THE EMERGENCE OF THE RENMINBI AS AN INTERNATIONAL CURRENCY: WHERE DO WE STAND NOW?

Transcription

1 Amundi Discussion Papers Series DP September 2016 THE EMERGENCE OF THE RENMINBI AS AN INTERNATIONAL CURRENCY: WHERE DO WE STAND NOW? Bastien DRUT, Philippe ITHURBIDE, Mo JI, Éric TAZÉ-BERNARD, Amundi For professional investors only

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3 Abstract IIn the future, the Chinese yuan has a very good chance of being an international currency and playing a major role in Asia, as the US dollar and euro do in their respective zones. Competing with the dollar on the international level will take much longer, and it is a complex goal. Nevertheless, the Chinese currency is gradually emerging as an international currency, thanks to the efforts made by Chinese officials to make the yuan the major currency in Asia as a reserve currency, an intervention currency and a settlement currency. The RMB as an international currency also means increasing its use in settling cross-border trade and financial transactions, an area in which the US dollar has excelled so far. The debate about capital account openness remains intense as regards China, because such a liberalisation implies major constraints on Chinese policy: a less independent monetary policy, a more flexible FX rate, a more important role for international players in determining asset prices, greater transparency in terms of economic indicators, independence of statistical offices, state-owned-enterprises, monetary, fiscal and FX policies these are the usually mentioned consequences. History recalls that a gradual opening of the capital account is better than a big bang. History also recalls that financial liberalisation does not necessarily pave the way to financial crises, except when policy makers and central banks misunderstand the effective operation of newly unregulated financial markets. Moreover, to avoid boom-bust cycles, reforms need to be properly sequenced to minimise pro-cyclical effects. At present, around 62% of China s FX reserves are denominated in USD, 20% are in EUR, which is in line with other emerging market countries. The PBoC has started diversifying FX reserves into other currencies, especially in Asia. On the other hand, the yuan is undoubtedly gaining ground as a component of FX reserves in the rest of the world. A growing number of central banks and sovereign wealth funds have diversified their holdings to include renminbi reserves and investments or have plans to do so. This is one of the major prerequisites for the yuan to become an international currency. Our results clearly suggest that the RMB is already an anchor for emerging currencies and its influence seems to go well beyond its neighbourhood area. Note that the RMB as reserve currency held by foreign central banks will necessarily increase after SDR inclusion in October Amundi Discussion Papers Series - DP

4 The question of the undervaluation of the yuan has been debated for the past two decades, particularly because it plays a more dominant role in determining the valuation of emerging countries and hence the rest of the world s currencies. While the question of the renminbi being undervalued was relevant before the Great Recession, the valuation of the renminbi is far less clear at present. We tend to conclude that the RMB is broadly in line with fundamentals. The emergence of the RMB as an international currency will have major consequences. The USD never had a real contender in the past, and a tripolar system (USD, EUR and RMB), more precisely a system of competing international currencies, may be unstable during some periods of time. History recalls that this instability is essentially due to the capacity and incentives for investors, including central banks, to shift the composition of their international portfolios and FX reserves. Keywords: renminbi, yuan, China, FX reserves, international currency, capital controls, undervaluation 4 Amundi Discussion Papers Series - DP

5 TABLE OF CONTENTS Introduction P. 7 I. The Renminbi as an international currency P A quick refresher on international currencies P International currencies: advantages and disadvantages P Why did the Japanese yen never become an international currency? P The milestones on the path to RMB internationalisation P The RMB as part of the SDR basket: a strong message P. 22 II. Capital flows and capital controls: the debate about capital account openness P Why restrict capital flows? P Financial liberalisation: lessons from past experiences P China s capital outflows: what is at stake P What are the perspectives for the Chinese equity and bond markets? P. 37 III. China s FX reserves and the Renminbi in global FX reserves: be ready for major changes P Why hold FX reserves? P China FX reserves: where do we stand now? P Central Banks: using RMB for reserve management P. 52 IV. The Renminbi, a new anchor for emerging currencies P The renminbi is impacted by global monetary policies P The renminbi, the new cornerstone of emerging currencies P. 60 Conclusion P. 67 Appendix P. 71 References P. 81 About the authors P. 85 Discussion Papers list P. 89 Amundi Discussion Papers Series - DP

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7 THE EMERGENCE OF THE RENMINBI AS AN INTERNATIONAL CURRENCY: WHERE DO WE STAND NOW? Introduction The size of China and its rise during the reform era paves the way for the rise of RMB as an international currency, Chinese capital account openness, RMB as a reserve currency, and a new era of RMB valuation. This article develops four topics. First, the emergence of the Chinese currency as an international currency, focusing on the characteristics of such a currency and on the efforts already made by Chinese officials to make the yuan the major currency in Asia as a reserve currency, an intervention currency and a settlement currency. RMB as an international currency also means using it in settling cross-border trade and financial transactions. RMB bilateral swap agreements between 2008 to 2015 have reached a total maximum value of RMB 3.2 trillion. There are more than 10,000 financial institutions doing business in RMB, the RMB is now the third most important currency of global issuance on letters of credit for trade-related purposes, there are more than 15 official offshore RMB clearing centres in the world, and a number of banks and sovereign wealth funds have diversified their holdings to include RMB reserves and investments internationalisation is definitely underway. Second, we develop a section on capital flows and capital controls: the debate about capital account openness is intense as regards China, because apart from the advantages of lower capital controls, such a liberalisation represents major constraints on the Chinese policy. A less independent monetary policy, a more flexible FX rate, greater transparency in terms of economic indicators, independence of statistical offices, state-owned-enterprises, monetary, fiscal, tax and FX policies these are the consequences usually mentioned. Capital account openness has progressed to a level that 35 out of the 40 capital accounts classified by the IMF are already convertible. Although 22 of them are only partially convertible, this is already a significant achievement. Despite these developments Amundi Discussion Papers Series - DP

8 China is still considered as a country with very low capital openness. The price to pay for the absence of capital controls would be moving to a floating exchange rate regime and abandoning an independent monetary policy, two critical decisions for China. In that sense, opening up the capital account has to be gradual, and the big bang solution adopted by Scandinavian countries in the mid-1980s would certainly be a disaster in the case of China. The third develops the trend in FX reserves, both in China and in the rest of the world. At present, 62% of China s FX reserves are held in USD denominated assets and 20% in EUR denominated assets, which is in line with other emerging market countries. The PBoC has started diversifying FX reserves into other currencies, especially Asian currencies. On the other hand, the yuan is undoubtedly gaining ground as a component of FX reserves in the rest of the world. This is one of the major prerequisites for the yuan to become an international currency. Our results clearly suggest that the RMB has risen as a major reference currency for EMEs and its influence seems to go well beyond its neighbourhood area. Note that the RMB as a reserve currency held by foreign central banks will increase after the SDR inclusion in October The question of the valuation of the yuan is developed in the fourth section. The RMB valuation is entering a new era where it plays a more dominant role in determining the valuation of EM currencies and hence those of the rest of the world. While the question of the renminbi being undervalued was relevant before the Great Recession, the valuation of the renminbi is far less clear at present. We tend to conclude that the RMB is globally in line with fundamentals. 8 Amundi Discussion Papers Series - DP

