RMB Internationalization and Offshore Markets Developments. Zhihuan E. I. A brief history of dollar internationalization and its main factors

Transcription

1 RMB Internationalization and Offshore Markets Developments Zhihuan E As the RMB is increasingly used in cross-border trade and investment, a number of offshore RMB centers have rapidly emerged. With consistently improving market depth and breadth, these offshore centers have helped further the internationalization process. The experience of major international currencies proved that offshore markets, as an extension of the jurisdiction of domestic financial markets, were instrumental in helping a currency achieve and maintain international status. I. A brief history of dollar internationalization and its main factors A number of scholars have researched on the internationalization of the U.S. dollar and its major factors. Cooper (1997) and Mckinnon (2001, 2002, 2003) showed that the maturity of a country s financial markets was a key determinant of its currency being an international vehicle currency. In addition, Krugman (1980), Dooley, Lizondo and Mathieson (1989), Mckinnon (1998), Eichengreen and Mathieson (2000), Kenen (2002, 2003), Truman (2007), and Chinn and Frankel (2007) have all proved the key international status of the dollar and its resulting popularity in foreign reserve, international trade, and international finance generated powerful network effects and externality, which created a virtuous cycle that helped maintain the dollar s status. Meanwhile, Rey (2007), Rose (2007), Setser (2007), Curcuru, Dvorak and Warnock (2008), Posen (2008), and Truman and Dowson (2008) asserted that international currency behaviors cannot be fully explained by economic or financial factors. The U.S. s leadership in defense, commerce, and even culture played a vital role in the use of the dollar. The internationalization of the dollar took about half a century, from late 19 th century to mid-20 th century. We believe that the U.S. s ascending economic might was a decisive factor. The size of the American economy first exceeded that of the U.K. in By World War I, the U.S. s industrial production had accounted for one third of the world s total output, surpassing the output of the U.K., France, Germany, and Japan combined. In 1915, U.S. exports overtook the U.K. Moreover, during the First World War, the U.S. accumulated an enormous amount of gold reserves and turned from a debtor country into a creditor country. As a result, in early 20 s, the U.S. was the only country able to fulfill obligations in gold trading, and the dollar was the only currency that could be exchanged for gold. Buffeted by the global Great Depression from 1929 to 1933, the U.K. was unable to comply with the gold standard and had to turn to the U.S. for help. Thanks to the U.S. s leadership in economic power and gold reserves, the dollar had a breakthrough. World War II also inadvertently provided dollar internationalization with a 1

2 historic opportunity. As the U.S. offered its European allies strategic supplies, the dollar was able to penetrate much of Europe. By the time of the Bretton Woods convention in July, 1944, the U.S. had stockpiled gold reserves worth 20.8 billion dollars, or 59% of world total at the time. This enormous gold reserve served as a foundation for the peg between the dollar and gold and fixed exchange rates between the dollar and other currencies, which helped the dollar become a dominant international currency. The Marshall Plan was officially launched in July, 1947 and lasted for 4 fiscal years. Dollar loans helped alleviate the capital crunch in Western Europe. Thanks to the financial aid, Europe was able to purchase U.S. goods and became a new market for U.S. excess capacity. The U.S., in turn, benefited from strong European demand and gained pricing power in commodities and raw materials. In the 50 s, trade barriers between European countries were eliminated, and free trade underpinned by a multilateral payment system helped the dollar become a dominant currency. Clearly, the U.S. s lopsided economic outperformance, scale of international trade, and gold reserve played a decisive role in propelling the dollar s international status. II. Developments of the offshore dollar market and the dollar s international currency status The developments of an international currency are closely intertwined with those of domestic and overseas financial markets, with offshore financial markets playing a particularly important role. The Eurodollar market, for instance, was instrumental in strengthening the dollar s international functions. The Eurodollar market first emerged in the 50 s of the 20 th century when the former Soviet Union and other socialist states tried to avoid possible sanction imposed by U.S. government. In the 60 s, the Eurodollar market grew rapidly in response to U.S. financial regulations and capital controls, interest equalization tax, and regulation Q. A large number of foreign corporations turned to the Eurodollar market for dollar funding. In the meantime, American commercial banks also set up subsidiaries in London to circumvent stringent financial regulation and capital controls in the U.S. The Eurodollar market helped them reduce costs and increase profits by expanding their funding sources and exploring new investment channels. The U.K., in an effort to maintain London s position as a competitive international financial center, refrained from levying interest taxes on dollar transactions and imposing reserve requirements on financial institutions. Such lax regulatory oversight and the resulting efficiency attracted an influx of dollar assets and financial institutions. The lines of business, meanwhile, expanded from dollar deposits and loans to deposits, loans, bonds, commercial papers, and equities in various currencies. As a result, offshore financial markets grew from a narrowly defined Eurodollar market to a European currencies market. 2

