Chinas Financial Market and RMB Internationalization

1. Introduction to forex market

Foreign exchange is a virtual place where different currencies are traded.  For foreign business or trade to be conducted, there must be an exchange of currencies. For instance, a US based company seeking to purchase supplies from Germany will need to pay for the supplies in Euros.  The US based company is required to exchange its US dollars into euros. The case is similar for travelling which is a common example that requires FX. An American tourist to Kenya in Africa will not pay in USD to see the migration of wild beasts as the dollar is not the local trading currency. The USD must be exchanged in the local currency.  Forex is the most liquid and largest market in the world because of the never ending need to exchange currencies. 

Brief history of exchange rate in china

Strong currencies have a universal meaning such that they are basically convertible or can trade freely like the USD.  China has been and is still on a quest to make the RMB a global currency. Here is a brief history of the foreign exchange system in china. 

1988: setting up of an exchange swap center all over China to permit firms to trade in the RMB at a rate that reflect the market demand.

Early 1994: Unification of the dual exchange rates. This was done by harmonizing the swap center and the official center rates which saw the RMB reduce by 33% vis–à–vis the dollar in just in one night.

Mid 1994: Setting up of an interbank currency market and the central bank stepped in to stabilize the RM because it was stagnant and headed towards further depreciation.

2000: The RMB widens by up to 10 points against the dollar (from 8.2760 to 2.800).

2001: Joining of WTO and pledge to slowly adjust the currency regime. 

2003: Huge trade surplus between china and the US puts Beijing under pressure to allow the rise of RMB to balance global trade.

2005:  The RMB revalues by 2.1 percent and the central bank names the Euro, dollar, Korean and yen as main currencies. 

2007: The RMB daily trading band widens from 0.3 to 0.5 against a dollar. 

2009: The RMB tests internationalization as some regions are allowed to use it in paying for imports and exports.

2012: RMB hits a high of 6.2884 against a dollar.

2012: All forms of businesses are allowed to trade globally with the RMB. 

2. Internationalization of the RMB
   1. Introduction

Factors that pushed china to seek independence from the dollar include the mortgage crisis in the United States, stagnation of the Japanese economy and debt crisis in the zones that are dominated by the Euro. China has been on a constant promotion of internationalization of the RMB and on larger perspective, it can now be considered a global currency and specifically the fifth largest currency globally that can be used to settle international payment. The government of china has put in place various strategies to ensure that the RMB goes global. During the 13^th 5 year plan, china highlighted promotion of RMB to circulate in the global market as a main agenda.  Chinas vision to internationalize the RMB is aligned in the efforts to flood the market with RMB debts. By insuring the RMB dominated bonds, there will be increased currency demand and greater liquidity injected in international market. 

2.2. Internationalization of RMB through offshore Dim Sum bond market

China can enrich its financial structure by developing the offshore and onshore RMB markets. Foreign investors have the ability to give out RMB dominated bonds and inject liquidity in it. By so doing, the use of RMB as investment and trade currency will increase. China has put in place initiatives that are aimed at revising the capital control, therefore, increasing the liberalization and convertibility of the RMB. The establishment of RMB market in places away from China i.e. Hong Kong can be termed as an experiment of the implications of attaining convertibility of the RMB. 

Dim Bonds can be classified into certificates of deposits and bonds.  The difference between the two lies in the tenors such that bonds have tenors longer than 5 years while Certificates of deposits have shorter tenors usually less than 5 years (Richelson and Richelson, 44) . By 2013, china had more than 70% of its Dim bonds as certificates of bonds since investors prefer short term tenors over long term ones. The main reason why investors prefer this kind of investment is to guard against possible risks resulting from foreign exchange fluctuations. China is therefore attempting to make bond investments larger by developing the yield curve for longer tenor bonds.  In the recent past, there has been a clear indicators of growth on total returns on Dim Sum bonds. 

Establishment of Hong Kong offshore market benefits that ultimately internationalize RMB include utilization of cross border arbitrage, opening access to the offshore RMB funds and setting up of RMB bond market yield curves. Issuers can hedge against liabilities as well as operational expenses by raising capital though Dim Sum bonds when they have offshore subsidiaries (Thomas, 95).  In addition, they can get access to low funding costs unlike onshore banks loans. From another perspective, investors can create varieties of portfolio to enter the Dim Sum Bond Markets. In case the RMB goes higher than the dollar, investors will achieve higher yields. 

In an attempt to attract foreign investors who are to increase offshore RMT activities, China has implemented several strategies such as initiation of bilateral currency swap deal with several countries. Through this deals, china can exchange huge sums with countries whose currency value is the same and then reverse when they mature. This strategy minimizes limitation on capital exchange and control. By so doing, china is setting itself free from dependence on the dollar. In case there comes a shortage of the dollar, china will ease the trade tension by initiating exports using RMB. This investment strategy and deals have worked for china because there is a stable increase in the numbers of non-resident deposits. The figures doubled between 2011 and 2014.

