All reform roads lead to yuan internationalisation

Is China doing enough to “reform”, or is it simply re-treading the well-worn path of conservatism? In all the cacophony, it is easy to lose sight of what China’s long term strategic goal is — which is essentially to push for internationalisation of the yuan.

With a combination of audacious and cautious steps, Chinese policy makers are using their own brand of pragmatism to achieve its ends. The strategy for internationalising the currency is two-fold: increase the supply of yuan overseas, make the yuan an investible currency and push for it to be a reserve currency.

Withstanding pressure

There’s a clear pattern emerging on how China is more intent on getting the world to increasingly use the yuan for real trade settlement. While foreign economists pressure China that opening its capital account is a pre-requisite to internationalising its currency, domestic policy-makers think otherwise.

To increase the supply of yuan overseas, China announced a pilot project, in 2009, allowing trade to be settled in the Chinese currency. After expanding the pilot a number of times, the amount of trade settled in yuan increased tremendously from just 3 per cent in 2010. Now, almost one fifth of China’s total trade is settled in yuan.

This month, the China Securities Regulatory Commission expanded the said scheme — the RQFII, or Renminbi Qualified Financial Institutional Investor — to include London and Singapore as well. A 200 billion yuan (Dh120 billion) currency swap agreement between UK and China became a landmark event, signalling a big step in China’s road to currency internationalisation.

For a number of years, China had dipped its toes only in Hong Kong which was its major offshore yuan market. And since 2009, the amount of yuan deposit accounts in Hong Kong has steadily risen to almost 700 billion from 63 billion. In June, Taiwan-based financial institutions were also allowed to invest in mainland capital markets.

The most obvious benefit of the yuan trade settlement for China and its trading partners is the reduction in currency risk caused by fluctuations in the value of the US dollar against the predictability of the yuan.

More needed

However, trade settlements alone will not make the yuan an investible and reserve currency. At the end of the day, this requires more stable domestic financial markets and progress on capital account convertibility. China cannot ignore the fact that to be acceptable, foreign investors should be comfortable holding large amounts of its currency.

In order to make holding the yuan more attractive, China does need to open the capital account to allow for more free investment of the currency. Domestic banks must be strengthened to a point where they can manage the impact of capital flows. China needs to stand the test of being able to absorb large capital inflows without creating the risk of asset bubbles.

In the previous years, the government dealt with excess inflows and their inflationary impact through strict administrative controls. Significantly, the new government, has taken the opposite approach, now proposing a relaxation of controls on outflows.

Caution

Policy-makers are showing a sign of greater maturity and confidence in their ability to handle large capital inflows by extending yet another quota — which is the QFII or qualified foreign institutional investor scheme. This quota allows foreign investors to convert dollars into yuan for domestic investment. Recently, this quota was nearly doubled to $150 billion from $80 billion. The QFII programme was established in 2002 under which foreign institutional investors were allowed to invest in the mainland China markets in a very limited manner.

As China’s economy grew, foreign investors showed a stronger interest in investing in the mainland capital market, but the government kept the proportion of foreign capital in the A-share market remarkably low. As of now, the value of shares held by foreign institutional investors stands at a mere 1.6 per cent of the A-share Shanghai market.

Conventional wisdom says foreign investors can act as a stabilising force in the domestic equity markets and provide a new funding source. But the question remains: Will China take the full plunge, allow more space to foreign funds and accelerate the opening up of China’s capital markets? The answer probably is “not just yet”.