Chi on China Renminbi Gran Turismo (Part 1 of 3): The Next Step for Internationalisation

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1 For professional investors 17 September Chi on China Renminbi Gran Turismo (Part 1 of 3): The Next Step for Internationalisation 0 SUMMARY Beijing s first step to internationalise the renminbi (RMB) by promoting its role in foreign trade settlement has been successful so far; the RMB is now ranked the seventh most-widely used world payments currency by SWIFT. The next step to deepen the internationalisation process is to create non-trade demand for RMB. This will involve enlarging the offshore RMB market and creating RMB-denominated assets and hedging tools supported by onshore financial liberalisation. Empirical evidence shows this next step still to be in its infancy. Even the rapid expansion of offshore RMB financial transactions is essentially trade-driven. This means that offshore centres that have a natural advantage in accumulating RMB will continue to dominate in the medium-term. China is building its Renminbi Gran Turismo. No, it is not a super car like the Bentley Continental GT or Maserati Gran Turismo. It is the grand tour that the RMB has made in its internationalisation process from Hong Kong to the rest of the world, most recently to Europe. Despite the recent development of the offshore RMB market, which has generated all the fuss about fast currency convertibility, the most important mechanism behind the expansion of offshore RMB-denominated assets has been the ability of Chinese importers and exporters to settle their foreign transactions in RMB. Non-trade demand for RMB has yet to be fully developed. In other words, RMB internationalisation remains a function of foreign trade; offshore RMB financial transactions are only a derivative of it at this stage. This needs to change if the internationalisation process is to be deepened. A successful first step RMB-denominated trade settlement has soared (Chart 1) since Beijing started allowing Chinese companies to settle foreign trade in the currency in mid These RMB funds have flowed offshore and have been

2 RMB Gran Turismo (Part 1 of 3): The next step for internationalisation 17 September trapped mostly in Hong Kong, where 90% of RMB trade settlement takes place, leading to a significant buildup in RMB deposits (Chart 2). However, China s current account surplus is not conducive to deepening the internationalisation process because, when all current account transactions are settled in RMB, a surplus means more RMB flows back to China than flows out (as China exports more than it imports). With a closed capital account, where nontrade capital flows are blocked, a current account surplus will only shrink the offshore RMB pool, frustrating the internationalisation effort. So what else can China do? RMB and the demand for money theory The demand for money theory sheds some light on the next step for RMB internationalisation. There are three motives for demand for money: transactional, precautionary and speculative. Promoting the RMB as a foreign trade settlement currency is the first step in that it captures the transactional demand motive. The next step involves deepening internationalisation by capturing the precautionary demand (from central banks as one of their reserve currencies and from the foreign private sector as one form of foreign currency savings) and the speculative demand for RMB (as an investment currency in an international portfolio).

3 RMB Gran Turismo (Part 1 of 3): The next step for internationalisation 17 September These other two RMB demand motives are closely related to the availability of a deep and mature Chinese capital market, with Chinese financial products and hedging tools made available to foreign players. Such development remains slow due to the deep-rooted structural and institutional reforms needed, and most of the offshore non-trade demand for RMB at this stage remains, arguably, speculative (this is not to be confused with the speculative demand for RMB). This can be seen in the behaviour of RMB deposits in the Hong Kong banking system. Non-trade RMB demand remains speculative Despite the big jump in RMB deposits in the Hong Kong banking system, its share is still around 12% of total. It is noteworthy that the sharp rise between 2009 and 2011 came mainly at the expense of a fall in the share of other foreign currency deposits (Chart 3), as investors speculated on RMB appreciation. When the market started to bet on RMB depreciation in the second half of 2011, RMB deposits in Hong Kong also started to drop. Granted, as Beijing gradually liberalises capital inflows, more avenues for offshore RMB to flow back to China have also prompted the decline 1. But speculation on RMB depreciation was the major reason for investors abandoning the RMB between 2011 and The fact that the rise in the share of RMB deposits in Hong Kong came at the expense of other foreign currency deposits in the gogo months between 2009 and 2011 reflected investors portfolio reallocation within their foreign currency holding. There was no long-term demand for RMB by switching out of the Hong Kong dollar. As soon as market expectations turned towards RMB depreciation in late 2011, deposits flowed out of RMB and back into other foreign currencies. 1 These avenues include foreign direct investment (FDI) using RMB as the investment currency, increased export trade (by Chinese exporters) settling in RMB and new and expanded quota schemes, like RQFII, for investing RMB back in China s capital markets. This list will grow over time.