Fig. Non-resident deposits in RMB 

In 2014, china officially tapped into the Eurozone by launching RMB dominated bonds. Before the official launch, RMB had already started expanding into the zone as witnessed in Luxemburg, Switzerland, Frankfurt and London. The launch of RMB in the Eurozone was a huge step in internationalization of RMB and prove of commitment. Besides showing of confidence, there is evidence of acceptance of the RMB in the Eurozone by that fact that it was successfully launched. Since the currency was received positively, there are prospects of seeing it become a major FX trader globally. 

2.3 Internationalization of RMB through panda bonds

Panda bonds are foreign issued and is an alternative for foreigners to source funding to be used in capital expenditure and any other projects. RMB is now becoming available for international investors. Currently, panda bonds are experiencing hardship but in the long run, when they become huge, they will have appreciable benefits. Current panda benefits include enabling foreign investors to access funds at low interest and diversified risk of Forex(Yu and Gao, 105).  The low interests are due to monetary surplus at the Peoples Bank of China coming from interest rate cuts and reserve retirement ratio.  Panda bonds enable both domestic investors and foreign issuers to have a survival advantage in the case of negative balances in the FX conversions.  Foreign issuers with onshore subsidiaries can use their panda bonds to survive the FX risks. Onshore RMB funds will benefit issuers who operate with RMB liabilities because they can reduce associated FX conversion risks.  The panda bond issuers consists of very large investors and corporations who buy the RMB dominated bonds as a way of hedging over their RMB liabilities and this has been proven to eliminate the associated FX risks. China benefits from this kind of trade as it promotes the demand for panda bonds eventually increasing the convertibility of RMB hence its internationalization.  Developing the panda bond market helps RMB to internationalize by not only increasing the global acceptability and desirability of the currency but also but also by effectively increasing the effectiveness of platforms that raise capital on long term basis (Yu and Gao, 120).  With the inclusion of the RMB the SDR basket, china should carefully revise its capital accounts so as to pull in massive foreign input. 

3. Challenges facing RMB internationalization

Internationalization of a currency has to come with ability to support trade with that currency, to support with that currency and then to be acceptable as reserve currency by other nations. With RMB, global trade can be carried out using this currency however, the percentage of RMB dominated exports is lower than the other international currencies such as the dollar. The RMB exports cannot go past one fifth of the entire trade volume (Yu, Li and Xue, 56).  China has tried to facilitate trade so as to increase its RMB dominated trade percentages by availing RMB swap lines in various countries but the lines are insufficient.  RMB therefore can be facilitate trade but to limited extends

Investment flows in and out of china are not wide but they have managed to issue debts in RMB in other countries as we have discussed above with the RMB dominated Dim Sum bonds in Hong Kong.  However, the way capital flows cannot be matched with what other countries have. China’s assets and liabilities are smaller compared to the G20’s average GDP.  Just like trade, investment can be done in RMB. However, not all types of investments. Some still have a very long way to go considering the time required to hit the average GDP of the G20 is much. 

Fig: Global Reserve Makeup as of Q4 2016 (Billions USD); Source: IMF

According to IMF, the illustration above shows that china RMB reserves are lower than those of the dollar and euros globally (Lee).  However, there are plans to increase the use of RMB globally. Despite current limitation of the RMB as a reserve currency, it is in the SDR basket which makes it optimistic to see the RMB level the euros as a reserve currency soon. 

4. Conclusion

Despite open and massive challenges in the Internalization of the RMB, many which arise from the ongoing financial repression and depreciation pressure, china is not relenting in the push to internationalize the RMB.  One of the greatest projects that will boost the spread of RMB once complete is the One Belt One Road although the ventures are funded using dollars (Bradsher).  If all the industrial and trade link transactions that will be associated with the OBOR will take place in RMB, then it is projected that its internationalization will receive a main boost that can level or surpass the euros trade, investment and reserve status.  China is also becoming more market oriented and it is revising its financial policies. The new policies facilitate RMB internationalization as they are making the financial sector more resilient to outside forces.  Generally, the path to RMB internalization is not showing signs of coming to an end but china is also not showing signs of relenting any sooner.

Works Cited

Bradsher, Keith. “U.S. Firms Want In on China’s Global One Belt, One Road Spending – The New York Times.” The New York Times – Breaking News, World News & Multimedia, 14 May 2017, www.nytimes.com/2017/05/14/business/china-one-belt-one-road-us-companies.html.

Lee, John. “Sorry China, The Yuan Still Has Ways To Go Before Replacing The Dollar.” Forbes, 2 Dec. 2015, www.forbes.com/sites/realspin/2015/12/02/prestige-over-power-including-chinas-yuan-in-international-reserves/#1b708466116a. Accessed 27 July 2017. 

Liu, Yi, Yuan Li, and Jiaqi Xue. “Ownership, strategic orientation and internationalization in emerging markets.” Journal of World Business 46.3 (2011): 381-393.

Richelson, Hildy, and Stan Richelson. Bonds: The Unbeaten Path to Secure Investment Growth. Bloomberg P, 2011. 

Thomas, Rollin G. Our Modern Banking and Monetary System. Kinokuniya Bookstore Co., 1966. Yu, Yongding, and Haihong Gao. “The Internationalization of the RMB.” Asia and China in the global economy (2011): 119-218