3 On August 15, 1971, President Nixon abandoned the peg set at 35 dollars for 1 ounce of gold and thus destroyed the Bretton Woods system. The global financial system then entered an age of floating exchange rates. During this period, dollar inflow into European offshore markets accelerated, further propelling the growth of the Eurodollar market spearheaded by London. The oil shock in late 70 s created a lot of petro dollars, which oil-producing countries elected to park in the Eurodollar market. These petro dollars quickly became a new growth stimulant for the Eurodollar market. Also in the late 70 s, developed countries began to relax financial regulations and capital controls as well as reduce tax rates and improve international cooperation. As the regulatory frameworks and fiscal environments of offshore and domestic markets converged, the traditional advantages of offshore markets were being eroded. However, financial innovation and securitization resulted in strong growth of derivatives trading, which required quality financial infrastructure including macro-prudential oversight, information disclosure, and settlement and payment systems. As market scale, liquidity, and breadth continued to improve in major international financial centers such as New York and London, the role of offshore financial centers in facilitating cross-border capital flows, far from declining, went from strength to strength. Clearly, in spite of the disappearance of traditional advantages, offshore financial markets managed to grow thanks to opportunities created by new financial services as a result of improved division of labor in global financial activities. In terms of timing, a booming European offshore dollar market only emerged after the dollar attained its international currency status. At first, the Eurodollar market s merits lied in its ability to provide non-residents with a market for dollar-denominated assets, circumventing political disagreements. In the later stage, the Eurodollar market mainly worked against capital controls imposed by the U.S. by providing non-residents with dollar assets and settlement support. III. Features of offshore RMB market developments Since Bank of China (HK) was appointed the RMB clearing bank in Hong Kong, offshore RMB businesses have grown for 10 years. In 2013, the People s Bank of China also appointed clearing banks in Taiwan and Singapore, which became new offshore RMB centers. In March, 2014, China s central bank signed a memorandum in Frankfurt with the Bundesbank on RMB clearing arrangements. Meanwhile, the Chinese government has allotted an 80 billion Yuan RQFII quota to France. Moreover, on March 31 st, the People s Bank of China and the Bank of England signed a memorandum on RMB settlement and clearing. This agreement reinforced London s role as an RMB trading center in the Western Hemisphere, making the city the first 3

