A Thought on Internationalizing the Won and the Yuan

Transcription

1 A Thought on Internationalizing the Won and the Yuan Hyun, Suk The leaders of Korea and China recently agreed on concrete measures to facilitate the use of the Chinese yuan, including the establishment of a won-yuan direct exchange market. But facilitating direct trading between the Korean won and Chinese yuan and increasing the use of the won are like the head and tail of the same coin. They should be pursued together. Korea should now think through how to internationalize the won for the future. At a summit in July 2014, the leaders of Korea and China agreed upon concrete plans to boost the use of the Chinese renminbi (RMB) in Korea, including creating a direct won-yuan trading market, designating a yuan clearing bank, and encouraging the issuance of yuan-denominated bonds. These actions reveal the desire to boost yuan-denominated transactions, to create business opportunities for the financial industry, and to take a leap forward as an offshore yuan trading hub. More recently, Korea is set to sign a bilateral free trade agreement (FTA) with its largest trading partner China, raising expectations for higher yuan-denominated trade settlement and other financial transactions. For Korea to successfully facilitate yuan-denominated transactions and become an offshore yuan hub as the government aspires, it is essential to promote the use of the Korean won in foreign exchange related settlement. The Korean won can currently be traded onshore only and non-residents are banned from wire-transferring the won. With such restrictions in place, nonresidents avoid settling transactions in won, and future won-yuan transactions will be based on the arbitrage transaction using the US dollar. 1) The won should be traded freely offshore to All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as Korea Capital Market Institute s official position. Ph.D., Research Fellow, International Finance Department, Tel: , hyun@kcmi.re.kr 1) Korea s Foreign Exchange Transaction Regulation bans the transfer or disposal of won-denominated funds among non-residents unless the transaction qualifies for a current transaction or an authorized capital transaction prescribed in Article 7-8 and Article 7-9 therein. 1 December 02, 2014

2 facilitate direct won-yuan trading, instead of the existing won-yuan transaction of using the US dollar. Also a market that has diverse participants and trades currencies other than the yuan is a prerequisite for accomplishing Korea s aspiration for a financial hub. This article explores the past failures in the direct won-yen trading market in 1996 and future challenges to direct won-yuan trading with the focus on The Measures to Stimulate Direct Won-Yuan Transactions recently released by the Korean government. Additionally, this article examines the idea of boosting the issuance of yuan-denominated bonds by creating a private placement market for professional investors, in connection with the ASEAN+3 Multi-currency Bond Issuance Framework (AMBIF) market currently being discussed at the ASEAN+3 Bond Market Forum (ABMF). Last, the impact and implications of the greater use of the yuan for the internationalization of the Korean won are presented. Direct trading of won-yen vs. won-yuan The direct won-yen trading market began in October 1996, but halted operating only four months later because of limited liquidity. A decade later in 2007, the discussion about reestablishing direct trading between the won and yen resumed for the purpose of stabilizing the won-yen exchange rate. That discussion ended due to: 1) the low percentage of yendenominated trade settlement between Korean and Japan, 2) the lack of yen supply because of Korea s trade deficits against Japan, and 3) the insignificant effect of cost reduction. Reflecting on the past failure, Korea s direct trading scheme this time is backed by many devices: The Korea-China currency swap agreement, which helps supply the yuan smoothly in the direct trading market; clearing and settlement infrastructure through a clearing bank in Korea; and liquidity provisions. Korea is also trying to meet demand for the yuan by earning the RMB Qualified Foreign Institutional Investors (RQFII) quota and promoting the issuance of yuandenominated bonds by creating a private placement market for professional investors. On top of these, the Korea-China FTA is expected to help Korea maintain a trade surplus with China and lead to more trades being settled in the yuan, both of which should boost yuan trading. But the hitch is that the limitations in using the Korean won offshore may deter the facilitation of direct won-yuan trading. While the yuan can be freely traded for current and capital transactions (e.g., trade settlement, yuan-denominated deposits, and bond issues, etc.), offshore trading of the Korean won acquired in exchange for the yuan is strictly limited 2

