Renminbi Internationalisation: Forecasting and Scenario Analysis
By Dr Dr Yuning Gao and Dr D'Maris Coffman
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Published, August 2014.
From its inception, this project was conceived to meet the needs of both investment professionals and professional academics, who want to understand the historical context, the current status, and the most plausible course for the internationalisation of the Renminbi. Naturally, their respective reasons for doing so vary greatly, but both academics and investment advisors understand the seriousness of the current global economic outlook.
The Eurozone Sovereign Debt Crisis of 2010-2013 has served to remind policymakers, practitioners, and academics alike of the need to understand the historical determinants of both sovereign borrowing and currency internationalisation. This is even more pressing because sovereign bond markets in their modern form date from the 1990s, whereas the post-war period had characterised by direct bank loans coordinated by the World Bank. The Centre for Financial History’s research on the origin of markets for debt securities in early modern and early late modern Europe has helped academics and investment analysts understand that key features of the Washington Consensus are historically suspect, and moreover that political stability matters more to bond markets than specific macroeconomic policies or institution building (Coffman, Leonard, Neal 2013). This view has been born out by events.
Another issue that was raised in these discussions between academics and investment managers was how to understand China’s position vis-à-vis the Eurozone. Gao and Coffman both believe that China’s role in the Eurozone crisis would largely be limited to seeking investment opportunities and that the RMB would not suddenly begin to rival the euro, sterling or dollar as a potential reserve currency. To the contrary, it would remain a small part of central bank reserve holdings for the foreseeable future.
In July 2011, Schroders commissioned further research from the Centre for Financial History on Internationalisation of the RMB and the deepening of offshore Chinese capital markets. The resulting innovative, cross-disciplinary study combined Gao’s expertise as a trade economist with the historical perspective offered by Coffman to provide a novel interpretation of RMB internationalisation, which was well-received not only by Schroders, but also by academics and China watchers in Hong Kong at the annual INET conference. This report represents the fruits of that work.
In brief, this report on RMB internationalisation comes to the following conclusions: 1) the conceptual/analytical distinction between internationalising a currency (its use in trade settlement and eventually invoicing) and having a currency become widely held by central banks as a reserve currency is under-appreciated in both specialist literature and in the financial press; the second need not follow the first; 2) there are relevant historical antecedents of projects to internationalise a currency in Western Europe, North America (the Latin Monetary Union in the 19th century and the U.S. dollar in the 1920s), and East Asia (Japan and to a lesser extent Korea); there is nothing new about the use of multiple reserve currencies by central banks; 3) what is new is the role of central banking coordination and independence in the post Bretton Woods system, leading to capital account liberalisation in almost all advanced economies; 4) capital account liberalisation in China (including the probable effect on the domestic banking sector and the internal struggles within the Peoples Bank of China) is for many Chinese policymakers at least as important as RMB internationalisation per se as it would allow global financial markets to discipline the banking sector; 5) there are the geopolitical considerations behind the bilateral swap line agreements with regional powers that arise mostly from competition with Russia; 6) there is a solid methodological basis for using the tools of a trade economist (and specifically the gravity models) combined with a macroeconomic-historical approach to understand the probable trajectory of RMB internationalisation.
The internationalisation of the Renminbi (RMB) was greatly accelerated after the 2008 financial crisis when the “Triffin Dilemma” and the “global imbalance” emerged as key issues. To provide the background to this research, this report first reviews the history of the British pound, the US dollar and the euro as the major foreign exchange reserve currencies, main trade credit and invoicing media, and tools for foreign exchange markets and international debt securities markets.