4 choice for RMB settlement outside of Asia. Developments of offshore RMB centers are obviously policy-driven. An offshore RMB market first emerged in 2004 when Hong Kong banks began to offer offshore RMB services. This policy initiative was a stimulus response to help jumpstart Hong Kong s economy, which was then ravaged by the SARS outbreak. At first, the offshore RMB market in Hong Kong grew very slowly. As of the end of 2007, RMB deposits in Hong Kong only amounted to 33 billion Yuan. In 2008, the subprime mortgage debacle in the U.S. trigged a global financial crisis. Subsequently, the RMB s role as a pricing currency gradually strengthened within the region. Hong Kong s RMB market then grew rapidly to become both a pioneer and a hub for the innovation and promotion of RMB products. In fact, the growth of offshore RMB markets is directly influenced by the relaxation of various regulations. In January, 2007, the People s Bank of China began to allow qualified domestic financial institutions to issue RMB-denominated bonds in Hong Kong. Thanks to market-oriented credit rating, pricing, and issuance procedure, the outstanding amount of such bonds rose from 56 billion Yuan at the end of 2010 to 310 billion Yuan at the end of 2013 for an increase of 460%. From 2009 to 2013, RMB-denominated sovereign bonds issued by the Chinese government amounted to 80 billion Yuan. In July, 2009, the launch of cross-border RMB trade settlement ushered in a second phase of RMB businesses in Hong Kong. In August, 2011, the RMB trade settlement program was expanded to cover all Chinese territories. RMB businesses in Hong Kong were also extended from individuals to corporations and institutions. More importantly, RMB movement shifted from one-way inflow back to the Mainland to capital flow in both directions, which represents a major step forward in the process of RMB internationalization. In 2011, the Chinese government implemented the RQFII program, which allows qualified foreign investors to invest in the domestic securities market. Since March, 2013, all financial institutions that are registered in Hong Kong or operate mainly in Hong Kong are qualified for the RQFII program. RMB deposits in Hong Kong s banking system account for about 60% of the global total, while RMB trading volume in the city has a 90% market share in offshore RMB spot exchanges. Moreover, Hong Kong is also the biggest offshore RMB bond market. Meanwhile, RMB trade settlement processed by Hong Kong banks jumped from billion Yuan in 2010 to trillion Yuan in 2013 for an increase of over 10 times. As of the end of 2013, there were nearly 4.5 million RMB deposit accounts in Hong Kong, averaging 191,400 Yuan per account. By the end of 2013, Hong Kong had amassed the biggest RMB pool outside of the Mainland, with 4

5 the trillion Yuan total being comprised of 860 billion Yuan in deposits and 191 billion Yuan in certificates of deposits. Meanwhile, a total of 216 banks participated in Hong Kong s RMB clearing platform, including 191 subsidiaries of foreign banks and overseas branches of Mainland banks. The limited number of channels for RMB inflows back to the Mainland is still a major constraint of the growth of offshore RMB markets. There are different ways for offshore RMB funds to flow back to the domestic market. Due to comparatively low interest rates in Hong Kong, many banks and companies are willing to borrow in Hong Kong s RMB market. Cross-border RMB lending in Qianhai was officially launched at the end of Institutions registered in Qianhai can obtain RMB loans from Hong Kong banks. Applications for cross-border RMB loans in Qianhai amounted to over 10 billion Yuan last year and could exceed 50 billion Yuan this year according to the Qianhai Management Bureau. Meanwhile, as of the end of 2013, billion Yuan of RQFII quota had been used, with the number of eligible institutions increasing to 52. RQFII funds such as ETF products sold well in Hong Kong, which facilitated RMB inflows back to the domestic market. Hong Kong s RMB financial infrastructure plays a vital role in global offshore RMB market developments. The core of Hong Kong s RMB financial infrastructure lies in its RMB RTGS system, which is connected with the RTGS systems for Hong Kong dollars, U.S. dollars, and Euro, as well as the central settlement system for stocks and bonds. The resulting ability to simultaneously clear foreign exchange settlements in four different currencies greatly improves capital market efficiencies and guards against credit and liquidity risks. Moreover, Hong Kong s RTGS clearing system is also connected with the RTGS systems of major central banks worldwide and is capable of carrying out simultaneous payments in all major financial markets. For the time being, the RMB RTGS system operates 15 hours daily and covers trading hours in Europe, with 90% of the trades being offshore trades. As an RMB clearing bank, Bank of China (HK) has assumed an increasingly central role in global offshore RMB markets. Thanks to the increasing popularity of the RMB in trade and investment activities, the settlement amount of Hong Kong s RMB RTGS system consistently reached new record highs. RMB settlement exceeded that of Hong Kong dollars in a number of months in 2013 and, for the whole year, grew 86% from IV. The impact of Hong Kong s offshore RMB market on RMB internationalization In academia, there exist diverging views on the topic of whether offshore markets should play a role in RMB internationalization. For instance, scholars at Boyuan Foundation believe that offshore RMB markets help further RMB internationalization and the offshore market in Hong Kong plays into this trend. He and McCauley are of the opinion that foreign investors tend to use offshore 5