3 to transactions through non-resident free Korean won accounts. Otherwise, non-residents cannot trade the won. Direct trading between a currency whose usage is strictly limited and a currency that is freely traded is asymmetric and thus hard to facilitate. These circumstances leave conventional dollar-mediated trading as the only option. The yuan is supplied to Korea through various channels, including trade settlement, the clearing bank, the offshore yuan market, the Korea-China currency swap, etc. Trade settlement is the ideal way to secure yuan liquidity, compared to liquidity through currency swaps and the clearing bank. 2) That requires Korea to sustain its trade surpluses against China and for Korean exporters to receive export proceeds in the yuan. However, this still exposes Korean exporters to foreign exchange risk: The risk from the US dollar merely shifts to the Chinese yuan. A rapid increase in yuan-denominated financial assets (e.g., deposits, bonds, etc.) may be a factor that increases external debts and negatively affect Korea s sovereign credit rating. 3) In the end, direct won-yuan trading and Korean won internationalization are interconnected such as the head and tail of a coin. Without a long-term roadmap and phased deregulation for the goal of internationalizing the Korean won, direct won-yuan trading will not be substantial and remain similar to dollar-mediated arbitrage transactions, and Korea will see the failure in direct won-yen trading repeat once more. The professional investor market vs. the AMBIF market The most notable aspect of The Measures to Stimulate Direct Won-Yuan Transactions is the plan to set up a private placement market for professional investors. The market will facilitate yuan-denominated bond issues and give domestic investors broader opportunities to invest in yuan-denominated financial assets. It is noteworthy that it is not just for yuan-denominated bonds. Developed nations are already trying to develop and internationalize their bond markets by establishing a private placement market where professional investors are subject to relaxed or no disclosure duties. 4) The private placement market for professional investors is similar in concept to the ASEAN+3 2) Liquidity provision through currency swaps and clearing banks may not be competitive because of financing costs. 3) Borrowing the US dollar to purchase yuan-denominated deposits for the interest rate spread between the won and yuan will only increase short-term external debts. 4) The examples include the Qualified Institutional Buyer (QIB) market in the US, the Professional Securities Market (PSM) in the UK, and the Pro-bond Market in Japan. 3 December 02, 2014

4 Multi-currency Bond Issuance Framework (AMBIF) market, where ASEAN+3 members can issue and trade bonds more conveniently and quickly. The main purpose of the AMBIF market is to connect professional investor markets across the ASEAN+3 member nations and form a common bond market in the ASEAN+3 region. 5) In a previous issue of KCMI s Capital Market Opinion, I pointed out that Korea should develop the theoretical knowledge and insights about the professional investor market so that it can better understand the AMBIF market and prepare for future changes. 6) In this regard, the government s plan to establish a professional investor market is welcome. So far, Korea s position in the AMBIF initiative has been timid due to the absence of a professional investor market, which is the core of AMBIF discussions. 7) The plans to establish a professional investor market should go beyond the boundary of the yuan-denominated offshore bond market. By making necessary reforms (e.g., allowing for English disclosure, and loosening the resale restriction), the discussions should link to those about the AMBIF market, through which Korea can internationalize the bond market and enhance the competitiveness of the overall capital markets. Furthermore, if the direct won-yuan market is created in China, and if the Korean won acquired in exchange for trade settlement can be invested in won-denominated AMBIF bonds issued offshore, the Korean government will go hand in hand with China to lead the agenda of standardizing bond issues in the Asian region. Core elements of the AMBIF market Elements Target investor Issuance currency Details Banks, securities firms, insurers, and other professional investors excluding retail investors ASEAN+3 currencies / other key currencies Types of bonds Government bonds, corporate bonds issued by multinationals, large firms, and others with high credit ratings, Sukuk, etc. Disclosure rules Exemption from a securities registration statement (replaced by a simple registration form) Language English as the official language, and others spoken by member nations Target market Professional investor market with relaxed disclosure rules Source: ABMF-K materials (as cited in KCMI Capital Market Opinion, ). 5) The market excludes retail investors and applies relaxed requirements for investor protection and disclosures. 6) For details about establishing a professional investor market, refer to A Study on Asian Currencies and Development of Crossborder Bond Market in Asia (pg. 57, KCMI Research Paper 11-03), and ABMF and Standardization of the Asian Bond Market (KCMI Capital Market Opinion, ). 7) Although Korea has a qualified institutional buyer (QIB) market of this kind, it can be accessed only by limited participants (e.g., SMEs). 4