4 RMB Gran Turismo (Part 1 of 3): The next step for internationalisation 17 September Such erratic behaviour in RMB-deposit growth is not a sustainable way to internationalise the currency. To deepen internationalisation, Beijing must create an incentive for foreigners to use and hold RMB other than for trading good and services. Internationalisation stuck in first gear Arguably, most of the increase in offshore RMB financial transactions in Hong Kong, the largest offshore RMB centre, is still driven by international trade activity. Free convertibility of offshore RMB, or CNH, has caused its exchange rate to deviate from the onshore rate, or CNY. When foreigners are bullish on the RMB, they push up CNH so that it trades at a premium to CNY. This gives Chinese importers an incentive to pay for their imports offshore with RMB as they can convert CNY into CNH at par, yet CNH buys more foreign exchange. CNH supply/deposits increases in the process. On the other hand, when foreigners are bearish on the RMB, they sell CNH and depress its exchange rate so that CNH trades at a discount to CNY. This gives Chinese exporters an incentive to accept payment in RMB offshore since they get more CNH for any given amount of foreign exchange and can convert CNH into CNY at par. CNH supply/deposits falls as a result. But this phenomenon is not common because CNH seldom trades at a discount to CNY (Chart 4). The CNH premium has averaged 0.1% since Thus, there has always been an excess of CNH settlement in imports over exports in response to the prevalent CNH premium. This phenomenon is in stark contrast to evidence in other countries where exporters tend to settle in their home currency more often than importers do 2. The excess CNH import settlement is the main driver of offshore RMB-supply growth. It also helps offset the negative effect of China s current account surplus on the offshore RMB pool. 2 The Rise of the Redback and the People s Republic of China s Capital Account Liberalisation: An Empirical Analysis on the Determinants of Invoicing Currencies, Hiro Ito and Menzie Chinn, ADBI Working Paper Series, No. 473, April 2014.

5 RMB Gran Turismo (Part 1 of 3): The next step for internationalisation 17 September In other words, CNH supply responds endogenously through the import settlement channel which, in turn, is a function of the CNH-CNY premium. The larger the CNH-CNY premium, the bigger the incentive for Chinese importers to settle in RMB, boosting CNH supply and, hence, the size of offshore RMB deposits. Empirical evidence 3 shows that this is indeed the case, where a sustained 1 ppt premium will boost CNH deposit by RMB8.2 billion a month in Hong Kong 4. The model is robust with an R-squared of The inclusion of additional explanatory variables, such as the CNY-CNH bond yield differential, the spread between the one-week CNY repo rate and one-week US LIBOR, and the one-year CNY forward premium does not improve the explanatory power, as all the additional variables are not statistically significant even at the 10% confidence level. These results should not be surprising as China s closed capital account has created on-shore and off- shore market segregation. The evidence shows that growth of the CNH market is largely driven by trade (via the Chinese importers RMB settlement) not by capital flows. Since China has yet to deepen the second step for RMB internationalisation, there remains much potential for financial activity to develop in the offshore market. However, before China opens its capital account, offshore centres, notably Hong Kong, which have a natural advantage in accumulating large amounts of offshore RMB through trade will remain the main beneficiaries of CNH activities. Other centres will have to compete for CNH from these and other centres since offshore RMB is fungible. The game changer will be full capital account convertibility, which will take some years to unfold. Chi Lo Senior Economist, BNPP IP 3 Internationalization of the Renminbi: The Role of Trade Settlement, Joseph E. Gagnon and Kent Troutman, Policy Brief, number PB14-15, Peterson Institute for International Economics, May The model for estimation is: Dt = α + ß1Pt + ß2 Dt-1 + et Where Dt is the change in RMB deposits at time t Pt is the CNH-CNY premium at time t Dt-1 is the change in RMB deposits at time t-1 et is the residual term See footnote 3 for reference.

6 RMB Gran Turismo (Part 1 of 3): The next step for internationalisation 17 September DISCLAIMER This material has been prepared by BNP Paribas Asset Management S.A.S. ( BNPP AM )*, a member of BNP Paribas Investment Partners (BNPP IP)** and is made available in Australia by BNP Paribas Investment Partners (Australia) Limited ABN , AFSL , ( BNPP IP ). It is produced for general information only and does not constitute financial product advice. You should consider obtaining independent advice before making any investment decision in relation to any financial product referred to. The value of investments can go up and down. Past performance is not necessarily indicative of future performance. Any opinions included in this document constitute the judgment of the document s author at the time specified and are subject to change without notice. Given economic, market and other risks, there is no guarantee that any investment strategy referred to in this document will achieve its objectives. The contents of this document are based upon sources of information believed to be reliable, but no warranty or declaration, either explicit or implicit, is given as to their accuracy or completeness. BNPP IP to the extent permitted by law, disclaims all responsibility and liability for any omission, error, or inaccuracy in the information or any action taken in reliance on the information and also for any inaccuracy in the information contained in the document which has been provided by or sourced from third parties. *BNPP AM is an investment manager registered with the Autorité des marchés financiers in France under number 96-02, a simplified joint stock company with a capital of 64,931,168 euros with its registered office at 1, boulevard Haussmann Paris, France, RCS Paris ** BNP Paribas Investment Partners is the global brand name of the BNP Paribas group s asset management services.