In October 2016 the International Monetary Fund introduced the renminbi into the special drawing right, its composite currency unit, in recognition of the currency’s strengthening global reserve status. Much fanfare accompanied the move.
In the 12 months since, however, the renminbi’s internationalisation has slowed down. China’s growth model precludes further opening of its capital account and loosening of domestic financial repression. Ensuring domestic financial stability and reform, as well as a lower, more sustainable growth target, will need to precede the next phase of currency liberalisation.
Until 2015, the rise of the renminbi was considered a one-way trend. As China grew in importance, it embarked on a tightly controlled, incremental process of liberalising its capital account and currency. This led to increased global usage, starting from a low base. Extrapolating the upward trajectory suggested the renminbi was certain to become one of the world’s major currencies, alongside the dollar and euro. However, that trend began to stall around August 2015.
Sceptics point to the challenges facing the Chinese economy as reasons why further liberalisation should not be expected, as the government appears unwilling to relinquish control to market forces. This, however, underestimates structural factors which make continued renminbi internationalisation inevitable.
Over the last decade, China has been moving rapidly towards an open capital account that would accompany any meaningful internationalisation. China has created the essential infrastructure to allow future capital flows to move in and out of domestic financial markets, and therefore to accelerate the currency’s global usage. The stock and bond market ‘connects’ between Hong Kong and the People’s Republic are key programmes which allow foreign investors to access Chinese capital markets. The timing of further capital account opening, therefore, is a question of political will.
Additional steps towards capital account liberalisation and greater convertibility would come at the expense of state control. Increased reliance on market forces would lead to greater volatility in asset price movements. In exchange, markets would presumably impose more discipline on lending and investment decisions in China, thus helping to rebalance the overall economy in line with development needs.
Regardless of the economic rationale, the renminbi’s progress will remain dependent on the government’s tolerance of the vagaries of markets. It would require, too, the People’s Bank of China to secure greater autonomy, something that would run counter to current trends of institutional consolidation in the Communist Party. The 19th party congress will be held on 18 October, where President Xi Jinping is expected to name the next governor of the PBoC.
Another overarching challenge stems from the accumulation of substantial macroeconomic and financial imbalances. These need to be reduced before China can resume capital account liberalisation. China has a high gross savings rate (close to 50% of GDP), which can lead to asset bubbles. Highly indebted state-owned enterprises with significant default risks present further dangers. Potential systemic risks such as these, which could engender sudden capital outflows, must be defused before the capital account is opened further.
The Chinese government, fortunately, has a variety of tools at its disposal. It can resolve debts through bail-outs by shifting liabilities from the corporate to the stronger sovereign balance sheet. It can provide liquidity to struggling debtors over prolonged periods to enable gradual deleveraging. It may impose soft restructurings, as state entities represent most borrowers as well as lenders. Or it could allow defaults and let defaulted debt be re-priced.
A combination of these measures should enable a smooth overall deleveraging – a precondition for further currency liberalisation and integration with global capital markets.
Elliot Hentov is Head of Policy & Research, Official Institutions Group, at State Street Global Advisors, and a Member of the OMFIF Advisory Board.
This was the first article in a two-part series on ongoing market liberalisation in China. The second part is available here.