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China cannot achieve the internationalization of its currency without making it fully convertible

Although it is not advertised on its website, the Paris branch of the Bank of China is now offering its customers residing in France to open an account in Renminbi (RMB), the Chinese currency. This is a modest but symbolic advance of the big maneuvers that have taken place for the past two years around the currency of the second world economy.
By Christophe Destais
 Post, July 2, 2012

Like all communist countries, China had no real currency or financial system before it undertook economic reforms. While these reforms immediately focused on export development, administrative procedures allocating foreign currency resources (rare at the time) soon found their limits. Therefore, the Chinese authorities initiated in the early 90s a process of liberalization of their "current account" (imports, exports, debt service, dividend payments). Initially, swap centers were organized where foreign currency could be exchanged between those in excess and those who needed it to pay for import. Very quickly, however, this system was abandoned in favor of a full liberalization of the current account transactions, formalized in 1996. In late 1993, the Chinese authorities had announced that their goal was to let the exchange rate fluctuate and make Renminbi convertible.

Nearly twenty years later, we are far from achieving the objectives of 1993. First, financial crises in emerging markets in the late 90s and early 2000s showed the extent to which countries that had abolished all restrictions on capital flows can be vulnerable. In the 2000s, Chinese authorities maintained the closest possible control of these flows and maintained a strict control on the exchange rate which was allowed to appreciate, first between July 2005 and August 2008, then since June 2010. The combination of the huge success of the products manufactured or assembled in China and the implementation of these rules led to an unprecedented accumulation of foreign reserves which are currently around 3,500 billion and repeated confrontations, especially with the United States, on the accusation of "manipulating" the exchange rate.

The financial crisis of 2008 marked a new turn. Initially, the governor of the Chinese central bank has tried to resurrect the Special Drawing Rights (SDRs), an international reserve asset created in the late 60's through the IMF but the use of which is very limited. This proposal was not echoed and the Chinese authorities have implemented a purely unilateral policy ofinternationalization of the Renminbi. As it is often the case with China’s economic reforms, the path towards RMB internationalization is highly unusual. Usually the first step is to remove capital controls, that is the regulatory restrictions on the holding of domestic assets by non-residents or the holding of foreign assets by non-residents.

China chose instead to maintain most of these restrictions and to define a policy of currency internationalization by three sets of exceptions to these non-convertibility rules:
1. A new monetary asset was established in Hong Kong, the offshore Renminbi. This asset had existed de facto since the mid 2000s but a July 2010 agreement between China's central bank, the PBOC, and the Monetary Authority of Hong Kong gave it an official existence and provided for the establishment of an organic link between the offshore RMB market and the onshore RMB market. This link goes through the Hong Kong subsidiary of Bank of China (BOCHK), a Chinese government owned commercial bank. BOCHK clears transactions in offshore RMB between licensed banks in Hong Kong, provides the liquidity to this market thanks to an organic link between the offshore RMB and onshore RMB that passes through the channel of an account opened by the BOCHK at the PBOC branch in Shenzhen (and perhaps through direct links with banks in mainland China). The opportunity thus offered to open accounts in RMB in Hong Kong has aroused the enthusiasm of Hong Kong depositors between July 2010 and November 2011. Since late last year, the volume of deposits has tended to decrease slightly.

2. Chinese companies now have the ability to make almost all their business transactions in RMB in Hong Kong.

3. The PBOC has signed fifteen foreign exchange reserves swap agreements with central banks in Asia and Latin America. The official justification for these agreements is laconic and their contents remain secret. It seems that, for now, they are primarily symbolic, since the RMB reserves held by central banks cannot be mobilized to ensure payment transactions or to defend their currencies because the RMB is not convertible. The agreement with Japan goes further. It provides that the Japanese central bank could buy other RMB assets and the fixing of a bilateral exchange rate.
This policy is clearly inspired by a form of pragmatism which is both bold and cautious. This is the idea that one must cross a river feeling the stability of each rock on which it relies, dear to the late Deng Xiaoping. However, the originality of this policy may lead to several interpretations.

The first interpretation is that the main purpose of this policy is technical. This would facilitate trade relations in RMB between Chinese companies and their foreign customers or suppliers. The offshore platform in Hong Kong and, perhaps, currency swaps would help. This strategy would mainly be focused on Asian countries. For now, this approach faces a difficulty with the overvaluation of the RMB. This is an incentive to hold assets denominated in that currency, but there is no incentive to get indebted in this same currency. The result is a significant difference between Hong Kong banks assets and liabilities in RMB as they struggle to allocate resources to appropriations denominated in that currency (credits and "dim sum" bonds). As a result, Hong Kong banks are channeling RMB to mainland China via BOCHK and PBOC Shenzhen and the PBOC has to sterilize all or parts, which interferes with its monetary policy. However, the recent stabilization of the exchange rate RMB / USD suggests that the level of overvaluation of the Chinese currency is now reduced and investors present in Hong Kong have less incentive to hold RMB on speculative grounds. This should help to clear the difference between Hong Kong banks RMB assets and liabilities. One can also wonder whether the financial sector of Hong Kong would have the capacity to sustain a large outstanding in RMB in view of its size but this problem could be alleviated if the exchange rate of HK dollar is no longer fixed to the U.S. dollar, as is the case since 1983, but vis-à-vis the RMB.
Another interpretation, which is not exclusive than the previous one, is that China has the ambition to develop a truly international currency in a global competition with the dollar as an instrument for international transactions, measurement of value and store of value. Our analysis suggests that measures taken so far cannot suffice and that China cannot really internationalize its currency by making it fully convertible. The debate on the possibility to internationalize a currency without making it fully convertible exists but the arguments in favor of this thesis are unconvincing: they refer mainly to the fact that when the accumulation of dollar offshore (the "Eurodollar") began in the late '50s, it was precisely to escape restrictions on the free convertibility of the currency. This argument is limited in scope since, at that time, the dollar remained the currency whose use by non-residents was the easiest. As highlighted in Genberg (2009), the currency for which transaction costs are the lowest will always be favored. Therefore, China would have to fully remove restrictions on the free convertibility of the RMB in order to compete internationally with the dollar. In turn, this goal would require the implementation of rather deep financial reforms, the contours of which are to be defined, for Chinese financial institutions to be able to withstand international competition. Now, a coalition opposes this reform which would affect their financial interests. Export oriented firms, state owned companies or local authorities do not want to lose privileged access to credit they receive while the banking sector does not wish to be exposed to foreign competition while deregulation would deprive comfortable margins.

In total, it is likely that the Chinese authorities have committed to a short term approach above all pragmatic, aimed at reducing the risk to which Chinese firms are exposed in their business operations and, themselves, on the foreign exchange reserves that they have accumulated. Pragmatism does not exclude a more cultural approach designed to accustom the economic agents in the world to the use of the RMB by offering to open accounts denominated in that currency even though China does not, for now, really need the money.


Genberg, H. (2009) Currency Internationalization: Analytical and Policy Issues, Hong Kong Institute for Monetary Research - Working Paper No.31/2009, October 2009
Emerging Countries  | Money & Finance 
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