6 markets to increase their positions in the currency in question. Even with capital controls in place, offshore RMB markets can still grow. A necessary condition is that offshore financial institutions maintain onshore clearing accounts that allow free withdrawals. Therefore, RMB internationalization does not require an open capital account. Ma Jun, meanwhile, claims the assertion that currency internationalization does not require offshore markets lacks proof. A more accurate conclusion is that capital account opening in small and medium-sized economies does not require offshore markets. On the other hand, Zhang Bin of the Social Sciences Academy expects that using offshore markets to promote RMB internationalization will entail amassing more foreign assets and domestic liabilities. Under these circumstances, welfare loss will occur when the RMB continuously appreciates. According to this view, reforms on RMB exchange rates and foreign reserve management are more urgent and should predate offshore market developments and capital account opening. However, some argue that offshore RMB market developments can force domestic financial market reforms. Tetsuji claims that the onshore-offshore RMB markets growth pattern will provide special interest groups with new opportunities for rent-seeking behaviors. As a result, domestic financial reforms will be stalled. Yu Yongding claims that offshore RMB markets create arbitrage opportunities and complicate macroeconomic management, and it is unclear that such developments can become a driving force for domestic financial market reforms. Li Daokui and Liu Linlin proposed a two-pronged approach for RMB internationalization, with the offshore RMB market in Hong Kong being a testing ground for relaxing capital controls. Eichengreen proposed three approaches for RMB internationalization. One is to liberalize domestic financial markets and strengthen contract fulfillment, corporate governance, and the rule of law. Improved regulatory oversight and reforms carried out by an independent central bank can then help achieve convertibility of capital accounts. The second approach is to open capital accounts and minimize interest rate regulations. The third approach is to selectively relax capital controls and use offshore financial markets such as Hong Kong as a platform for RMB internationalization. Eichengreen believes this approach is an attractive compromise of the first two options. We believe that the impacts of Hong Kong s offshore RMB market on RMB internationalization are reflected in the following areas. 1. Hong Kong can to some extent make up for the lack of openness of the Chinese economy. 6

7 According to the IMF, economic size and openness are the prerequisites of currency internationalization, while adequate balance of payments and relatively stable economic performance also help. China obviously excels in economic scale and trading volume but still has a lot of room for improvement when it comes to its economy s openness and market mechanism. In particular, China has a long way to go before it can meet the requirements of an open capital account, floating exchange rates, and highly developed financial markets. Fortunately, Hong Kong, the freest economy in the world, can to some extent make up for the lack of openness of the Chinese economy and help China meet the basic conditions of currency internationalization. 2. So long as China maintains capital controls, non-residents must use Hong Kong to obtain RMB assets. The U.S. experience shows that capital controls alone do not hinder currency internationalization. Arrangements that facilitate two-way capital flows between Mainland China and Hong Kong can help connect the Mainland s and Hong Kong s capital markets. Even as the Mainland s capital control measures remains in place, Hong Kong and overseas investors will be able to enter the Mainland s capital markets via the offshore market in Hong Kong. Meanwhile, under some predetermined conditions, domestic Chinese residents should be allowed to invest overseas. 3. To deepen China s financial markets, Hong Kong s experience can be duplicated. Currency internationalization requires support from financial markets with breadth and depth, which Mainland China still lacks. However, as financial cooperation between Hong Kong and the Mainland improves, Hong Kong s experience can play an active role in the developments of the Mainland s financial markets by helping the Mainland s financial infrastructure become more market-oriented. 4. The growth of Hong Kong s offshore market can boost international investors confidence in RMB-denominated assets. Ultimately, whether the RMB can become a reserve currency will depend on the level of acceptance by international markets. As the Hong Kong dollar is pegged with the U.S. dollar, Hong Kong s financial markets are unique and irreplaceable. Prior to becoming an offshore RMB center, Hong Kong had already been a mature offshore financial market, specializing in syndicated loans, asset management, and equities trading. Offshore RMB provided Hong Kong s offshore financial market with a new trading currency and related financial products, which will boost both Hong Kong s 7