The impetus for China to internationalize her currency was chiefly a response to China’s tremendous foreign exchange reserves, dominated by US dollars, through the “double surplus” in both the current account and capital and financial accounts. This led to a currency mismatch between China’s external assets and liabilities. At least three steps are needed for the realisation of the internationalisation of the RMB; therefore this report examines this process through the following threads:
- the wide use of the RMB in the settlement of trade and direct investment: the accumulated settlement for trade has exceeded CNY2.94 trn Yuan and CNY253.6 bn for outflow direct investment versus CNY30.4 bn for inflow, backed by the CNY2.2 trn in central bank currency swaps and more than CNY600 bn deposited in Hong Kong;
- RMB financial products becoming important investment tools for main institutions: although the 207 Qualified Foreign Institutional Investors have been authorized to make an overall quota of USD43.5 bn in portfolio investments, securities issuance and OTC market participation are still highly restricted;
- the offshore RMB market is growing large enough for it to become a reserve currency: the offshore non-deliverable forward market of RMB was well-developed ($23 billion US dollars per day), in contrast with the fast growing deliverable CNH market ($5 billion per day). The Dim Sum bond market was much more popular than the RMB IPO market, whose total outstanding has reached CNY237.2 bn. However, these markets are still too small to support the RMB as a reserve currency.
Overall forecasts with regard to RMB internationalisation should be based on a projection of China’s economic scale in the near future. Following the growth accounting method, we can estimate the potential of China’s output and forecast its GDP growth. In contrast to some forecasts that China’s GDP growth will slow down to less than 8 per cent in the midterm, our analysis suggests that China’s GDP growth will return to its long-term potential growth rate and return to double-digit growth by 2016 with an average growth rate of 8.1 per cent between 2011 and 2016.
Through sector level (final consumption, capital formation and net export) projections, we can obtain a blueprint for the Chinese economy. Following the trough of another fixed investment cycle, China’s investment rate will drop from 48.3 per cent in 2011 to 42.4 per cent in 2016, while the final consumption rate will rise from 49.1 per cent to 53.9 per cent. By decomposing China’s trade balance, we believe China’s trade balance will remain at around 3 per cent of its GDP, with its total trade accounting for 62.1 per cent of its GDP, which will be 9 trillion US dollars by 2016.
Moreover, as the use of RMB outside China will be dominated by trade settlements, forecasting of bilateral trade using a gravity model becomes a key part of the overall projection. Based on different scenarios through China’s trade partners, we predicted that RMB trade settlements will account for 17.2 per cent of China’s total trade, with a range of between 8.7 to 11.4 trillion Yuan by 2016. Dominated by the flow through Hong Kong, China’s overall RMB settlements in direct investments will still be quite limited; our projection suggests that the use of RMB will account for about 10 per cent to 12 per cent of the total direct investment, with a median of 41.4 bn USD equivalent, or just 2.7 per cent of the settlement through trade.
The internationalisation of the RMB depends upon the development of China’s financial markets. This report focuses on the depth of China’s financial markets through measurement of the ratio of credit, stock market capitalisation, and total debt to GDP. The benchmark model based on cross-country panel data and the error correction model of China’s own time series data provide us with the bounds of projection of its financial depth in the future.
China’s raising of capital relies on credit from its banking system much more than that of many other emerging economies, with China at a similar level to high income economies. By 2016, our projection suggests that China’s ratio of total credit to GDP will rise from 1.42 to 1.49, and bank deposits will rise to 1.78 times its GDP. If we assume the offshore deposit of RMB will follow the pattern of the internationalisation of the Japanese yen in the early 1980s, the overall amount will have reached 3.5 trillion Yuan by 2016.
The projection of China’s stock market by 2016 produces estimates that range between about half (USD7.8 trn) and almost all (USD13.8 trn) of the market capitalisation of the US today. As RMB IPOs are still very unpopular, we have assumed that the protagonists during the next five years will still be the QFII (together with RQFIIs as a cycling channel). Their share of China’s stock market will then have quadrupled to around 2.5 per cent.
China’s total debt to GDP ratio will still be quite moderate even five years from now. It may rise to 0.77 of China’s GDP with a total scale of USD7.4 trn in 2010 prices. The most impressive thing is that the ratio of international bonds issued to its GDP remained between 1 and 2 per cent during the past two decades. If China decides to follow the pattern of the liberalisation of the Korean bond markets in early 1990s, the scale of offshore Renmibi bonds will increase seven-fold to CNY1.5 trn by 2016.