9 I. The RMB as an international currency An international currency is used and held beyond the borders of the issuing currency, for transactions with the country s residents, but more importantly for transactions between non-residents. In other words, an international currency is one that is used instead of the national currencies of the parties directly involved in an international transaction, whether the transaction in question involves a purchase of goods, services or financial assets (P. Kenen). China decided to accelerate the internationalisation of the renminbi in the late 2000s, for five major (official and nonofficial) reasons: To align the role of the currency with the size of China in the world economy; To allow Chinese corporates to reduce their dependence on the US dollar and also to reduce FX cost and risk; To reduce the accumulation of FX reserves; To develop a fixed-income market to attract foreign investors and a way to finance reforms; To introduce additional and external pressures towards a necessary financial liberalisation. In the same way, the entry of China into the WTO in 2001 kickstarted the reforms of country s state-owned commercial banks. At the same time, the euro was created, and many experts started to consider that the euro and the yuan would compete with the dollar in the long run for the status of international currency A quick refresher on international currencies Before assessing the current situation, we should explain what an international currency is. Its four main characteristics are: Liquidity: its market must be liquid. The euro and the dollar are very liquid. Acceptability : the currency must be accepted everywhere. Undoubtedly, the lack of full convertibility of the yuan is a drawback. Stability: it is a complex concept given that currencies fluctuate by pair. But here stability refers to the economic situation of the country, to its structural imbalances In that field, the yuan is gaining ground, while the PBoC has decided to change its FX policy towards more stability. Predictability : it is also a complex concept that refers to the country s ability or will to manage its currency. Regarding exchange rates, the United States tend to have a more laissez-faire attitude than Europe and, more recently, China. Besides, an international currency has four different functions: Amundi Discussion Papers Series - DP

10 A reserve currency: as mentioned above, the lack of diversification of international reserves is essentially linked to the dollar s intrinsic weakness and to the will to control USD crosses or avoid an excessively sharp fall in the greenback. This was particularly true in the absence of any challenger to the US dollar. Any rise in the euro or yuan to challenge the US dollar will certainly force the United States to alter their FX policy. An intervention currency: from the start, the euro has always been a true intervention currency as it is the currency of a representative group of countries. The convertibility of the yuan and the increase of the yuan in FX reserves all over the world (or in Asia at least) are two prerequisites for the Chinese currency to become an intervention currency. A settlement currency: in fact, the true value of an international currency is determined by its ability to establish itself in third-party trade. So, we must admit the US dollar is the only international currency in the world. The share of US dollar-denominated world trade is more than three times higher than the US share of world trade (by comparison, the share of yen-denominated world trade is much smaller than Japan s share of world trade, which means that the yen is not an international settlement currency). It is too early to consider if and when the yuan will become a settlement currency in third-party trade. The first battle will be to replace the US dollar in Asia. A reference currency, especially for debt and commodities. To conclude, as regards liquidity, convertibility, FX reserves the yuan has a long way to go to be considered as a full international currency, for both official and private use (see table below). The lessons from the past are quite clear: before becoming an international currency, some prerequisites are to be met: capital market liberalisation, capital account openness, capital controls abandoned, full convertibility of the currency, etc. It will be a long time before these prerequisites are met. It is unlikely that the yuan, (which still plays a weak role as a reserve currency, a settlement currency and an invoicing currency) will rapidly become an international currency. Financial reforms are on the way, but they will be completed over a long period of time. The internationalisation use of a currency Private use Official use Medium of exchange Invoicing trade and financial transactions Vehicle currency for foreign exchange intervention Store of value Currency substitution International reserves Unit of account Denominating trade and financial transactions Anchor for pegging local currency Source: B.J. Cohen (1971); P. Kenen (1983) 10 Amundi Discussion Papers Series - DP

11 The process of internationalisation is a long process, and several conditions are to be met before concluding that a currency plays an international role. P. Kenen (2011) pointed out 7 conditions: First, the government must remove all restrictions on the freedom of any entity, domestic or foreign, to buy or sell its country s currency. Second, domestic firms are able to invoice some, if not all, of their exports in their country s currency, and foreign firms are likewise able to invoice their exports in that country s currency, whether to the country itself or to third countries. Third, foreign firms, financial institutions, official institutions and individuals are able to hold the country s currency and financial instruments denominated in it, in amounts that they deem useful and prudent. Fourth, foreign firms and financial institutions, including official institutions, are able to issue marketable instruments in the country s currency. Fifth, the issuing country s own financial institutions and non-financial firms are able to issue on foreign markets instruments denominated in their country s own currency. Sixth, international financial institutions, such as the World Bank and regional development banks, are able to issue debt instruments in a country s market and to use its currency in their financial operations. Lastly, the currency may be included in the currency baskets of other countries, which they use in governing their own exchange rate policies As we can see, it is a long process, and the emergence of an international currency is a competitive process. History recalls that several international currencies can coexist, though. In the 1920s, the pound sterling and the US dollar shared this role evenly. Before 1914 the pound sterling dominated, but the French franc and the German mark each accounted for 20%-25% of international reserves and international transactions. History also recalls that the emergence of a currency such as the RMB or the euro as an international currency occurs only if a severe shock undermines the confidence in the US dollar and its attractiveness. In the 1970s, it was the case: the decision of major central banks to refuse to defend the dollar further on FX markets, the two devaluations of the US dollar and the end of the Bretton Woods system seriously undermined the confidence in the USD. As a consequence, the Deutsche Mark, and to a lesser extent the Swiss Franc, the pound sterling and the French Franc emerged in FX reserves while the USD also lost ground in cross border trade. However, thanks to its liquidity and to the absence of any real contender, the USD had regained its losses less than two decades later However, in the past 10 years, the situation has changed, especially as regards the RMB, and the improvements are significant, with an increase in both the development of offshore RMB markets and RMB settlement in cross-border trade. Amundi Discussion Papers Series - DP

12 RMB is now the fifth most important payment currency but only accounts for less than 3% of worldwide payments for cross-border trade and financial transactions. RMB also only accounts for 4% of turnover in global foreign exchange markets. However, milestones have been reached on the path to internationalisation of RMB, and the weighting of RMB either as an international payment currency or trading currency will increase significantly over time along with Chinese capital account openness, RMB as reserve currency being held more by other central banks, and RMB s influence on global currency valuation especially on EM currencies. Share of RMB in total international payments 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Share of RMB in OTC foreign exchange turnover Source: SWIFT, Amundi Research 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 4.0% 2.2% 0.9% 0.5% 0.0% 0.1% Source: BIS,Amundi Research 12 Amundi Discussion Papers Series - DP

13 1.2. International currencies: advantages and disadvantages An international currency offers several advantages to the country: First, thanks to the billing process, the internationalisation of the currency gives the country s exporters / importers the possibility to limit exchange rate risk and even to transfer the risk to the foreign customers / providers. Thanks to the internationalisation, the domestic capital markets expands much quicker than foreign markets, a strong advantage for domestic entities. Second, it allows domestic firms and financial institutions to access international financial markets without incurring exchange rate risk and to borrow more cheaply and on a larger scale than they can at home (P. Kenen, 2011). Third, it benefits to the domestic economy, thanks to a larger and more profitable financial sector, able to better serve the domestic non-financial sector. Fourth, currency internationalisation will allow the country s government to finance its budget deficit by issuing domestic currency debt on international markets, and not by issuing in foreign currency denominated instruments. As a consequence, at the opposite of numerous countries, internationalisation of the currency may allow the government to finance current account deficits without drawing on its reserves. Last but not least, history recalls that it allows the country to adopt benign neglect attitude for its own currency, forcing economic partners to protect FX rates. The US is certainly a good example of this laissez-faire. On the other hand, an international currency may represent some dangers for the economy: First, with an international currency, there is a good chance the country s public debt to be in the hands of foreign investors. As a consequence, periods of high volatility and depreciation of the currency are inevitable, Mistrust may also generate financial crises This is even worse for countries having relatively small - and vunerable - financial markets compared to the size of their economy (it is not the case for the US or the Euro zone). Second, the country cannot control capital flows anymore. Currency internationalisation usually moves in tandem with the absence (reduction) of capital controls, which limits the capacity of the central bank to control domestic interest rates. Chinese officials have no doubt that in mind 1.3. Why did the Japanese yen never become an international currency? A frequently asked question is : which currency, Yuan or Yen, has a good chance to become an international currency? In other words, which currency will be able to compete in the future with the US dollar and with the Euro? When looking at the table page 10, it is easy to conclude the yen is not an international Amundi Discussion Papers Series - DP

