The Central Government in China has been planning a sequenced internationalization of the Renminbi (RMB), through giving authorization for domestic and foreign companies to settle transactions of goods and services in RMB, enabling that a limited number of financial transaction are also settled in RMB and, finally, promoting the international use of the RMB for other purposes such as a foreign reserve currency.
Relative to its size, China still has a small and underdeveloped financial market, especially resulting from restrictive policies regarding the free movement of capital across borders, and a managed floating exchange rate regime. With respect to the exchange rate, China’s main goal from the start of Deng Xiaoping’s Reform until 1983, was to rapidly develop all the essential infrastructures, hence the currency was kept overvalued (2.8RMB/USD) so that imports where cheaper. After that, the goal was to strengthen the industrial sector and increase employment, which meant the currency should be kept undervalued (8.28RMB/UDS from 1997 to 2005, around 6.4RMB/USD today) so that exports are more competitive.
Regarding the efforts to liberalize the capital account as smoothly as possible, the Government along with the People’s Bank of China and other important players, launched some programs throughout the years. In 2002, certified foreign investors had access to the stock market for A-shares (Qualified Foreign Institutional Investor – QFII). In 2006, certified domestic banks were allowed to invest their clients’ funds in financial products overseas (Qualified Domestic Institutional Investor – QDII). In 2010, a new program allowed foreign central banks, monetary authorities, RMB clearing banks, insurance companies and QFII to invest in the onshore interbank market (China Interbank Bond Market Scheme – CIBM). In 2011, RMB funds offshore, from Hong Kong, could be invested in securities in China (Renminbi Qualified Foreign Institutional Investor – R-QFII), in 2012 this program was extended to Taiwan, London and Singapore. Finally, in 2013, the Free Trade Zone in Shanghai was created allowing several transactions in and out of that area.
Despite the fact that the Government already stated interest in further internationalizing the currency, as well as, in the liberalization of the capital account as a condition for the previous, we must understand what that means. A report by the Bank of England (2013) predicts that gross international investment, representing only 5% of GDP in 2012, would represent around 30% of GDP in 2015, equivalent to the ratio in the US nowadays. This stems from three hypotheses. First, there will be a gap reduction as to the level of openness of the capital account, e.g. if China was to fully liberalize its capital account tomorrow and immediately reached the same position in the stock of international investment as the US that would imply an increase in inflows and outflows above 100% of GDP. Second, there will be a catch-up in growth (China is expected to grow 1.5 times more than the world economy), thus, even if capital flows do not increase relative to its own economy, they will increase relative to the world economy. Third, there will continue to be a decline in preferences towards domestic financial products, hence a substitution effect is expected, resulting in an increase in total flows of capital.
Internationalizing the currency brings great advantages regarding trade: reduction of foreign exchange risk, reduction of overall costs in transactions, potential increase in the total volume of transactions, greater efficiency in settlement, more cooperation and integration among countries. About the possibility of a flexible exchange rate regime, monetary policy could be more effective, since China will decrease its dependence from the Fed’s policy changes; nevertheless, flexibility implies greater volatility. As for the Renminbi being used as a reserve currency, it brings prestige and reputation, increasing China’s influence in foreign relations, and increasing investors’ confidence.
Focusing on the capital account liberalization, removing capital controls, especially on outflows, improves diversification of risk reducing the needs for preventive savings and releasing income to current consumption. Moreover, returns on foreign equity are usually higher, enabling a generalized increase in income.
However, although China has the biggest banking system in the world, it is still underdeveloped and extremely fragile. Additionally, bank activities are very dependent on central and local government’s interests. On the one hand, openness could increase funding efficiency and resilience against domestic shocks, leading to a higher competitiveness level and to the expansion of the financial services sector. On the other hand, there might be a shortness of capital upon large capital outflows, with the aggravation of the high level of monetization (M2/GDP=180%). The liberalization of the domestic interest rate would be a good policy response allowing for greater returns on domestic deposits, reducing the risk of sudden capital outflows.
In contrast, if there are large capital inflows, in the short-term, there might be congestions due to the lack of the development and deepness in the financial market. In the long-run, there might be maturity mismatches along with currency mismatches in the national accounts. Nonetheless, if there are prudential measures in order to reduce massive runs for credit and asset price volatility, it could improve access to credit and to new sources of credit.
In case liberalization causes a lower accumulation of foreign reserves by China, it might improve fiscal balance, since today the costs of sterilization are higher than the seigniorage revenues. Furthermore, it might help preserving the value of Chinese reserves since, because despite being the biggest holder of foreign currency, 70% of its reserves are still is USD, therefore, the risks associated with devaluation of the Dollar would be reduced.
How in the end it plays out will depend on multiple conditions. Theory suggests that the countries that benefit more from financial openness have a well developed financial system, including good regulation, a stable institutional structure and more efficient macroeconomic policies.
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