The core of internationalization of the Chinese yuan, or renminbi, is liberalization of its capital account, as was revealed in China’s practices over the past year. In other words, liberalization of renminbi’s capital account is a prerequisite for its internationalization, and each step of its internationalization must be conditioned by some corresponding progress in liberalization of its capital account.
Almost all discussions about renminbi internationalization have focused on the following issue so far: Should China step up the pace of liberalization of its capital account during the current international financial tsunami? If yes, what would be the right sequence and timing? This is a question we must answer before we take up the topic about promotion of renminbi internationalization.
The issue of renminbi internationalization has come to gain spotlight at a time when Chinese enterprises have come to be exposed to ever greater exchange risks and China’s foreign exchange reserves have come under ever greater pressure of capital losses. In practice, however, renminbi internationalization has been dissimilated into a lever to pry up the fire wall monitoring the cross-border flow of Chinese capital.
The progress of renminbi internationalization in the past year was best seen from the rise of renminbi deposits and the expansion of renminbi bonds issuance in Hong Kong, with thanks going mainly to the Chinese government for lifting its control over the swap and use of foreign exchanges for trade settlement by allowing importers to buy foreign exchanges with renminbi in Hong Kong for trade settlement and exporters to settle trade with renminbi.
At a time when the exchange rate of the Chinese yuan is lower on the Chinese mainland than that in Hong Kong (where the Chinese yuan is comparatively more expensive and the US dollar is comparatively cheaper) and when the interest rate at the mainland money market is noticeably higher than that in Hong Kong, permission of the flow of runoff renminbi back into the mainland money market, which would mean permission to non-residents using the renminbi in their pockets to invest in financial assets (renminbi bonds or renminbi FDI being planned for the future) on the mainland, those holding renminbi will reap double incomes through exchange and interest arbitrage. This explains the sharp rise of renminbi deposits and the fever for renminbi bonds in Hong Kong.
Capital account liberalization is of positive significance, and may also become inevitable in the end. It may also possibly trigger, however, a sudden flow of international capital into or out of a country, thus violently shaking the economic stability of this country. Under normal conditions, cross-border capital flow changes with interest or exchange arbitrages or other kinds of profiteering activities, and as such leaves due impacts on the economic and financial stability of a country. For economies that have completed market-oriented reform of their interest and exchange rates before liberalization of their capital accounts, the hazards from cross-border capital flow to their macro economic stability can be minimized. Nevertheless, these economies still need to resume capital control under some extraordinary circumstances, so that the opportunities for interest and exchange arbitrage will be scrapped within a short period of time along with changed interest and exchange rates.
So far as China’s present-day situation is concerned, neither the interest nor the exchange rate is quick enough to react to market signals. Under such circumstances, liberalization of the capital account will only give investors opportunities for interest or exchange arbitrage. With little or no risks at all, such arbitrage will never come to a stop, only to plunge the state (and taxpayers) into welfare losses in the end.
The renminbi internationalization as China has been promoting is actually an experiment with liberalization of the capital account before completion of its market-oriented reform of interest and exchange rates. Liberalization of the capital account is a prerequisite for internationalization of a currency, but not an ample condition. During the course or after completion of capital account liberalization, many other conditions including political ones must also be met before final achievement of currency internationalization.
he progress China has chalked up so far in renminbi internationalization is mainly – but not totally – a byproduct of its measures to liberalize a special part of its capital account under some special circumstances. To be more specific, China has achieved its up-to-date progress in renminbi internationalization mainly because international investors, seeing that the US dollar will continue to depreciate and the US bonds will surely be downgraded in the long run due to continuous deterioration of the US financial situation and that the eurozone debt crisis has kept worsening, are inclined to readjust the currency mix of their assets and liabilities by increasing their hold of the Chinese yuan while cutting that of the US dollar. The policy measures taken by China to internationalize its currency have precisely satisfied this demand from international investors. The progress in renminbi internationalization achieved in such a manner may easily come to a standstill or even go down the drain, however, with changes in the flow of international capital.
In the third quarter of 2011, the sum of cross-border trade settlement in renminbi fell below that in the second quarter, and the dimsum bonds were sold off in large quantities. This setback in the course of renminbi internationalization has proved one fact, namely, renminbi internationalization based exclusively on renminbi appreciation expectations will never hold for long. More importantly, it is now high time to reexamine the course of renminbi internationalization that has run for more than a year.