14 currency. In fact, there were several questionings about the internationalisation of the Japanese yen in the past decades. Japan tried to internationalise its currency, without major success. Three steps have to be pointed out: In 1984, the Yen-Dollar Working Group (officially the Joint Japan-US Ad Hoc Group on Yen-Dollar Exchange Rate, Financial and Capital Market Issues ) pleaded for some internationalisation, through deregulation of the domestic financial markets and the internationalisation of Tokyo financial markets. This group had been settled to curb the large and widening trade imbalances between Japan and the US. The yen was supposed to be undervalued because 1) Japan was not attractive to international investors, and 2) the currency was not attractive to international users (Frankel (1984)). The Japanese authorities did not necessarily agree with such an assessment, but went along because the alternatives (such as further trade concessions) were far worse (Takagi (2011)). The US position was to internationalise the yen (with, if possible, an appreciation of the currency) and to open Tokyo s capital markets (to allow US financial firms greater business opportunities in Japan). The Japanese position was not very different to the US one, and the final report recognized the necessity for both liberalisation and internationalisation. The government considered the yen internationalisation would be beneficial to the country for several reasons: It would reduce exchange rate risk for Japanese firms; It would strengthen the international competitiveness of Japanese financial institutions; It would facilitate the development of Japanese markets and Tokyo as an international financial centre; It would lead to greater stability of exports from Asian countries, and contribute to their economic stability; A greater use of the yen internationally, with the USD, would also contribute to a more stable international monetary system; It would at last offer a greater risk diversification for investors and central banks. In sum, the government supported the internationalisation of the yen, and favoured domestic financial liberalisation as a means of providing attractive yen instruments to non-residents in one hand, and both the liberalisation of euroyen transactions and the internationalisation of Tokyo on the other hand. However, in concrete terms, the yen has not emerged as an international currency, due to the prolonged economic stagnation / recession and to the lack of confidence. Tokyo as an international financial centre declined, and the government implemented a financial big bang in 1996 to restore financial markets and institutions competitiveness, with notably the elimination of barriers and a reform of the FX market. In 1999, The government defined the internationalisation of the yen as the expanding role of the yen in the international monetary system and the growing weight of the yen in current account transactions, capital account transactions, 14 Amundi Discussion Papers Series - DP

15 and foreign exchange reserves (MoF (1999)). A Study Group on the Promotion of Yen Internationalisation was established in September It concluded that the status of the yen as an international currency had not changed much due to the economic situation, the lack of confidence in the Japanese economy and the limited need to use yen (Takagi (2011)). It also explained why Japanese companies were unable to use the yen as a billing currency: market bargaining power, international price setting practices (energy products quoted, traded and billed in USD, for example), strong preferences for the USD The report still considered yen internationalisation as a long-term goal, but did not suggest any additional measures to internationalise the currency. In 2003, the focus of the Japanese government shifted from internationalising the yen to internationalising the Japanese capital markets, with the idea that the latter could favour the former Policymakers considered that the international status of the yen remained limited because 1) raw materials (for which dollar invoicing is the norm) constituted a large share of Japan s imports, 2) the currencies of Asia tended to fluctuate more with the yen than with the USD, with virtually no cross trading, and 3) there was little need for yen loans because most trade was not denominated in yen. These are reasons about which Japan alone could do very little (Takagi (2011)). In total, the internationalisation of the yen never progressed: As regard invoicing: the yen s share of Japanese export (respectively imports) invoices has remained flat at around 40% (respectively 25%) since the mid-1990s (Japanese MOF), far from what is expected for an international currency and even far from usual practices; As regard world trade: the yen is underutilised versus the importance of Japan s trade. Japan represents roughly 5% of world trade, while the yen is used in transactions for less than 3%. In other words, even Japanese do not fully use the yen. Same conclusion for the Chinese Yuan, and to a lesser extend, for the Russian ruble, the Mexican peso, the Singapore dollar, and the Hong Kong dollar As regard the euro and the US dollar, it is the opposite: the currency s share in world payments in larger than the country s share in world trade, and both currencies can be considered as international currencies. As an illustration and to give an idea about the potential of the Chinese currency, the share of the RMB in world payments was still, a few years ago, 40 times lower than China s share in world trade; As regard FX market turnover: the yen s share is down from 13.5% in 1989 to around 10% in 2016 (BIS, Triennial Central Bank Survey); As regard central banks foreign reserves: the yen s share is down from 6.8% in 1995 to 4.1% in 2016Q1 (IMF COFER). The Japanese experience: what are the lessons for China? First, in the foreseeable future, the Japanese yen has a very little chance to increase its role as an international currency: the RMB can fill that empty seat in Asia; Amundi Discussion Papers Series - DP

16 Second, the liberalisation of capital markets represents a prerequisite for the internationalisation of the currency; Third, confidence in the economy is crucial; Fourth, domestic markets have to be attractive to foreign investors and foreign financial institutions in order to increase the need to use the currency; Fifth, bargaining power in trade invoicing currency helps to install the currency as an international one; Sixth, domestic financial centres must be developed as regional centres; Seventh, the relative stability of the RMB in Asia is a prerequisite for this currency to be used and accepted as an international currency, and as a substitute for the US Dollar The milestones on the path to RMB internationalisation Capital account openness has progressed to a level that 35 out of the 40 capital accounts classified by the IMF are already convertible; however, 22 of them are only partially convertible. Nonetheless, this is still a significant achievement. Ever since 2002 when QFII (Qualified Foreign Institutional Investor) was first launched, QDII in 2006, the first offshore RMB (dim sum) bond issuance in 2007, RQFII in 2011, we have seen acceleration in capital account openness since 2013 with the launch of the Shanghai Free-Trade Zone in 2013, Shanghai Hong Kong Stock Connect in 2014, Mutual Recognition of Funds in 2015, and a game changer of opening up the China Interbank Bond Market in 2015 and SDR inclusion in October As expected, Shenzhen Hong Kong Stock Connect has been approved in Also, Shanghai Hong Kong Bond Market Connect is under consideration, and the inclusion of Chinese A-shares by MSCI is likely to happen in Financial liberalisation is a long trip to a new world, where capital flows, instability, dependence and risks are all increasing. China has decided to adopt a gradual, step by step, approach and not a big bang as some Scandinavian countries implemented in the mid-1980s. One can identify numerous (past and future) steps: China s initiatives for the internationalisation of the yuan Date Decision May 2000 Chiang Mai Initiative of the ASEAN+3 countries (ASEAN plus China, Japan and South Korea): currency swaps denominated in US dollars. November 2002 The Qualified Foreign Institutional Investor (QFII) program enables investors to buy shares in mainland Chinese companies using their domestic currency, which is then converted into RMB. In 2002, qualified foreign institutional investors (generally offshore subsidiaries of mainland asset managers with a base in Hong Kong) were permitted to purchase and sell a limited range of RMBdenominated exchange-traded securities in China PBoC designates BoC-HK as RMB clearing and settlement bank. 16 Amundi Discussion Papers Series - DP