8 economy and its financial sector s global competitiveness. Meanwhile, the one country, two systems arrangement is conducive to the accumulation of offshore RMB in Hong Kong, which will ensure that Hong Kong will become and remain the biggest offshore RMB market. Furthermore, Hong Kong s open and free financial markets, its common law legal framework, and modern regulatory oversight all help improve international investors confidence in holding RMB assets. There is no denying that the current onshore-offshore dual pricing mechanism generates arbitrage opportunities. That being said, we believe that the existence of arbitrage opportunities could force domestic exchange rate reforms. Meanwhile, to counter arbitrage activities, capital controls can be gradually relaxed, and exchange rates could be made more flexible in responding to capital flows. Moreover, in order to achieve external rebalancing, policy measures can create incentives to increase outflow in the capital account and inflow in the current account. V. Prospects of RMB internationalization An international currency has five major functions: store of value, funding, investment, reserve, and trading. The Bank of China s offshore RMB index (ORI) was a composite measure taking into account factors including offshore RMB s share of total offshore currencies, offshore RMB loans as a share of total offshore loans, the share of RMB-denominated bonds and equities, RMB s share of total foreign reserves, and RMB s share of total foreign exchange trading. This index is an overall evaluation of offshore RMB markets on the size of currency stock as well as use of funds and financial tools. At the end of 2013, the Bank of China s offshore RMB index was at 0.91%. In other words, in global offshore financial activities such as deposits and loans, the RMB accounts for 0.91% of market share. In contrast, the ORI index was at 0.32% as of the end of 2011 and 0.50% at the end of Clearly, in the past two years, the RMB s share in various offshore financial activities rose quickly. In 2013, the rate of growth accelerated to 82%, which suggests that the pace of internationalization is picking up. When it comes to the degree of internationalization, the RMB is far behind other major global currencies. By the same measure, the index scores for the dollar, euro, British pound and Japanese yen came in at 48.17%, 25.20%, 5.91%, and 5.50%, respectively. In other words, the dollar and euro are still dominant players in global financial markets. In spite of the rapid pace of RMB internationalization, the RMB plays only a limited role in international finance. The components of the ORI index show that there exist asymmetries in different areas of RMB internationalization. 8

9 First, RMB internationalization is mainly driven by offshore deposits and foreign exchange. In 2013, offshore RMB deposits increased over 500 billion Yuan. The outsized gain in deposits is a key reason for the jump in the ORI index. At the end of 2013, overseas RMB deposits approached 1.5 trillion Yuan. If domestic accounts for non-residents were included, the total would have been over 2 trillion Yuan, or 1.34% of all offshore currencies. This market share is not too far from offshore Japanese yen s share of 3.32% and the British pound s share of 5.59%. Meanwhile, the RMB is also featuring prominently in foreign exchange. According to the BIS, the RMB only accounted for 0.9% of foreign exchange trading volume in 2010 for a ranking of 17 th. In 2013, the RMB was ranked 9 th with a market share of 2.2%. Second, in offshore RMB markets, direct financing grew faster than indirect financing. In 2013, Dim Sum bond issuance in Hong Kong amounted to over 270 billion Yuan. RMB-denominated bonds were also issued in the offshore markets of Singapore, Taiwan, London, and Luxemburg. In addition to being an important funding source for various institutions, offshore RMB bonds have also become an important investment option for sovereign entities. In contrast, in spite of strong growth, the amount of loans is relatively limited. As it stands now, outstanding offshore RMB loans amounted to about 400 billion Yuan, a far cry from the trillions of offshore dollar and euro loans and only a fraction of total offshore RMB deposits. Third, the RMB has great potential to establish itself as an international reserve currency. Thanks to a stable exchange rate and promising economic prospects, the RMB has become a new choice for jurisdictions that desire diversification in foreign reserves. In recent years, countries including Nigeria, Thailand, South Africa, Belarus, and Indonesia have expressed their interests in allocating part of their foreign reserves to RMB assets. Meanwhile, Russia, Chile, Saudi Arabia, and many EU countries are also considering the feasibility of RMB reserves. In the future, RMB reserves will likely become an increasingly appealing option. Clearly, in global financial markets, the RMB has been used to settle international trade, investments, and securities trading. RMB internationalization is arguably already in a primary phase. However, RMB internationalization is a long-term process that depends on the breadth and depth of China s financial markets, exchange rate reforms, and opening of the capital account. Cross-border RMB activities in the Shanghai Free Trade Zone, the Shanghai Hong Kong equities connectivity program, and a prospective free trade zone for Guangdong, Hong Kong, and Macau will provide more room for growth and help propel RMB internationalization to another level. 9