What does it mean that RMB is the fourth largest payment currency in the world?
The quantity of RMB cross-border receipts and payments has reportedly been increasing since 2021 on the basis of the high base of the preceding year, according to the "2022 RMB Internationalization Report" released by the People's Bank of China a few days ago. The renminbi overtook the yen as the fourth largest payment currency in the world in December 2021, and it reached a record high of 3.2% in January 2022, according to the Society for Worldwide Banking, Financial Telecommunication (SWIFT).
What is the real reason why the Chinese government is promoting the internationalization of the renminbi? What does RMB internationalization mean for China and other countries or regions?
From the perspective of the external environment, in the international monetary system after the collapse of the Bretton Woods system, the US dollar is the world's most important reserve currency. Many developing countries use fixed or managed exchange rates that pegged their currencies to the United States dollar. Countries with a pegged dollar have no better option but to continue to pegg the dollar and have to accumulate large dollar-denominated foreign exchange reserves and fall into the "dollar trap". The excessive use of its privileges by the United States has resulted in very low interest rates on dollar-denominated foreign exchange reserves, such as U.S. Treasury bonds. During the 2007-2009 global financial crisis, Asian trade collapsed due to a shortage of trade finance dollars.
Due to the rapid growth of developing countries, the share of the United States in global GDP will continue to decline, and the fiscal capacity of the United States will eventually be unable to provide assets for the reserves and payments needed around the world. The world needs some other currency to fill this gap, providing another global public good as a medium of exchange for trade settlement. These are some of the reasons why China seeks independence from the dollar standard. One such approach is to promote the use of the renminbi internationally.
Other benefits of the internationalization of the renminbi include reduced reliance on foreign currencies such as the US dollar and related institutions such as payment systems. For example, the second phase of the RMB Cross-Border Payment System (CIPS) was fully rolled out in May 2018. Foreign banks abroad can send and receive RMB payments directly to China, and the importance of clearing banks will be greatly reduced.
In the long run, CIPS can allow China's international payments to circumvent legal coverage and sanctions in foreign countries (such as the United States through SWIFT); Lending internationally in RMB can provide more financial security; Get rid of the "dollar trap" of pegging to the dollar and accumulating huge foreign exchange reserves; Ability to borrow large amounts of money abroad at low interest rates in their own currency; And the ability to minimize exchange rate risk in trade, investment and financial transactions.
In addition, the extensive international use of the renminbi will provide more business for China's banking and financial sector; Issuing RMB abroad can be obtained by seigniorage or exchanged for physical goods. Similarly, the internationalization of the renminbi has an immeasurable role in enhancing China's political influence.
The benefits of RMB internationalization are not abstract or theoretical, but very concrete and tangible and can be felt and accessible to ordinary people. For example, more than a decade ago, the renminbi was rarely used outside of China, and the transaction costs for ordinary people to exchange the renminbi for the currency of their travel destination were extremely high. That is, the gap between the buying and selling exchange rates is quite large, usually accounting for a quarter to one-third of the value of the exchange currency.
This is because before the internationalization of the renminbi, its international demand was not high, and intermediary banks performing exchange functions need to collect more compensation to offset possible inconveniences and risks. The common cost of exchange at airports today is 7%-8%. For example, for parents whose children need to study abroad, the benefits of reducing the cost of foreign exchange brought by the internationalization of the renminbi are real.
However, the cost of exchanging renminbi is higher than the cost of yen or euro to dollar (about 1%). Reducing transaction costs is one of the goals of the further internationalization of the renminbi. Similarly, for operators in the financial industry or enterprises, the higher the degree of internationalization of the currency, the lower the financing cost of the government or enterprise to issue bonds, and the less burden the taxpayer will be. Because the more international the currency, the greater the international demand for assets denominated in the national currency, and the lower the borrowing cost of the country.
But even by the standards of developing countries, China's capital account openness is low. The outflow of resident capital is greatly restricted; Foreign ownership of domestic bonds, including central government bonds, is very low. Capital controls are numerous, often through administrative means.
For transactions under the capital account, the current amount of personal settlement and sale of foreign exchange is 50,000 US dollars / year, which is not low compared to countries with an annual per capita income of 10,000 US dollars. And this does not include transactions under the so-called "current account" such as the purchase of goods or services from abroad, such as paying tuition fees for children studying abroad.
One currency, two markets
How is China's RMB internationalization path different from other countries?
China is still an emerging economy, which means that its financial and legal institutions are still immature compared to the Western system. China also does not want to fully integrate its financial system with the West anytime soon. Because currency internationalization requires that currencies are basically convertible in the capital account.
Therefore, China has initiated the internationalization of the renminbi in its unique way, that is, adopting the approach of "one currency, two markets" (referred to as "one currency, two markets"), which requires the establishment of a global offshore market for the renminbi. Through this strategy, China has established a firewall of capital flows between onshore and offshore markets, allowing the renminbi to be fully convertible in the offshore market and partially convertible in the onshore market.