17 2004 Residents of Hong Kong and Macau were permitted to conduct personal business in RMB (they were permitted to open RMB -denominated deposit accounts). April 2006 China launches the Qualified Domestic Institutional Investor (QDII) scheme enabling Chinese institutions to invest overseas funds run by Chinese banks, insurers, and asset managers. The scheme was initially limited to fixed-income and money market products. July 2007 December 2008 Issue of the first offshore RMB (dim sum) bond by a mainland Chinese financial institution in Hong Kong then saw authorisation for corporations to issue RMB -denominated dim sum bonds in Hong Kong, principally for funding their investments in China. There was also an increase in the limit on FX purchases by Chinese residents for the purposes of remittance abroad for personal reasons saw the beginning of the process where RMB funds were made available for official transactions. December saw negotiation of the first RMB-local currency swap line between the People s Bank of China and a foreign country, namely South Korea This was followed by the negotiation of RMB-local-currency swap arrangements with additional countries (five in 2009, two in 2010, seven in 2011, four in 2012, five in 2013, five in 2014, four in 2015). These central bank swap agreements differed from earlier arrangements under the Chiang Mai Initiative of 2000, in which currency swaps were denominated in US dollars. In addition, where RMB swaps initially involved only other East Asian economies (Korea, Hong Kong, Malaysia), over time they evolved to include countries in other parts of the world. The role of these agreements is to permit foreign central banks to provide RMB liquidity to local banks and firms in need, thereby encouraging those foreign authorities to liberalise restrictions on the use of RMB by such companies Select Chinese companies were authorised to settle traderelated transactions with Hong Kong, Macau and ASEAN in RMB. January also saw a pilot scheme for cross-border direct foreign investment in the currency, with the elimination of review and approval requirements for outward remittances of funds for FDI abroad by Chinese corporations and financial institutions Companies in select Chinese provinces were permitted to settle import and export transactions with the rest of the world in RMB. Qualified foreign institutional investors with RMB funds (by this time foreign central banks, lenders in Hong Kong and Macau engaged in RMB clearing, and overseas banks involved in RMB cross-border trade settlement) were permitted to invest them in the Chinese interbank bond market (previously, qualified foreign institutional investors had been limited to purchasing the small number of exchange-traded Chinese bonds). Amundi Discussion Papers Series - DP

18 September 2010 The dim sum bond issuance widens to Chinese and foreign companies. The first dim sum bond by a foreign non-financial company was issued on 16 September 2010 by the US fast-food chain, McDonald s China opens its onshore RMB bond market to foreign central banks China publishes rules for Outbound Direct Investment (ODI) and Foreign Direct Investment (FDI) that enable RMB capital to flow more freely The authorisation to settle commercial transactions in RMB was extended to the entire Chinese economy. December 2011 November 2012 The RMB Qualified Foreign Institutional Investor (RQFII) program is launched in Hong Kong with an initial quota of RMB20 billion. The scheme enables foreign qualified institutional investors to buy securities such as bonds and shares in China using RMB. The RQFII quota ceiling has reached as high as CNY1.6 trillion by June Although the major market for dim sum bonds is Hong Kong, China Construction Bank became the first Chinese Bank to issue a renminbi-denominated bond in London. Earlier in the year, there were similar issues by non-chinese banks including ANZ, HSBC and Banco do Brazil The ceiling or quota for investment by qualified foreign institutional investors (QFII) in the Chinese securities market was increased from US$30 billion to US$80 billion. Quotas were extended from investors in Hong Kong and Macau to investors in London and then Singapore in In July, HSBC became the first foreign-owned bank to obtain a license under the QFII scheme; the bank announced the intention of using it to launch a mutual fund that would invest in China s domestic bond market. July 2013 September 2013 The ceiling for QFII was then raised from US$80 billion to US$150 billion. In addition, RQFII eligibility was expanded to London and Singapore in July Finally, the Chinese authorities announced their intention to allow essentially full capital account convertibility in the free trade zones of Qianha and Shanghai. The launch of the Shanghai Free-Trade Zone makes it easier for Chinese firms in the city to do business in RMB. 18 Amundi Discussion Papers Series - DP

19 December 2013 December 2013 April 2014 May 2014 July 2014 At the Third Party Plenum, the authorities announced the intention of taking further steps in the direction of capital account liberalisation. These included launching an internationally compatible international payments system, allowing for additional individual cross-border investments, and establishing Free Trade Accounts in Shanghai. The RMB overtook the euro to become the second most-used currency in global trade finance after the US dollar, according to the Society for Worldwide Interbank Financial Telecommunication (SWIFT). The China Securities Regulatory Commission (CSRC) and the Securities & Futures Commission of Hong Kong (SFC) announced a trial trading program known as Shanghai-Hong Kong Stock Connect, which enables retail and institutional investors in the two cities to invest in each other s stock exchanges. Shanghai Free-Trade Zone materialised. SAFE issued Circular 36 to extend benefits to foreign-invested enterprises (FIEs) in 16 other industrial parks and economic zones Three more free-trade zones are launched in Fujian, Guangdong and Tianjin The launch of Mutual Recognition of Funds enables approved Hong Kong domiciled mutual funds to be set up in mainland China and vice versa. July 2015 The PBoC allows foreign central banks, monetary authorities, international financial organisations and sovereign wealth funds to invest in the China Interbank Bond Market. August 2015 The PBoC improved the USD/CNY quotation mechanism, making it more market-based The PBoC allows foreign central banks, international financial organisations and sovereign wealth funds to trade in China s foreign exchange market. October 2015 CIPS (China International Payments System), an alternative to SWIFT is launched The IMF announces that the RMB will be included in its basket of SDR reserve currencies from October 2016 alongside the USD, EUR, GBP and JPY China approves the potential launch of Shenzhen-Hong Kong Stock Connect enabling retail and institutional investors in the two cities to invest in each other s stock exchanges. Amundi Discussion Papers Series - DP

20 February 2016 April 2016 The PBoC lifts the barrier to the China Interbank Bond market (IBB), the world s third-largest credit market. China announces that it will give the United States a RMB 250 billion (approximately $38 billion) RQFII quota to buy Chinese stocks, bonds and other assets In 2016, China is considering Shanghai-Hong Kong Bond Connect In 2017, Chinese A-shares are likely to be included in MSCI s indices. Sources: HSBC (2016), Eichengreen B., K. Walsh and G. Weir (2014), Amundi Following all these measures, as of the beginning of 2015, the increase in the RMB s role is significant: More than 10,000 financial institutions are doing business in RMB, up from just less than 1000 in The PBoC permits the settlement of trade transactions with the RMB. In 2015, trade settlement in RMB amounted to about $1.7 trillion, roughly 25% of China s annual trade volume, compared to 3% in 2010 and virtually 0% in In the US, thanks to the international role of the USD, the vast majority of trade settlements have long been in the domestic currency. Ito and Chinn (2013) have analysed the situation in China and find that the RMB underperforms as an invoicing/settlement currency, in comparison with the currencies of other countries. The renminbi is the third most important currency of global issuance of letters of credit for trade-related purposes. With a market share of around 5%, it is still far behind the dollar which accounts for 84% of the world total (the euro is second with 7% per cent). According to the latest triennial survey of foreign exchange and derivatives market activity published by the Bank for International Settlements (2016), the renminbi is now involved in 4% of global FX transactions. Up from 0.9% in 2010, the renminbi s market share is nevertheless quite small compared to a global share of 87.6% for the USD and 31.3% for the euro (note that given that two currencies are involved in each transaction, currency use in foreign exchange transactions totals 200%). There are more and more official offshore RMB clearing centres: Taipei (December 2012), Hong Kong (2013), Singapore (February 2013), Macau (2014), London (June 2014), Frankfurt (June 2014), Seoul (July 2014), Paris (September 2014), Luxembourg (September 2014), Doha 20 Amundi Discussion Papers Series - DP

