China’s economic policy has been oriented towards financial integration and the internationalization of the renminbi for a long time. In an international context dominated by risks and uncertainty, accessing the global financial market can be a challenging task for an emerging economy such as China, whose economic policy is now ambitiously pursuing other policy goals.
While seeking to bring the renminbi to the status of an international currency, the People’s Bank of China, the issuer of the national currency, has so far dealt cautiously with the goal of internationalizing the national currency. China’s prudence has entailed testing and experimenting new currency regimes in confined areas before going global with the Renminbi.
The convertibility of the renminbi is a medium term goal formally included in the 12th Five-Year Plan (2011-2015). The interest in expanding the Chinese economy’s degree of financial openness, however, harks back to the 1990s. In 2002 the Chinese authorities introduced the Qualified Foreign Institutional Investors (QFII)1, which allowed foreign investors to buy and sell stocks denominated in renminbi and softened constraints on cross-border capital flows. This policy was followed in 2006 by a program called Qualified Domestic Institutional Investor (QDII)2, which afforded domestic financial institutions the opportunity to buy and sell securities in foreign markets. These two policies are now part of a strategy of gradual relaxation on financial capital flows across the mainland’s border. Moreover, as part of its relaxation strategy on the flow of financial capital, Beijing has granted foreign investors and official financial entities a greater access to the renminbi interbank bond market.
The Chinese authorities have also used Hong Kong for their experimentation with the internationalization of the renminbi. In July 2009, Beijing removed constraints on direct settlement of renminbi transactions for China-Hong Kong cross-border trade. The impact has been positive thus far, with, for instance, more 800 billion renminbi worth ($125 billion) of trade cleared in the Chinese currency in the first half of 2011.
It is now legitimate to ask whether these developments pose a serious test to China’s capital control regime.
The European experience in the 1960s and 1970s is revealing in this respect. European monetary authorities were perturbed by the sudden rise of the Eurodollar deposit market in the 1950s, and even more so throughout the 1960s when that market increased so tremendously that it became a source of troubles for the central banks of the Eleven (The Group of Ten countries plus Switzerland, which joined in 1964). Eurodollar markets had the ability to escape the control of European monetary authorities, challenged the national credit policies and frustrated governments because national private banks had the possibility to raise funds abroad.
Most governmental officials bemoaned that their central banks had become “prisoners of the market” (the expression was coined by André De Lattre, deputy Governor of the Banque de France in the 1970s). The growth of Eurodollar markets frustrated European countries’ central banks in different ways: It weakened the monetary powers of central banks; it reduced the control over the supply side of their domestic money market; it impacted the structure of national interest rates; and it permitted investors to easily circumvent capital controls wherever they were in force.
Is there a risk that the People’s Bank of China faces a similar situation in the not-too-distant future? The odds are quite low, as suggested by the following considerations.
First, recent projections suggest that the size of renminbi offshore deposits as a percentage of mainland deposits for the period 2010-2020 will be significantly smaller than the amount of Eurodollar deposits as a percentage of U.S. deposits for the period1963-1973. The damage the Hong Kong renminbi offshore market could inflict on China’s banking system would therefore be smaller than the one the Eurodollar market had on European banks in the 1960s and 1970s.
Furthermore, the European monetary authorities’ control over Eurodollar markets in the 1960s was far less strict than the level of control Chinese authorities seems to have today. For example, banks in Hong Kong can extend credit to clients in offshore renminbi, but high bank reserve requirements (fractional-reserve banking) put limits on credit growth rates. They are also subject to agreements with the Chinese authorities on the amount of interest payable to clients’ deposits. All this means that, while the Eurodollar is a bona fide dollar, a mainland Chinese renminbi is something different from an offshore renminbi.
According to recent studies, controls on capital movements in China are still strictly applied (Guonan Ma and Robert McCauley, Do China’s Capital Controls Still Bind? Implications for Monetary Autonomy and Capital Liberalization, BIS Working Papers No 233, August 2007). The Chinese monetary authorities are clearly seeking to control – and slow down – the internationalization process of their currency. While it is true that a greater use of the renminbi on international markets will require more flexibility at fixing its exchange rate and further relaxation of capital controls, the Chinese seem well aware that the stability of their domestic banking system is at risk because of an increasing exposure to financial flows from abroad.
Achieving capital convertibility, however, will require Chinese monetary authorities to lay down some conditions that are still not met: The establishment of a robust financial sector with a proper corporate governance in banks and other financial institutions; the creation of a supervisory, regulatory and crisis management framework, supported by credible mechanisms to control liquidity and a fully flexible exchange rate regime.
It should be noted here that the enforcement of the strict capital control regime has so far protected China against nefarious financial disruption, such as the 1997/98 East Asian financial crisis and the international financial turmoil of recent years. However, apart from investing their money in the real estate market, the regime offers to Chinese customers a very limited range of financial options. The maintenance of controls also hamper China’s endeavor to enhance the international role of the renminbi. In effect, what is the incentive for foreign investors to hold a currency if they cannot invest it in its country of origin.
A joint report of the World Bank and the Development Research Center of the State Council of the People’s Republic of China (China 2030: Building a Modern, Harmonious, and Creative High-Income Society), released in February 2012, reminds the Chinese authorities that full capital liberalization in many European countries was achieved only nearly 15 years – and in some cases 20 years – after the collapse of the Bretton Woods system in 1973.
Beijing has many reasons to privilege a prudent approach during the transition from a capital control regime to a more open financial and exchange rate system. With more open financial markets, a rise in non-performing loans and bad assets would jeopardize a system that has otherwise served China’s economic interests well. It is doubtful that the Chinese banking system is fully prepared to face the challenges posed by competition from better protected foreign banks.
The Bank for International Settlement (BIS) came to this conclusion in a recent study on China (Robert McCauley, Renminbi Internationalization and China’s Financial Development, BIS Quarterly Review, December 2011). The BIS argues that the best way to bring down the risks stemming from more financial openness and better access to the domestic market is through the creation of a preferential route, such as Hong Kong.
The internationalization of the renminbi will definitely have positive effects on the Chinese economy and society in the long term. The intensification of the use of the renminbi to determine the value of China’s assets will help reduce fluctuations in the dollar-renminbi exchange rates, which can be quite detrimental to domestic stability. Caution is needed, however, as the risk of a serious destabilization of the banking and financial structure, which remains in fragile conditions and is poorly developed, is very high.
This article appeared at ISPI Online (PDF) and is reprinted with permission.
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