the renminbi. Following three decades of rapid growth, the Chinese economy is slowing and a more tradable currency would stimulate growth. However, achieving that would require modernising the financial system, and opening the financial markets to foreign investors. Doing this too quickly would risk exposing the country to destabilising inflows and outflows of capital.

"The main reason for not opening up a currency is the fear that it will lead to a mass exodus of wealth out of the country. This happened in 2007 when China liberalised with respect to Hong Kong. The result was a flood of investment in Hong Kong dollar assets."

The real issue is the degree to which people elsewhere will want to hold renminbi, says Mayes. In the next 10 to 20 years China is expected to become the world's largest economy and many analysts expect renminbi to become a reserve currency ahead of the euro.

"London is already trying to set itself up as the world market for RMB, and dim sum bonds – the foreign issue of RMB bonds – are to be issued there. They are already available in Hong Kong."

Part of the difficulty for China is the small number of financial assets that are able to be bought there, says Mayes.

The People's Bank of China now has 23 bilateral currency swap arrangements with foreign central banks, including New Zealand, that collectively are worth some RMB2.5 trillion. Early agreements were linked to trade and direct investment, but more recent ones appear more focused on promoting financial stability and cooperation. Nevertheless, says Mayes, a great deal more work on the development of financial instruments is needed.

Geopolitics also plays a part.

"China has regional ambitions. It is worried about the US, but it also wants to be liked by its regional neighbours. Many are relatively small countries, vulnerable to the standard problems of emerging markets – including the problem of a 'sudden stop', where lenders stop lending. That is where China can step in."

Analysts expect the renminbi to become fully convertible within the next two to three years which, among other things, will see a relaxation of rules on foreign ownership of banks, a freeing up of outward direct investment and fewer restrictions on individual foreign exchange purchases. Full renminbi convertibility is currently being trialled in the Shanghai Free Trade Zone.

The RMB is unlikely to challenge the status of the US dollar as the world's preferred reserve currency any time soon. But it has risen remarkably quickly as a trade and investment currency.

"China is playing a nice political and economic long game," says Mayes.

David Mayes

Until December 2017, David Mayes was Professor of Accounting and Finance at the University of Auckland Business School.

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