21 (November 2014), Toronto (November 2014), Sydney (November 2014), Bangkok (January 2015), Kuala Lumpur (January 2015), Santiago de Chile (May 2015) Note that following the establishment of offshore RMB markets, there are two distinct RMB markets for both residents and nonresidents: the CNY market is onshore, and both exchange rates and interest rates are heavily managed by the central bank. The CNH is offshore, with exchange rates and interest rates determined by supply and demand. Arbitrage between CNH and CNY is therefore possible at this stage. The CNH market will grow over time and will become increasingly important for exporters, importers and investors. China had closed currency swap agreements with more than 30 central banks by the end of 2015, totalling RMB 3.2 trillion: South Korea (December 2008), Hong Kong (January 2009), Malaysia (February 2009), Belarus (March 2009), Indonesia (March 2009), Argentina (March 2009), Iceland (June 2010), Singapore (July 2010), New Zealand (April 2011), Uzbekistan (April 2011), Mongolia (May 2011), Kazakhstan (June 2011), Russian Federation (June 2011), Thailand (December 2011), Pakistan (December 2011), the United Arab Emirates (January 2012), Turkey (February 2012), Australia (March 2012), Ukraine (June 2012), Brazil (March 2013), United Kingdom (June 2013), Hungary (September 2013), Albania (September 2013), Eurozone (October 2013), Switzerland (July 2014), Sri Lanka (September 2014), Qatar (November 2014), Canada (November 2014), Nepal (December 2014), Suriname (March 2015), South Africa (April 2015), Chile (May 2015), Tajikistan (September 2015), Morocco (May 2016) Note that, like FX reserves, currency swap agreements between central banks represent financial safety nets (FSN): they are a resource that can be used during a crisis or a liquidity restriction. A number of central banks and sovereign wealth funds have evidently diversified their holdings to include renminbi reserves and investments or have plans to do so. This is the case for the central banks of Australia, Austria, Brazil, Indonesia, Malaysia, Korea, Thailand, Pakistan, South Africa, Thailand, Venezuela, Nigeria, Hong Kong and Macau. The Reserve Bank of Australia (an important trading partner) invests around 5% of its foreign currency assets in renminbi securities in China. The Japanese Finance Ministry, the Kuwait Investment Authority and the World Bank/ IBRD also hold renminbi bonds. China aims to expand the international role of the CNH market by allowing foreign companies to issue bonds denominated in CNH. For example, during 2010, the first "dim sum" bonds were issued by McDonald s, Caterpillar, China Development Bank, and some Hong Kong corporates Amundi Discussion Papers Series - DP

22 The CNH market will improve its expansion due to lower capital controls currently impeding the flow of CNH. The PBoC sets up seven clearing hubs in different continents. (Table 3) The PBoC permits selected banks to offer offshore RMB deposit accounts. The PBoC creates a payment system for easier settlement of cross-border RMB transactions. Some projections suggest that, by 2020, with the RMB largely a freely floating currency and the capital account more open, 30% of China s trade should be invoiced in RMB, making the RMB the fourth largest global payment currency. Daily RMB FX turnover would exceed USD 500 billion (a three-fold increase compared with the current situation). The offshore RMB (dim sum) debt market would also amount to USD 500 billion (up from around USD 90 billion in 2013). The PBoC will continue to set up more offshore clearing centres in more countries. At the same time, the PBoC will help improve market infrastructure including liquidity provision. In terms of increasing the depth of the offshore market, we think more issuance of RMB denominated bonds overseas are to come, with more issuance of ETFs and other derivatives products. At the same time, the Chinese government will relax approvals and procedures for remitting back the proceeds. We expect that the rules on Chinese banks overseas lending in RMB will be relaxed further, to facilitate overseas investment demand. The Chinese government will also continue to simplify the approval and monitoring procedures on external borrowing by domestic entities. The PBoC will gradually loosen control over commercial credit with real trade backgrounds, which tend to have a close relationship with current accounts, with great stability and relatively low risks. The loosening on commercial credit meets a growing need, with Chinese companies taking on bigger roles in global trade, investment, production, and financial activities The RMB as part of the SDR basket: a strong message At the end of 2015, the IMF decided to reshuffle the SDR basket. The weight of the dollar will be maintained while the other currencies lose out. As of October 2016 the basket is USD: 42%, : 31% (-7%), : 8% (-3%), : 8% (-1%), and RMB: 11%. The RMB s inclusion in the IMF's Special Drawing Rights (SDR) basket comes within the scope of the PBoC governor Zhou s campaign since 2009 and of the reform of the international monetary system. It moves away from global over-dependency on USD liquidity. The decision to include the RMB in the SDR basket will let market forces play a larger role in determining the RMB's relative prices. It will also accelerate the RMB s internationalisation and legitimise its use a reserve currency. 22 Amundi Discussion Papers Series - DP

23 New SDR weights (after 1 October 2016) USD EUR RMB JPY GBP Old New Source: IMF, Amundi Research Brief on Special Drawing Rights Special Drawing Rights are FX reserve assets designed and maintained by the International Monetary Fund (IMF). They were launched in 1969 not long before the Bretton Woods gold standard collapsed, which eventually led to a sharp decline of the US dollar in 1971 and thereby set the stage for the SDR to play a role in the world economy. Technically speaking, the SDR represent a claim to currency held by IMF member states. More precisely they represent a claim to a specific currency basket, the makeup of which is decided by the IMF Executive Board and reviewed once every five years. The composition of the basket is decided according to a set of rules so as to enforce its role in promoting a stable evolution of the international monetary system. In 2000 the rules had been officially formulated as follows: i. The basket should contain currencies issued by IMF member states. ii. Their weights should be in line with the respective member states export volumes. iii. The currencies should be freely usable on the foreign exchanges. During the last review in 2010, the rules were reformulated slightly to recognise certain fundamental changes in the global economy. The guideline for the basket weights has been loosened to, in addition to export volumes, give consideration to: Amundi Discussion Papers Series - DP

24 i. International capital flows, ii. The denomination of international debt securities, iii. The composition of the Central Banks cash reserves. In the communication of these new rules it was expressly stated that if a composition change were decided, it should reflect a significant and lasting evolution in the international monetary system. No change had been decided in The conditions for a composition change at the next round in 2015 were considered to be met, with the inclusion of the yuan in the SDR. Source: M. de Jong and N. Doisy (2014) RMB inclusion in SDR and FX policy: adding a currency into the basket has to respect economic rules (see insert above), but it has to add diversification in portfolios. As long as China opted to maintain the trading corridor against the dollar, the renminbi continued to reflect price information that is already reflected by the dollar, on the US economy essentially, not on China. From the moment the renminbi enters, the dollar would dominate the SDR exchange rate to the extent that it would lose its attractiveness as a reserve asset. Why buy any SDR if it resembles a US dollar? Adopting a more flexible FX regime in China is essential to make the SDR more attractive. Monetary policy outlook after RMB inclusion into SDR: one important aspect of the RMB s internationalisation is the further liberalisation of the capital account, meaning the RMB exchange rate will have to move toward a more flexible regime. As such, we believe a more market-based monetary policy framework with operations targeting short-term interest rates and a better transmission mechanism will be the direction. The PBoC is moving away from quantitative targeting by mainly managing the M2 growth rate, towards price targeting by forming the interest rate corridor and short-term benchmark interest rate. What are the likely FX market impacts? The information from the August 2015 RMB exchange rate move is very clear it will be more market-oriented and decided by market supply and demand, and the trading band will be expanded further. In the medium to long-term, we believe the RMB will be traded on its fundamentals more than it has been in the past. The offshore CNH spot is wholly driven by market supply and demand factors, whereas the onshore CNY spot has been guided by the PBoC's daily fixing rate within the +/-2% band (market forces had a role, but were suppressed due to the band). The lack of government intervention in the CNH market, where there is less liquidity, and lack of easy access to arbitrage are the reasons why CNY/CNH diverge. Going forward, more opening of the capital account (banks are able to participate more easily in the onshore repo market, etc.) could narrow the spreads and make them converge further. 24 Amundi Discussion Papers Series - DP

