International Use of the Renminbi: Developments and Prospects Conference on The BRICS & Asia, Currency Internationalization, and International Monetary Reform Hong Kong, 10-11 December 2012 International Use of the Renminbi: Developments and Prospects Dong HE (何東) Executive Director (Research), Hong Kong Monetary Authority Director, Hong Kong Institute for Monetary Research * The views expressed here do not necessarily represent those of the HKMA or the HKIMR

Questions to address What is the macroeconomic and financial market context in facilitating the international use of the renminbi? What are the infrastructure requirements that need to be put in place for the renminbi to be used for cross-border trade and investment? Why do non-Chinese residents have incentives to hold renminbi-denominated assets and liabilities? How do they acquire renminbi-denominated assets and liabilities? Is renminbi internationalisation compatible with the gradualist approach to capital account liberalisation? What’s the progress? Where do we go from here?

Outline of presentation The context The role of official policies Incentives The role of offshore markets Prospects

The context The “dollar shortage” during the trans-Atlantic financial crisis of 2008-2009 highlighted the danger of relying excessively on one reserve currency in international trade and payments, and the possible benefits of using a wider array of currencies, including emerging market currencies, especially in transactions between emerging markets More broadly, the spread of the crisis globally was seen as an intrinsic defect of the international monetary system, where domestic policy objectives of the major reserve currency country override its obligations to maintain global monetary and financial stability I will speak mainly on two issues: first, elements of the post-crisis global and regional order; and secondly, what does this new order mean for Hong Kong as an international financial centre.

The role of official policies Whether or not a currency is used extensively for international transactions is primarily determined by market forces Renminbi internationalisation is more a process of dismantling extant restrictions against its international use, rather than active promotion Since mid-2009, the Chinese authorities have moved quickly to remove restrictions against the use of renminbi in current account transactions, and have gradually expanded the scope for the use of renminbi in capital account transactions The main challenge in managing the process is to delineate the relationship between currency internationalisation and capital account liberalisation Currency internationalisation is seen as an integral component of the broad financial sector reform and development agenda, and can be made consistent with the Chinese approach to capital account liberalisation

Capital account liberalization with Chinese characteristics “Proactive, controllable, and gradualist” Sector- or location-specific policy experiments “Quick small steps” “Speed bumpers” The degree of convertibility of the renminbi is best seen as a spectrum, not black or white

Preconditions for international use of currencies Except for non-deliverable markets, international use of currencies is impossible without the cooperation of onshore banks Cross-border use of currencies is an international financial transaction and requires some degree of non-resident convertibility Offshore banks need to be able to keep and have access to clearing balances with onshore banks

Special arrangement in Hong Kong Before July 2009, offshore banks generally could not maintain and have access to renminbi balances kept with onshore banks Hong Kong was the first place outside Mainland China to provide renminbi banking services since 2004 For renminbi banking in Hong Kong, a “Clearing Bank” was appointed by the People’s Bank of China (PBoC) in late 2003 to be the conduit, which accepts deposits from participating Hong Kong banks and in turn maintains balances with PBoC acts as the counterparty of currency exchange transactions of the participating banks and in turn squares its own positions in the China Foreign Exchange Trading System in Shanghai

Non-resident convertibility further expanded in 2009 and 2010 With the launch of pilot scheme of RMB trade settlement in July 2009, overseas banks could open correspondent accounts with banks inside China From August 2010 overseas nonbank institutions accepting payments for exports to China in renminbi can deposit the proceeds from such transactions on accounts with banks inside China

Sources and uses of renminbi funds Outflows from China Payments in renminbi for imports by Chinese firms Payments in renminbi for outbound direct investment (ODI) by Chinese firms Banks make loans to overseas firms in renminbi Onshore banks make loans to offshore banks in renminbi Swap lines with foreign central banks Inflows to China Payments in renminbi for imports from China Payments in renminbi for FDI investment inside China Repatriation of renminbi proceeds from bonds issued overseas by Chinese banks and firms, subject to approval Investment in the interbank bond market by foreign central banks and commercial banks which provide renminbi trade settlement services, subject to approval and quota Investment in the bond and equity market by Qualified Foreign Institutional Investors (R-QFII), subject to approval and quota

Incentives (I) Market forces have responded quickly to official policies Non-Chinese residents have strong incentives to increase their exposure to renminbi assets and liabilities because the starting positions are in all likelihood significantly below their desired or optimal portfolio allocations in the renminbi Such optimal allocations are likely to grow with the increasing weight of the Chinese economy in global production and trade The underlying incentive to increase exposure to renminbi assets and liabilities by non-Chinese residents is likely to have an upward trend, not easily reversed by cyclical fluctuations in exchange rate expectations

Incentives (II) From the Chinese residents’ point of view, the use of renminbi for trade invoicing and settlement allows Chinese firms and their counterparts to better share risks Internationalising the renminbi can also be expected to reduce currency mismatch of China’s international balance sheet An internationalised renminbi would allow governments and firms outside China to borrow in renminbi and thereby allow Chinese life insurers and pension funds to diversify credit while matching renminbi liabilities