5 The future of the offshore yuan hub and the Korean won Countries that have a stake in global financial centers or China s real economy have long vied for an offshore yuan financial hub to reap the benefits of China s rising economic presence and yuan internationalization. Against the backdrop, it is never easy for Korea to compete with other global financial centers that have freely traded diverse currencies and thus have high market liquidity. Even in Asia, Hong Kong has already secured its foothold as an offshore yuan financial hub. Because Korea, compared to Hong Kong, barely has an edge except for its large trade with China, a critical point is how Korea can accumulate strength in yuan-denominated financial transactions and services. What is necessary above all is a diversity in participants and currencies in the foreign exchange market. However, Korea s current Foreign Exchange Transactions Act and its Enforcement Decree strictly limit the scope of market participants and transactions allowed in the inter-bank foreign exchange market. 8) The Triennial Central Bank Survey (TCBS) conducted for central banks by the Bank for International Settlements (BIS) showed that the yuan share in global foreign exchange trading volumes surged from 0.9% (17th) in 2010 to 2.2% (9th) in 2013, while that of the Hong Kong dollar declined from 2.4% (8th) in 2010 to 1.4% (13th) in Drawing out future implications from the BIS statistics requires a mid- to long-term perspective, but for now, it suggests the necessity for Korea to do much more than use the yuan to replace its dollar and won demand, and to further develop a true yuan hub that can absorb the overseas yuan demand. In other words, Korea should build an offshore yuan hub that ensures diverse market participants and free currency trading. As mentioned above, materializing this goal requires the pursuit of won internationalization, which has been controversial and discussed extensively. Now, Korea s pursuit for won internationalization is deterred by concerns that higher volatility of currency value due to offshore speculative demand may dwarf the potential benefits of currency internationalization. 9) Other small, open economies such as Australia and New Zealand successfully overcame similar concerns and successfully internationalized their currencies. 8) Although the current law uses a negative system for foreign exchange banks, non-bank financial institutions are subject to a positive system, meaning that they are allowed to engage in only the transactions listed therein. 9) In Chapter 3 in A Study on Asian Currencies and Development of Cross-border Bond Market in Asia (KCMI Research Paper 11-03), I show the empirical analysis showing that cross-border transactions (including offshore transactions) will increase the size of the foreign exchange market and therefore contribute to the stabilization of exchange rates, rather than increase foreign exchange rate volatility. For discussion about the economic size and exchange rate volatility, refer to Fundamental Challenges to Internationalization and Overseas Expansion of Korea s Financial Industry (KCMI Capital Market Opinion, ). 5 December 02, 2014

6 Recently, non-residents demand for won-denominated financial assets (stocks and bonds) has grown and their non-deliverable forward (NDF) transactions are on the rise. These indicate a favorable market environment forming in terms of the demand for Korea s currency internationalization. Also notable is the extremely low use of the Korean won in trade settlement (2%) although Korea s exports account for over 50% of its GDP. Ultimately, settling trade proceeds in the Korean won, as opposed to the Chinese yuan, is a better option for Korean exporters for reducing their foreign exchange risk. This closely relates to a structural flaw of the Korean economy, more specifically, the inability, despite the heavy reliance on trade, to use the Korean won in cross-border transactions (e.g., trade settlement and overseas investments). This, of course, makes Korea more susceptible to external shocks. The Measures to Stimulate Direct Won-Yuan Transactions will be a win-win situation for both countries only if Korea sets up a long-term plan for currency internationalization and implements it properly. If internationalizing both capital and current transactions of the won is daunting, it is advisable to benchmark China s case of managed internationalization, meaning a phased approach that internationalizes current transactions first and then expands to capital transactions. By unveiling the plan to establish the direct won-yuan trading market, Korea, half willingly and half forced, has jumped into the race for currency internationalization and now must think about how to pursue it going forward. 6