25 What are the likely bond market impacts? Alongside RMB internationalisation and the SDR inclusion, we expect a gradual opening up of the domestic bond market to foreign investors. China s domestic bond market is around RMB 40 trillion, and foreign investors account for only about 2.4% of all holdings, vs. India (4.8%), Korea (6.6%), Thailand (8.5%), Malaysia (19.7%) and Indonesia (36%). China Government Bonds (CGBs) would be attractive from both an absolute yield and a carry perspective. An increase in foreign participation in the onshore bond market might help Hong Kong s dim sum bond market as well. Opening up the domestic bond market could, in a way, help mitigate FX outflows or domestic capital flight should RMB weaken. What are the likely stock market impacts? We think the RMB s inclusion in SDR could lead to more demand for RMB, though not enough to weaken the USD. In addition, to help increase the chance of SDR inclusion, China will keep RMB reasonably strong and stable, which should cap capital outflows and help maintain domestic liquidity, which we assume is indirectly supportive to the domestic equity market, while the impact on the US stock market should be limited in the near-term. The SDR inclusion may also indirectly push the A-share market into the MSCI EM index, which may bring more liquidity into the Chinese equity market. Three key obstacles have been 1) quota allocation; 2) capital mobility; 3) capital gains taxation. The inclusion requires the agreement from the majority of the global top 50 asset owners/managers. It is estimated $1.7tn is benchmarked to the MSCI EM index, and the A-share weighting in the MSCI EM could be as much as 20% on a 100% inclusion. Amundi Discussion Papers Series - DP

26 26 Amundi Discussion Papers Series - DP

27 II. Capital flows and capital controls: the debate about capital account openness 2.1. Why restrict capital flows? Capital controls can be used to protect domestic industries, correct a balance of payment surplus or deficit, support the financial sector, secure financing for the government, restrict foreign ownership of sectors considered strategic for the economy, and prevent foreign exchange movements in either direction. In other words, with capital controls, countries try to manage both inflows and outflows of capital. The table below summarises the different purposes for capital control implementation. The rationale behind capital controls Purpose Description Control of Generate revenue/ finance war effort Financial repression/ credit allocation Correct a Balance of Payments Deficit Correct a Balance of Payments Surplus Prevent potentially volatile inflows Prevent financial destabilisation Controls on capital outflows permit a country to run higher inflation with a given fixedexchange rate and also hold down domestic interest rates Governments that use the financial system to reward favoured industries or to raise revenue, may use capital controls to prevent capital from going abroad to seek higher returns Controls on outflows reduce demand for foreign assets without contractionary monetary policy or devaluation. This allows a higher rate of inflation than would otherwise be possible Controls on inflows reduce foreign demand for domestic assets without expansionary monetary policy or revaluation. This allows a lower rate of inflation than would otherwise be possible Restricting inflows enhances macroeconomic stability by reducing the pool of capital that can leave a country during a crisis Capital controls can restrict or change the composition of international capital flows that can exacerbate distorted incentives in the domestic financial system Outflows Outflows Outflows Inflows Inflows Inflows Amundi Discussion Papers Series - DP

28 Prevent real appreciation Restrict foreign ownership of domestic assets Preserve savings for domestic use Protect domestic financial firms Restricting inflows prevents the necessity of monetary expansion and greater domestic inflation that would cause a real appreciation of the currency Foreign ownership of certain domestic assets especially natural resources can generate resentment The benefits of investing in the domestic economy may not fully accrue to savers so the economy, as a whole, can be made better off by restricting the outflow of capital Controls that temporarily segregate domestic financial sectors from the rest of the world may permit domestic firms to attain economies of scale to compete in world markets Inflows Inflows Outflows Inflows and Outflows Source: Christopher J. Neely, Federal Reserve Bank of St. Louis, Review, Nov./Dec Capital controls drive a wedge between the domestic economy and the rest of the world. With the capacity to limit the arbitrage between onshore and offshore interest rate markets, capital controls allow domestic interest rates to be used to target inflation. Moreover, the local currency is not impacted by pressures potentially brought by higher interest rate differentials. We can divide capital controls into two main groups: Capital controls reducing inflows and outflows to the real economy, including restrictions on foreign ownership of real estate, utilities, natural resources or other sectors considered strategic; Capital controls affecting flows to capital markets. The debate about the effectiveness of capital controls to reduce the potential destabilising effect of short-term capital inflows is unclear. In fact, there is no clear verdict whether controls ultimately achieve their objective. Empirical studies tend to confirm that: Open capital accounts are positive for long-term growth. Controls on inflows of capital would not affect the volume of net flows in most countries, although in the short term they tend to affect its composition. In the long-term, capital markets find ways to circumvent the controls. There is little statistical significant evidence that having capital controls reduces financial vulnerability. In fact, the number of financial crises in countries with capital controls is higher but there is a statistical bias as 28 Amundi Discussion Papers Series - DP

29 countries having capital controls have usually bad fundamentals and difficult political situations. A reduction in capital controls is frequently the consequence of better fundamentals and tends to be correlated with additional capital inflows. In crisis periods, with appropriate macroeconomic and financial policies, capital controls contribute to the stabilisation of the exchange rate. Capital restrictions may be successful in limiting the volatility of capital flows. China is a typical example. As seen above, different forms of capital controls exist with different objectives. Their impact is limited compared to the impacts of other policies. Sometimes, capital controls have unintended consequences. To give an example, while New York was at that time the major centre for bonds issuance, the US imposed in the 60 s a tax on US purchases of foreign securities (the interest equalisation tax) to limit capital outflows and to reduce the balance of payments deficit Unintentionally, because of this tax, New York lost its predominant position. The migration of international bond issuance and trading to London became irreversible. In other words, once the currency is internationalised and financial centres developed, efforts to maintain it are still necessary especially in a multipolar world. The potential increase in the international role of the RMB and the projections mentioned above are undoubtedly impressive, but China is not yet considered as an open country should we focus on the capital account openness through the Chinn-Ito index (KAOPEN index), which gives a measure of a country s degree of capital account openness. Initially introduced in 2005/2006 by M. Chinn and H. Ito, this index is based on the binary dummy variables that codify the tabulation of restrictions on cross-border financial transactions reported in the IMF s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). According to the most recent update, which contains information on regulatory restrictions on cross-border financial transactions as of the end of 2014, China is still considered to be an economy lagging behind the bulk of emerging and less developed economies. Ranked 106 out of 160 countries (with the same ranking as countries such as Tajikistan, Swaziland, Thailand, Togo, Tunisia, Zimbabwe and Turkmenistan), the score reflects the efforts still to be made. Only 15 countries have a weaker score, including Ghana, Guinea, Eritrea, Myanmar and Surinam, with Venezuela ranked last at 160. The elimination of capital controls is always difficult due to the implications on FX policy and monetary policy. The Impossible trinity is a trilemma which states that it is impossible to have all three of the following at the same time: A fixed FX rate system, Free capital movement (i.e. the absence of any capital controls), A fully independent monetary policy. Amundi Discussion Papers Series - DP