The onshore RMB FX market may have more intervention than the offshore market, such as setting a median price or directly intervening. The offshore RMB foreign exchange market has fewer, more volatile, larger scale, and there is a deliverable forward market. As of April 2019, offshore foreign exchange turnover accounted for 64% of the total global RMB turnover (the total global RMB turnover was about US$285 billion per day, of which Hong Kong accounted for 38%, or US$107.6 billion per day). In addition, the northbound investment of Shanghai-Hong Kong-Shenzhen-Hong Kong stocks must use offshore renminbi, and offshore renminbi or foreign currency is used for northbound bond investment.
The role of the offshore market is reflected in the fact that on the one hand, the currency risk of the traded financial assets can be separated from the national risk of the offshore market to form an offshore RMB financial market, which in turn makes it possible for the offshore RMB to be used as a means of value storage.
On the other hand, the credibility of offshore centers and developed financial infrastructure can promote the development of balance of payments flows and offshore financial markets, and can also enhance the impact of domestic financial development and capital account opening on the international use of the renminbi.
However, the development of offshore markets is constrained by insufficient onshore capital account openness and onshore financial development. At present, the relative size of the offshore RMB market to the onshore market is only 1/44 of the US dollar market.
However, because the four key factors for the success of RMB internationalization include the size of China's economy large enough, its commitment to free capital flows, the development of financial markets with depth, breadth and liquidity, and people's confidence in the RMB and the Chinese government, the internationalization of RMB requires more than just offshore markets, the development of onshore finance and the opening of the capital account remain the main drivers.
The size of the world's second-largest economy alone is not enough to make the renminbi one of the major payment currencies in one fell swoop. China needs to open its onshore capital account at its own pace while internationalizing its renminbi.
It is unclear whether and when China will achieve sufficiently high capital liquidity and financial market development. Based on my econometric research, I speculate that the renminbi will be the third largest payment currency after the dollar and the euro in the medium term. Because China needs strong trust from the international community, it can be a little difficult for the renminbi to become a safe-haven currency, even in the long run.
In the long run, due to China's huge gross domestic product, the continuous advancement of reform and opening up, and the demand of central banks for safe assets for foreign exchange reserves, the world may form a diversified reserve currency system with the dollar, the euro and the renminbi as the main reserve currencies. However, the renminbi's path to achieving this goal can be quite long and uncertain.
The internationalization of the renminbi is not an end in itself
How important is the opening of the capital account and the liberalization of financial markets to the internationalization of the renminbi?
Driven by the internationalization of the renminbi, the opening of the capital account and the liberalization of financial markets can be carried out simultaneously, but they must be gradual and play a synergistic role between the two.
In fact, as Zhou Xiaochuan, the former governor of People's Bank of China, suggested in an interview with Caijing magazine, "opening up to the outside world, reform of the exchange rate system, and reduction of foreign exchange control should be promoted as a whole, regardless of their respective speeds, the whole general direction is to move forward." This requires attention to the time window, some reforms can be accelerated when they meet the right time window, and some reforms may be slightly slower without a time window."
Capital account opening can bring more capital flows, higher foreign exchange turnover, a thicker market with a larger number of buyers and sellers, and lower transaction costs, making the renminbi an important denomination and settlement currency. Financial liberalization can amplify the effect of capital account opening and increase cross-border capital flows.
The free flow of capital and the liberalization of financial markets can promote RMB assets as an important means of international value reserves. Opening financial markets to foreign firms also helps to restrain domestic firms and improve their efficiency through competitive pressures and imitation.
However, these reforms will encounter huge resistance from vested interests, so it is necessary to use the internationalization of the renminbi to force domestic financial reform and opening up. I think an important motivation for the internationalization of the renminbi is to use the capital-account liberalization and financial market liberalization required by the renminbi to promote domestic financial sector reform.
But the cost of capital-account liberalization could be a sudden reversal of short-term capital flows that would hurt the economy and lead to currency crises, widespread bank failures and corporate bankruptcies.
Among the three dilemmas facing an open economy (i.e., monetary policy autonomy, exchange rate stability, and free capital flow), the internationalization of the renminbi requires increased capital liquidity, which means increased exchange rate volatility. As a result, China may need to give up a significant degree of exchange rate stability in exchange for capital flows and monetary policy autonomy.
Deepen reform and continue to open up
At the end of 2020, China's Ministry of Finance issued 4 billion euro-denominated sovereign bonds, with a 5-year issue of 7.5 billion euros, with an issue yield of -0.152%, which is the first time that China's sovereign bonds are issued at a negative interest rate, and the interest rate difference with domestic treasury bonds of the same maturity exceeds 3.3%, but it is still higher than the yield of sovereign bonds in other euro areas. This is the first time since 2004 that the Chinese government has issued a euro sovereign bond, and it is also the largest foreign currency sovereign bond issued by the Chinese government in a single time. Do you think China should issue more offshore bonds?
I think more offshore bonds should be issued, i.e. the international debt safety market can increase. These offshore bonds issued by the Chinese government can actually be regarded as international debt security, allowing the Chinese government or enterprises to borrow internationally in their own currency. Borrowing internationally in RMB is a new direction for RMB internationalization.
The development of the bond market, especially the central government bond market, is crucial for the renminbi to become a true global currency. However, there will also be obstacles such as the small size of the bond market, the lack of liquidity and the small share of foreign ownership. Therefore, I still believe that capital account opening and financial development are key to developing the offshore bond market. Because the opening of the capital account will promote the formation of thick markets, making the renminbi a more trusted currency.