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The Chinese Economy: Full Convertibility is Necessary for the Internationalisation of the RMB

Aug 29 , 2011

August 29, 2011

It has been widely argued that the Renminbi (Yuan) cannot become an international currency until it is fully and freely convertible.  Thus, as long as China maintains capital controls of any kind, the Renminbi cannot be used as a medium of exchange for international transactions.

The Renminbi has been current accounts convertible since 1994.  However, it has not yet become fully capital accounts convertible.  There still exist both inbound and outbound capital controls in China.  Some categories of capital movements require prior government approval.  But individual Chinese citizens can remit up to US$50,000 per person overseas each year, with few questions asked.  In Hong Kong, residents can convert HK$ into Renminbi or vice versa up to 20,000 Yuan per individual bank account per business day.

The willingness to accept and to hold a non-local currency depends on whether the currency is convertible, but it does not need to be fully or freely convertible, in the sense of a total absence of capital controls on the part of the non-local currency-issuing country.  A person or a firm may be quite willing to accept and to hold a non-local currency, fully convertible or not, if he (it) knows that the next person (firm) he (it) comes across is also likely to accept the currency.  Thus, even though the Renminbi is not de jure fully or freely convertible, it has gradually become de facto convertible in some economies in East Asia because of its wide general voluntary acceptance.  The Renminbi is today widely accepted and used in Hong Kong, Macau, Laos, Myanmar, and other border areas as a medium of exchange and a store of value even though it is not legal tender in these places.

Similarly, whether a currency can be used in the denomination and settlement of international trade and capital transactions depends on its acceptability to the parties of the transactions.  It will be acceptable if there are other ready potential users of the currency.  Thus, for example, an overseas exporter to China may be quite willing to accept Renminbi as payment as long as it knows that importers of Chinese goods and services in its country can use the Renminbi balances to pay for the imports.  It will be even more acceptable if the central bank issuing the currency is committed to its redemption or exchange into other “hard” currencies, inflation-index bonds, or even gold with other central banks through prior agreements.  Thus, the elimination of all forms of capital controls is not necessary for the Renminbi to be used as a medium of exchange in cross-border transactions.

It is therefore possible for there to be wide general voluntary acceptance of a non-local currency even in the absence of its full and free convertibility.  For example, in Hong Kong, Renminbi bank deposits held by Hong Kong residents (including firms) have grown rapidly in the past couple of years to almost 9% of total bank deposits in all currencies, attesting to the willingness of Hong Kong residents to accept and to hold the Renminbi (see Chart 1).

Chart 1: Renminbi Deposits as a Percent of Total Bank Deposits in Hong Kong

Mainland Chinese exporters and importers in selected regions have been permitted to settle their international trade transactions in Renminbi in Hong Kong since 2009 on a voluntary basis, by mutual agreement between the exporter and the importer in each case.  The practice will have been extended to the whole of Mainland by the end of 2011.  Settlement in Renminbi is welcomed by both exporters and importers because it reduces transactions costs.  For example, an importer on the Mainland can pay an exporter in Thailand directly in Renminbi, without having to convert it into U.S. Dollars first and hence also without having to assume any exchange rate risk.  While it is true that a Thai exporter may have to convert the Renminbi into Thai Baht, but there is only one currency conversion, from Renminbi to Baht, instead of two currency conversions, first from Renminbi to US$ and then from US$ to Baht.  Moreover, the Thai exporter may prefer to denominate its exports and settle in Renminbi, because the Renminbi is expected to appreciate relative to the US$ over time.  Similarly, an exporter on the Mainland may prefer to denominate and settle in Renminbi because it reduces both transactions costs and exchange rate risk.

The proportion of Mainland Chinese international trade settled in Renminbi has grown rapidly from 2.5% for 2010 as a whole to 7% as of the end of the first quarter of 2011 (see Chart 2).  This proportion is expected to increase further in the future, especially if a bureaucratic problem having to do with tax rebates for exports that has in effect prevented some Chinese exporters from accepting Renminbi for payment is resolved.  Thus far, trade settlement in Renminbi is predominantly for Chinese imports, accounting for approximately 90%.  In order for Renminbi settlement to be more widely used by Chinese exporters, overseas importers must be able to have access to Renminbi themselves.  This will take some time but as exporters to China in these economies are paid in Renminbi, their Renminbi balances will in principle be available for the importers.

Chart 2: Renminbi Settlement of Cross-Border Chinese International Trade

Approximately 35% of Chinese trade is conducted with East Asian economies.  Potentially, the Renminbi can be used as a settlement currency by Chinese exporters and importers with their trading partners in East Asia on a voluntary basis.  For comparison, approximately 25% of Japanese trade worldwide is denominated and settled in Yen.  Chinese imports from East Asia except Japan amount to US$300 billion a year.  If these imports alone can be settled in Renminbi, the requirement of foreign exchange reserves at the People’s Bank of China for transaction purposes can be significantly reduced.  Similarly, Chinese exports to East Asia except Japan amount to more than US$300 billion a year.  To the extent that the importers in these East Asian economies can obtain Renminbi (for example, from their exporters), they may also be willing and able to pay for their imports from China in Renminbi.  The use of the Renminbi as a trade settlement currency may also be facilitated if an offshore forward market for Renminbi is established by or under the authority of the People’s Bank of China (China’s central bank) with participation restricted to bona fide exporters and importers to and from China.

Recently, the Ministers of Finance of China, Japan and South Korea, meeting on the sidelines of the Asian Development Bank annual meeting in Hanoi, issued a statement to the effect that they would study the use of their own currencies in trade settlement with one another.  Trade settlement in the own currencies of the trading partner-countries is straightforward if the bilateral trade is basically balanced.  A problem arises only when there are persistent surpluses or deficits.  The central bank of the surplus country will wind up holding the currency of the deficit country.  What can be done to reassure the surplus country that it will not lose out by holding the currency of the deficit country for more than a short term?

What is needed are credible commitments through mutual agreements by the respective central banks concerned to convert the currencies of their respective countries presented by another central bank into U.S. Dollars or Euros or any other so-called “hard” currencies, or even gold at a pre-agreed parity, or its own inflation-indexed bonds.  With such assurances, central banks will feel comfortable holding the currencies of the other countries for potential transactions purposes.  The People’s Bank of China already has bilateral currency swap agreements in place with the central banks or monetary authorities of Argentina, Belarus, Hong Kong, Indonesia, South Korea, Malaysia and Mongolia and more such agreements are expected to come.

Thus, the internationalisation of the Renminbi is well on its way without the currency being fully and freely convertible.

Lawrence J. Lau is Landau Professor of Economics, Chinese University of Hong Kong and Ayesha Macpherson Lau is a Partner of KPMG China.

Reprinted with permission by the authors

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