30 History has shown that different international financial systems haven attempted to achieve combinations of two out of the three policy goals. For example, the Gold Standard system guaranteed capital mobility and exchange rate stability while the Bretton Woods system provided monetary policy independence and exchange rate stability. China still has monetary independence, low financial integration, capital controls and a stable FX rate. Europe and the US, to name a few, have financial integration, no capital controls, flexible exchange rates and not totally independent monetary policies. Aizenman, Chinn, and Ito also introduced the "trilemma index" in 2008 to quantify the degree of achievement along the three dimensions of the "trilemma" hypothesis: monetary independence, exchange rate stability, and financial openness, for more than 170 countries and from the 1960s: more precisely, the Monetary Independence (MI) index is available for 171 countries; the Exchange Rate Stability (ERS) index for 181 countries, and the financial openness index (the KAOPEN index) for 181 countries. Updated last July, the results show a slight improvement for the past 25 years in the Exchange Rate Stability Index and a stabilisation of both Monetary Independence and Financial Openness Indices. The road is still long, even compared to other emerging countries, particularly in terms of financial openness / financial integration 2.2. Financial liberalisation: lessons from past experiences It is worth comparing the current financial liberalisation in China with other experiences from the past. Throughout history, lots of countries have decided to liberalise the financial markets, open the capital account and abandon capital controls, and experiences are mixed overall, for at least five reasons: The liberalisation occurred in different periods of time, some of which were highly favourable, while others were hectic and resulted in financial crises; This decision has been implemented in advanced and developing countries at very different stages of development; When countries are different in size and importance, the impacts are naturally different. Financial vulnerability and political instability might be additional criteria making the difference between two experiences; There is no single way to adopt financial liberalisation: in history, some countries had promoted a big bang approach, while other countries preferred very gradual approaches; In some cases, financial liberalisation was simply a way back to a normal situation, a financial crisis having forced countries to adopt capital controls to curb the negative impacts (on the FX regime, on capital flows ). In the case of China, it is a major step to a brand new situation, to uncharted territories. 30 Amundi Discussion Papers Series - DP

31 Initially, it seems difficult to compare China today with past experiences in Asia, Eastern Europe, continental European countries, Scandinavian countries, etc. What are the best proxies? As Chen Jonung Unteroberdoerster (2009) mention, how can we compare small, advanced market economies and welfare states, with China, a big and far less developed country, "without a modern social security system, lacking a firm legal infrastructure, with large stateowned banks, and a dormant financial system: in short, a country in transition from a socialist mode to a market economy? The Scandinavian countries Denmark, Finland, Norway and Sweden may not be the first case of financial liberalisation and financial crisis that spring to the minds of policy-makers when they are searching for lessons that are relevant for China at the present time. However, as these authors mention, there are several reasons to consider the Scandinavian experience to be useful, simply because China today and the Nordic countries before liberalisation, i.e. in the mid-80s, share a critical mass of common features: "A bank-dominated financial system, Strong credit controls, Exchange (capital account) controls, Lack of risk management experience, Lack of financial knowledge, Open on the current account side. In sum, similarities are much higher than generally thought. So, what are the lessons for China? Among the different lessons Chen Jonung Unteroberdoerster (2009) developed, we will examine the five most important ones: Lesson#1: Financial liberalisation does not necessarily pave the way toward financial crises, except when policy makers and central banks misunderstand the effective operation of newly unregulated financial markets. With capital account openness and the end of capital controls, a country always enters a riskier world, and usual behaviours have to be avoided. In Scandinavia, policy-makers, central bankers and financial regulators underestimated the risks that a combination of deregulation and accommodative monetary and fiscal policies could represent. Credit growth and rising consumption were excessive, and no major counteracting stabilisation policy measures were taken in time. At that time, Scandinavia failed to identify the boom-bust cycle: for many years or even decades, policy-makers and other players had experienced a financially closed and strongly regulated economy, with limited financial risks. As a consequence, they strongly misunderstood the effective operation of unregulated financial markets. In other words, understanding the linkages within the financial system and to the rest of the economy and the workings of open financial markets is central to making financial liberalisation successful. History recalls that Amundi Discussion Papers Series - DP

32 particular attention has to be paid to the growth of credit aggregates, as credit is the main driver of boom-bust cycles. The risk is particularly high nowadays because at the time of its financial liberalisation, market participants will have access to instruments and techniques that did not exist in the Nordics in the 1980s and that facilitate capital flows, credit, etc. Lesson#2: Reforms need to be properly sequenced to minimise procyclical effects. It is very common to liberalise capital inflows before liberalising capital outflows. China is in the same mood. The danger is simple: to generate at first a lending boom, and then to be forced to reverse the economic policy to protect the FX regime (usually a peg or a closely managed floating exchange regime) or to curb the damages of a financial crisis when financial markets are externally deregulated. In Scandinavia, once the financial difficulties appeared, the exchange rate regime had to be protected with high interest rates, thus contributing to the economic downturn. In several cases, the peg had to be abandoned. This happened in September 1992 in Finland, in November 1992 in Sweden and in December 1992 in Norway. No doubt floating exchange rate regimes had to be adopted earlier. To cut a long story short, China should strengthen its financial system before it is exposed to international competitive forces. Lesson#3: The financial supervisory system has to be reformed prior to or (at the latest) simultaneously with financial liberalisation. In Scandinavia, prior to financial deregulation, no doubt financial supervision was appropriate, despite the fact that there were no weak banks, no corruption, no dubious links between banks and companies, and no subsidies to banks. Nevertheless, when the financial crisis surfaced in the early 1990s, the entire banking system collapsed in most of the countries. In reality, supervision became less and less effective as financial liberalisation gained ground. The consequences were very severe, especially in Sweden and Finland, where the downfall in output and production in the early 1990s were larger than during the previous crises, matching the depression of the 1930s. Lesson#4: A "big bang" approach to financial liberalisation as applied by the Nordics (apart from Denmark) should be avoided in China, where a cautious approach should be favoured by liberalising in small, but substantive steps. To stay flexible ahead of potential difficulties is essential in general, and especially in the case of China due to its role in US debt financing. As a consequence, any financial instability coming from financial reforms in China might have an impact on world financial markets. Indeed, according to US Statistics, China accounts for about 1/4 of US Treasury bills and bonds held by foreigners. The build-up of such a high level of FX reserves is mainly due to 1) large and rising current account surpluses, and 2) long-term capital inflows (such as foreign direct investment) attracted by China s rapidly growing economy. Another reason for a flexible and gradual approach comes from the 32 Amundi Discussion Papers Series - DP