With this understanding, our discussion of efforts to further renminbi internationalization should go back to the issue about how to reshape China’s mechanism for the formation of interest and exchange rates. Instead of centering our current discussions on the roadmap to advance renminbi internationalization, which is actually a timetable for pushing forward capital account liberalization, we should rather direct our efforts first to drawing up a timetable for liberalizing our interest rates and transforming our mechanism for exchange rate formation.
Thanks to the advancement of renminbi internationalization, some foreign investment banks and Chinese conglomerates saw their purses burst last year. For their own ends, these people will surely urge the Chinese government to further lift its control of capital and get renminbi internationalization into a momentum as strong as before, such as raising or even removing the ceiling of renminbi used for trade settlement. These will be suggestions that can never be adopted. On the contrary, we should suspend promulgation of new policies on renminbi internationalization. Or to be more accurate, we should suspend measures on capital account liberalization before any decisive progress is reaped in our interest and exchange rates reform.
When we suggest not doing something, we do not mean not to do anything at all. The recent change in expectations for the renminbi exchange rate due to the outflow of international capital is actually a good thing. The monetary authority may shake off some pressure, for instance, from the yuan appreciation. It will not feel so pressed, in other words, for foreign exchange reserve growth or hedging operations. The latest reserve ratio cut, for instance, may have something to do with the shrink of liquidity due to declining foreign exchange reserves. The current two-way fluctuation of the renminbi exchange rate should be treasured as a rare opportunity for stepping up reform of its formation mechanism.
We have got two options.
First, taking advantage of the current opportunity from the balancing foreign exchange market to establish a whole package of clear-cut rules governing exchange rate fluctuations, rules that comply with the targets set for the exchange rate reform. Specifically speaking, three intermediate parameters should be written into these rules, namely, the proportion of current account surplus to GDP which shows the target for external balance, the amount of renminbi outstanding for foreign exchanges which marks the target for internal balance, and the effective exchange rate which tells our competitiveness in export and costs in import. During the course of managed fluctuation of the renminbi exchange rate, these three intermediate parameters may be turned, through weighting, into a comprehensive parameter to provide the basis for working out a whole set of clear-cut rules on government control of the foreign exchange market.
Second, announcement by the central government, at an opportune time, to stop its interference in the foreign exchange market and leave the exchange rate to market decision, an option that is a little bit more radical but also much simpler. Achievement of free fluctuation of the renminbi exchange rate will root up the thorn pricking Sino-US relations for good.
Under the current situation, big-margin appreciation of the renminbi is hardly likely even if the Chinese central bank ends its interference in the exchange market. On the contrary, its depreciation might be possible. Even the latter happens to be case, the US would say nothing more (because China has not manipulated its currency). Given the fundamentals of the Chinese economy, appreciation will be the long-term trend of movement of the Chinese yuan. Viewed from China’s position in international balance of payments, the yuan’s appreciation will only move within a limit affordable by the Chinese economy. Should any mishaps crop up, the capital account might be their soil.
One possibility may be the sudden inflow of hot money at an unexpected speed. Should this happen, the yuan may over-appreciate. As a precaution, China should take good care of its capital account to dam the inflow of hot money. By non-interference, we do not mean total freedom for renminbi fluctuation. We will try to curb the inflow of foreign capital through exercise of capital account control so as to prevent the yuan’s over-appreciation. The central bank may also preplan for unexpected developments so that it can step in once again to interfere, just as in Japan’s case. But will the US reach out for a yard after taking an inch? It will, fore sure. In such a case, it will be fairly easy for China to counterattack and win greater international support.
In one word, the topic about renminbi internationalization may be put aside for the time being. In face of the upheaval of the international financial market, China should tighten instead of loosening its capital control to keep off external impacts, just as most developing countries have. Under the protective wing of capital control, efforts may be made to quicken the pace of market-oriented development of the interest and exchange rates. Issues about capital account liberalization and renminbi internationalization will be brought up only when due conditions have ripened.
Yu Yongding is an academician of the Chinese Academy of Social Sciences