About D'Maris Coffman
Table of Contents
Part I Background
1. History of Currency Internationalisation
1) The Pound and the Gold Standard
2) Rise of the US dollar
3) European Currency Unit to Euro
2. Reality and Impetus for China to Internationalise its Currency
3. Costs and Benefits of RMB Internationalisation
1) Potential benefits
2) Potential costs
Part II Policy Scenarios and Status Quo of RMB Internationalisation
1. Policy Scenarios
1) Policy on capital account liberalization
2) Policy on Cross-Border RMB Usage
3) Policy in Offshore RMB Market
2. RMB Settlements
1) Bilateral Currency Swap Agreements
2) Cross-Border Trade RMB Settlement
3) Cross-Border Direct Investment RMB Settlement
3. Domestic RMB Financial Products
1) Portfolio and Private Equity Investment Channels
2) Securities Issuing Channels
3) Forward and Swap Markets
4. Offshore RMB Market
1) Currency Spot and Derivative Markets
2) Dim Sum Bond Market
3) RMB IPOs
4) RMB Cycling Channel
5. The Use of RMB: Red Backs as Reserve?
Part III Macroeconomic Forecasting
1. Growth accounting
2. Hodrick-Prescott filtering of TFP
3. Potential Output and its mid-term projection
4. Sector Structural Projection
Part IV Gravity Model of Trade distribution
1. Regional Breakdown of China’s Trade
2. Gravity Model Analysis of Bilateral Trade Flow
3. Projection of China’s Bilateral Trade and RMB Settlement
4. Cross-Border Direct Investment Projection and RMB Settlement
Part V Projection of Offshore RMB Markets
1. Financial Market Development – Perspective of Financial Deepening
2) Stock Market
3) Bond Market
2. Financial openness – Capital control to Capital Account liberalization
2) Stock Market and ETF
3) Bond Market Structures: International Bonds
3. Capital and Financial Account Projection
Appendix 1 List of QFII, RQFII and Dim Sum Bonds
Appendix 2 Description of Data
Appendix 3 Projection of China’s GDP per capita in PPP method
Appendix 4 China’s Financial Openness under IMF AREAER Framework
List of Tables
Table 1.1 Trade Invoicing by currencies.
Table 1.2 Currency distribution of global foreign exchange market turnover.
Table 1.3 Approximate national currency weights to the ECU value.
Table 1.4 Net International Investment Positions of Main Debtors and Creditors.
Table 1.5 NIIP Structure of the US and China.
Table 1.6 Currency Denominations of the External Balance Sheets of the US and China.
Table 2.1 Bilateral Currency Swap Agreements between China and its Partners.
Table 3.1 China’s Growth accounting with human capital 1978-95 and 1995-2010.
Table 3.2 Growth in factor productivity and capital labour ratios.
Table 3.3 Comparison of Different Projections for GDP Growth.
Table 3.4 Share of Merchandise Trade in GDP (PPP).
Table 3.5 Summary of Sector Structural Projection (Medium Values).
Table 4.1 Estimation Result of Gravity Model
Table 4.2 Scenario Analysis of RMB Trade Settlement by 2016.
Table 4.3 Adjusted FDI from Top 10 Investor to China.
Table 4.4 Scenarios of RMB Settlement of China’s Direct Investment.
Table 5.1 National Balance Sheet of China.
Table 5.2 Survey on Financial Sector of China and the US.
Table 5.3 Financial Depth and its Composition.
Table 5.4 Projection for Credit/GDP ratio and Credit Scale of China.
Table 5.5 Predicted Stock Market Capitalisation of China.
Table 5.6 Predicted Total Debt of China.
Table 5.7 External Deposits and Loans of All Sectors to GDP.
Table 5.8 Predicted Offshore RMB Deposit.
Table 5.9 Predicted QFII Assets in Stock Market.
Table 5.10 Domestic and International Bond Outstanding to GDP.
Table 5.11 Predicted Offshore RMB Bond Outstanding.