33 fact that the Scandinavian economies were market-based systems when they decided to liberalise their financial markets, which is not the case for China, still at present an economy in transition: as a consequence, the process is certainly more complicated and riskier, and it pleads for gradualism. Denmark adopted a more gradual process, which allows time to learn from mistakes and provide the opportunity to back-track if signs of major tensions develop and its financial liberalisation was implemented without creating a sharp boom-bust pattern. Lesson#5: In the long-run, financial liberalisation tended to be beneficial for the countries that decided to move this way. It should be the case for China, and as Chen Jonung Unteroberdoerster (2009) pointed out, a properly functioning financial system is a key determinant of growth and transformation. Maintaining the present status quo of financial underdevelopment brings high costs and the risk of abrupt and thus very damaging - changes in the future. Note that even if in some cases countries have implemented temporary capital controls in period of crises, none of them have reversed the financial liberalisation trend. And none of the three Nordic countries (Sweden, Norway and Finland) that suffered the costs of financial crisis of the 1990s has made the decision to go back to financial autarchy and to drastically limit capital flows, or otherwise to turn the clock back. This suggests that the long-term benefits of financial integration outweigh its short-term costs. To conclude, it is evident that financial liberalisation is always a risky journey, and that the gradualism of the Chinese policy does not fully guarantee the absence of turbulence. However, the short-run costs and risks have to be compared with the long-run benefits China s capital outflows: what is at stake The breakdown of China s capital outflows China s capital flows (inflows or outflows), i.e. non-fdi capital flows, are generally calculated by taking changes in FX reserves minus the trade surplus, net FDI, valuation effects and interest earnings. This equates roughly to the non-fdi capital flows for that month. Markets try to do little revisions on overinvoicing or services trade, but they are not significant enough to change the overall picture. It is clear that China has been experiencing non-fdi capital outflows for more than two years, the scale of which has increased ever since last August when the RMB unexpectedly depreciated, with an average of US$120 billion in non-fdi capital outflows from last August to this January. This is double the average rate of US$60 billion in non-fdi capital outflows from July 2014 to July Amundi Discussion Papers Series - DP

34 China Equity Funds Cumulative Flows ($ Billions) Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul China Bond Funds Cumulative Flows ($ Billions) Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Resident Foreigner Total Source: EPFR, Amundi Research What are the driving forces behind China s capital outflows? Data has clearly shown, especially in 2015, that a negative change in FX reserves leads to non-fdi capital outflows. What are the forces driving China's capital outflows? We think there are two main reasons: 1. Repaying foreign debt. Chinese corporates foreign debt was around US$1.1 trillion in early As such, there has been huge unwinding pressure, where corporates sold RMB and bought USD to repay their foreign debt. This foreign debt was reduced to US$800 billion by the end of Clearly there have been around US$300 billion of non-fdi capital outflows in Hedging. Financial institutions, corporations, and individuals who never thought that the RMB would depreciate, have had to hedge the risk of RMB depreciation ever since August Hence the demand to sell RMB and buy USD is also very strong. The hedge ratio has had to rise from its previous level of 20-30%. At what level will China s capital outflows moderate? As for repaying foreign debt, we believe that China s non-fdi capital outflows could stabilise when the level of foreign debt reaches around US$ Amundi Discussion Papers Series - DP

35 billion, which is a 50% drop from the current level. It will take at least another six to nine months, given the accelerated pace of outflows. As for hedging, the situation may stabilise when it reaches around 50-60%, a rise from the previous 20-30% level. This may take a similar amount of time to reach that level. In the short term, we continue to see FX reserve depletion, capital outflows and RMB depreciation. And, if we focus on the trends in the near future, what are we likely to see? A one-off RMB depreciation to save FX reserves, and minimise capital outflows? Or a gradual RMB depreciation, resulting in FX reserve depletion and extended capital outflows? We tend to think a gradual approach to RMB depreciation would very likely be the path chosen by the PBoC, given that it cannot afford to trigger consequences like those caused by the previous two episodes of RMB depreciation. What is the roadmap forward for capital account openness? First, the pace: capital account openness is not reversible. Will the pace of openness increase? We tend to think so, as the major arguments for accelerating capital account opening are valid enough: Favourable FX environment with relative weakness in other major currencies such as the US dollar and UK pound; Cheap valuation leading to increasing demand from foreign direct investment; More capital account openness will grant more room for RMB internationalisation. Second, the path: capital account openness may not follow a straight line given market conditions and developments. The RMB depreciation fuelled turbulence in the global markets in August 2015 and in January As a consequence, the Chinese government tightened certain rules and regulations especially in terms of restricting channels of capital outflows. Also, overinvoicing of exports and fraudulent trade financing in early 2013, at a time when interest rate and exchange rate arbitrage led to rapid FX lending, the Chinese government tightened rules on Chinese banks FX lending as well as scrutiny of exporters documentation. Third, the timeline: the PBoC has achieved basic convertibility. We expect that the PBoC will fully achieve capital account convertibility in 2 to 7 years time, i.e. by 2018 to By that time, equity markets, bond markets and property markets will all be fully open. The logic behind opening up these markets is and will be inflows first, outflows second. Sequencing becomes significantly important in the opening process more mature markets will open first, and less mature markets will open later. How to differentiate real demand, investment demand or speculative demand within these three markets, hence Amundi Discussion Papers Series - DP

36 how to regulate, would be the most difficult obstacle to overcome. If these issues are not dealt with cautiously, the consequences would be devastating. Fourth, the areas: we expect there will be spikes in quotas and expansion in areas that can be invested for QFII, RQFII, QDII, QDII2 and etc. There are different access channels currently but they are not exclusive. 1) In the same way as for QFII and RQFII segregated accounts, we think there are possibilities to allocate quotas to different asset classes and to appoint fund managers or advisors. This is best suited for long-term investments for institutional investors already holding licenses/quotas; 2) As for direct access channels such as stock connect (Shanghai Hong Kong Stock Connect is already a good practice for the launch of Shenzhen Hong Kong Stock Connect) and the Chinese Interbank Bond Market, they are best suited for long-term investments for institutional investors without licenses/quotas; 3) As for access through funds such as QFII or RQFII mutual funds and ETFs, Chinese mutual funds accessible in HK through Southbound MRF (Mutual Recognition of Fund) are best suited for smaller sizes or tactical investments. We expect rules and regulations will have to keep pace with the developments when capital account opening becomes wider and deeper, until they are fully convertible in 2 to 7 years time if on schedule without other setbacks. Fifth, the constraints: China has changed its FX policy, from managing a sort of peg vs. the USD to managing the stability vs. a basket. The stability of the yuan is crucial to establishing a regional and international role for the yuan. It is also crucial due to the inclusion of the yuan in the SDR. It is crucial, last but not least as regards China s commitment to the G20. China also wants to develop a debt market to attract capital flows from abroad. It is a good idea, but the reduction of capital controls simply means China will have to accept either a less independent monetary policy, or a more flexible FX rate, or both. In other words, this will involve a massive change to the way monetary policy is actually managed. Developing an offshore market means that 1) part of the debt will not follow the rules, controls and constraints of the onshore market, and 2) liquidity and valuation might be in the hands of foreign banks. Investors will ask for greater transparency on economic indicators, independence of statistical offices, state-owned-enterprises, and on monetary, fiscal, tax and FX policies in order to avoid a country risk premium on top of issuers. Another consequence is that the increased activity of foreign investors implies higher volatility and higher turnover, impacting yields and FX rate. 36 Amundi Discussion Papers Series - DP

37 2.4. What are the perspectives for the Chinese equity and bond markets? In the recent years, China has pursued the development of its equity market. Its market capitalisation has increased significantly, and China is now ready to open capital markets to foreign participants (see graph). The S curve of financial deepening Market Capitalisation % of GDP Japan South Korea China Malaysia Thailand Vietnam India Indonesia Time Improved institutional framework including legal and credit transparency Rising household savings and growing per-capita income seek new investment choices Organic growth as bank dominance fades and corporations raise cash via issuance Opening up of capital markets to allow foreign participation Slowing in per-capita income growth relative to frontier economies Divestment out of equity market as population ages and becomes less risk tolerant Source: ANZ Insight Report 2014, Appendix I A recent market research report by ANZ suggests that: China s equity market could be the largest in the world, with a market capitalisation of around US$30 trillion or just under 25% of projected world market capitalisation compared to US$22 trillion (18%) for the US; China s bond market could be the second largest in the world after the US, and equal in size to that of the entire Eurozone. Amundi Discussion Papers Series - DP