Why do offshore markets exist? Offshore markets play essential economic functions even when capital can flow freely across the border (He and McCauley (2010)) Separation of currency risk from country risk Convenience factors (legal systems, accounting standards, language, time zone/geography) Diversification of operational risk Even nowadays, when foreigners use the US dollar to settle trade and make investments, they concentrate their transactions in international financial centres such as the euro-dollar markets in London, not onshore in New York City In fact, one may argue that without the offshore markets, the US dollar would not probably have attained as dominant a position in international trade and payments as it occupies today

Hong Kong as a renminbi offshore centre Hong Kong was the first place outside Mainland China to provide renminbi banking services since 2004 Because of the willingness and ability of Hong Kong monetary and regulatory authorities to cooperate closely with their counterparts on the Mainland, Hong Kong is the ideal offshore jurisdiction to provide a reliable testing ground for the international use of the renminbi Gradual and steady expansion of business scope, markets and products

The CNH market in Hong Kong Since July 2010, Hong Kong has produced a second set of spot and forward exchange rates for the renminbi, dubbed the CNH, for delivery of renminbi against dollars outside Mainland China A second set of renminbi yield curves has also been formed in Hong Kong with the active issuance of bonds by the Chinese Ministry of Finance and firms from both inside and outside China These offshore renminbi exchange and interest rates have retained a spread over but have tended to move in tandem with onshore rates

Size of the renminbi forex market in Hong Kong Payment versus Payment (PvP) in the RMB RTGS system RMB 15 billion average daily turnover in H1 2012 There are however other forex transactions not reflected in PvP turnover; the actual size of the RMB forex market in Hong Kong is probably twice as large as the PvP figure of RMB 15 billion per day Efficient clearing and settlement systems, seamless interface with Mainland’s CNAPS PvP settlement device eliminates FX settlement risk for banks

Capital account liberalisation and renminbi fund flows in offshore markets At present, the renminbi balance sheet of banks in Hong Kong serves as a conduit for net renminbi lending from the rest of the world to the mainland. Renminbi bonds issued by non-banks and held outside the banking system tend also to result in a net renminbi claim of the rest of the world on China Looking forward, capital flows can be expected to become two-way and more balanced with capital account liberalisation (He et al (2012)) The expected path of the renminbi exchange rate shows much less consistent appreciation, even as the Chinese current account surplus has narrowed. Thus, non-resident borrowing in the renminbi looks to be less discouraged by one-way expectations on the exchange rate In this case, the renminbi offshore markets in Hong Kong and in other centres can be expected to evolve along the paths of the other types of offshore markets. Over time, the renminbi offshore market is likely to play above all the role of intermediary between non-mainland Chinese borrowers and lenders I will speak mainly on two issues: first, elements of the post-crisis global and regional order; and secondly, what does this new order mean for Hong Kong as an international financial centre.

How would offshore renminbi markets evolve? My colleagues also estimated a gravity model to analyze how the bilateral portfolio investments are determined among the OECD countries. Based on the results of the estimated gravity model, we can compare the relative attractiveness of different economies in competing for portfolio investment flows from China. The way to look at the chart: market capitalisation on Vertical axis, distance of each country from China on Horizontal axis; share of portfolio investment from China captured by each country represented by the size of bubbles; for ease to look at the ranking - darker colour denotes larger share captured. Based on projections from our model estimates, it is expected that Hong Kong is able to capture a significant share of China’s portfolio investment (over 9%), while a major portion would be invested in the US, Japan and UK, which have a combined share of around 75% of global stock market capitalisation. Source: He and McCauley (2012)

How fast will it go? The Mainland authorities are likely to proceed steadily and will strive to achieve a good balance between containing potential risks on the one hand and reaping the benefits of wider international use of the renminbi on the other They are likely to manage the pace of the international use of the renminbi so that it is consistent with their overall approach to captial account liberalisation, and maintain a “spectrum of convertibility” of the renminbi

Will the renminbi become a widely used international currency? In the long run, the status of the renminbi as an international currency will depend on the size of the Chinese economy and the sophistication of renminbi financial markets As long as Chinese economy keeps a fast pace of growth and further integrates with the global economy, the prospect of the renminbi is bright The status of the renminbi as a global reserve currency will also depend on China’s ability to transform the structure of its international balance sheet It needs to master the technology of providing liquidity service by issuing short-term liabilities to non-residents while at the same time making productive claims on non-residents

Concluding remarks (I) Large potential of trade and investment flows between emerging market economies provides a good opportunity for these economies to use their own currencies for such cross-border transactions Wider use of the renminbi in cross-border trade and investment will allow Chinese residents to share risks with their overseas counterparts Facilitating the international use of the renminbi requires a deliberate pace of institutional reforms and policy liberalisation, which in turn would be conducive to a more open and market-based financial system in China

Concluding remarks (II) The pace of financial system reform and capital account liberalisation in China is set to accelerate in the next five years How quickly will it go? Not too fast, not too slow Hong Kong is well positioned to benefit from the process as the premier offshore renminbi centre

Thank you for your attention! End of presentation Thank you for your attention!