Table 5.12 Projection of China’s Balance of Payment.
Table A.1 List of Qualified Foreign Institutional Investor.
Table A.2 List of Offshore RMB Bonds (Dim Sun Bonds).
Table A.3 List of RMB Qualified Foreign Institutional Investor.
Table A.4 Projection of China’s per capita GDP in Purchasing Power Parity.
Table A.5 China’s Financial Openness Indicators.
List of Figures
Figure 1.1 G10 Reserves by Currency.
Figure 1.2 Trend of World Official Reserves and US Dollar Dominance.
Figure 1.3 Share of Non US Dollar Currency in Allocated Foreign Exchange Reserves.
Figure 1.4 Share of International Debt Securities Issued in US dollar and Euro.
Figure 1.5 Development in Interest Rates on 10-year Government Bonds.
Figure 1.6 China’s Holding of US Securities.
Figure 1.7 Change of Position for Foreign Exchange Purchases of Financial Institutions.
Figure 1.8 “Double Surplus” of China and China-US Trade Surplus.
Figure 2.1 Cross-border Trade RMB Settlement.
Figure 2.2 Geographical Distribution of RMB Currency Trading Turnover.
Figure 2.3 Debt securities of Chinese non-financial corporations.
Figure 2.4 Offshore RMB Bonds and Notes Issued by Onshore Nationals and Residents.
Figure 2.5 RMB Deposits in Hong Kong SAR.
Figure 3.1 Growth in input, output, and TFP.
Figure 3.2 Decomposition of TFP Growth and relative Capital/Labour ratio.
Figure 3.3 Comparison of H-P filtered TFP growth series.
Figure 3.4 Real and Potential GDP growth (1980-2010).
Figure 3.5 Real / Potential GDP and Flat Projection.
Figure 3.6 Real / Potential GDP and Cyclical Projection.
Figure 3.7 Decomposition of Total Trade and its Projection.
Figure 3.8 Decomposition of Trade Balance and its Projection.
Figure 3.9 Final Consumption and its Adjustment.
Figure 3.10 Capital Formation and its Contribution to GDP Growth.
Figure 4.1 Regional Breakdown of China’s Total Trade.
Figure 4.2 Share of Iron Ore (SITC Rev 3 code 281) in Total Trade with China.
Figure 4.3 Projection of China’s Total Trade by Regions.
Figure 4.4 Regional Breakdown of China’s Total Direct Investment.
Figure 4.5 China’s Inward Direct Investment and its Projection.
Figure 4.6 China’s Outward Direct Investment and its Projection.
Figure 5.1 China’s Broad Money and Nominal GDP Growth.
Figure 5.2 PBoC Foreign Exchange Purchase to Monetary Supply.
Figure 5.3 Pattern of Broad Money Supply to GDP, 2009.
Figure 5.4 Credit by Deposit Money Banks to GDP.
Figure 5.5 Credit by Deposit Money Banks and other Financial Institutions to GDP, 2009.
Figure 5.6 Stock Market Capitalisation to GDP.
Figure 5.7 Pattern of Stock Market Capitalisation to GDP, 2010.
Figure 5.8 Total Debt Securities Outstanding to GDP.
Figure 5.9 Pattern of Total Domestic and International Debt to GDP, 2010.
Figure 5.10 Chinn-Ito capital account openness Index.
Figure 5.11 Share of Euro Currency to Domestic Deposit.
Figure 5.12 International Bonds Issued in Home Currency vs. by Nationality of Issuer.
Figure 5.13 Decomposition of the Change of NIIP and Financial Flow.
Figure 5.14 Decomposition of China’s Financial Account Balance (Reserves Excluded).
Figure 5.15 Decomposition of China’s Current Account Balance.
Figure 5.15 Projection of China’s Reserve Assets.
Figure A.1 Population, Working age population and Labour force growth.
Figure A.2 Change of Dependency Ratio, Participation and Unemployment Rate.
Figure A.3 Investment-to-capital ratio and its Determinants.
Figure A.4 PPP Conversion Factor Growth.