China scrapping the renminbi’s two-year-old US dollar peg can hardly be expected to make much of a dent in the country’s huge trade surplus. But Beijing’s move sent out a clear signal of its ambition to boost the financial power and the status of its currency.
By pegging renminbi to a basket of currencies instead of just the dollar, China is adopting a mechanism that could help cushion against currency swings. The movement should also boost liquidity and turnover in the mainland currency market, a boon for China to develop into a global financial center.
Nothing, however, will happen quickly. The People’s Bank of China did nothing more than pledge to increase the flexibility of China’s exchange rate regime and further improve the exchange rate mechanism. It ruled out a one-off appreciation. Rather the exchange rate mechanism will be tweaked, with activity based on market demand and supply in response to the value of currencies in the basket. Of these, the dollar remains dominant.
The market rallies that greeted the announcement were short-lived as investors came to realize that Beijing doesn’t plan to loosen its grip. In the week beginning June 21, the renminbi soared more than 0.4% on the Monday, reaching its highest level since the landmark revaluation of 2005, but gave back half the gain a day later.
The timing for the mechanism overhaul was apparently designed to ease pressure from developed nations ahead of the G20 meeting in Canada.
But it was perhaps less about silencing hawks in the US than assuaging China’s own concerns over the European export market. The renminbi’s upward trend against the dollar was halted in mid-2008 to help out domestic manufacturers who were caught short as the global financial crisis crippled external demand.
The ongoing European debt crisis has seen the renminbi gain more than 15% against the euro – corresponding to gains made by the dollar – in the past two months. This has hurt shipments to Europe, China’s biggest trading partner. Having the renminbi track a basket of currencies could help stabilize its value against major international currencies for exporters.
At the same time, China is seeking to reduce its reliance on the dollar in cross-border transactions.
The central bank has expanded its program under which renminbi is used to settle cross-border transactions to cover 18 more provinces after a trial in Shanghai and Guangdong. Slowly, the way that exporters in Jiangsu and Zhejiang carry out their business is changing.
But just enhancing the renminbi’s role in trade is not enough to boost its status globally. Foreign holders must be provided with more channels through which to make use of the currency.
Beijing should make it easier for overseas companies and investors to work in renminbi within China and also reduce barriers to its use abroad. In this sense, Hong Kong and Shanghai can play key roles in promoting the internationalization of the renminbi.
Hong Kong has a sophisticated investor base and sound financial fundamentals, making it well suited to become a major offshore market for the currency. More renminbi-denominated debt issuance is likely to be seen in the city in coming years.
Moreover, Hong Kong will maintain its status as Beijing’s barometer of the international response to further opening-up of the mainland financial markets. Already, Chinese regulators are mulling plans that would see Hong Kong-based Chinese financial institutions use investors’ renminbi deposits to trade A-shares.
Shanghai is equally important as it hosts the mainland’s biggest equity and currency markets. The city is on track to set up an international board for foreign firms to issue renminbi-denominated shares as early as this year.
Fang Xinghai, head of the Shanghai Financial Service Office, said in late June that overseas companies may be allowed to invest in domestic financial markets using the proceeds of cross-border trades settled in renminbi. If this does come to pass, it would pique foreign firms’ interest renminbi settlements as well as shore up the Chinese equity, bond and inter-bank credit markets.
Internationalizing the renminbi is a long process and it is impossible to predict when – or even if – the Chinese currency will be regarded as a global reserve currency, let alone challenge dollar dominance.
The principal obstacle is, of course, Beijing’s unwillingness to make the renminbi fully convertible under the capital account. Some analysts say this will happen by 2020, the target date set for Shanghai to become an international financial center, but the issue is clouded with uncertainty.
Zhou Xiaochuan, governor of the central bank, has said that efforts on capital account convertibility have been delayed by the impact of the global financial crisis. Even then, China’s financial markets are still too weak to deal with the volatility created by a huge inflow of capital should full convertibility be realized.
Most importantly, the key issue facing Beijing in the coming years doesn’t involve the renminbi at all – it is the structural shift in economic growth from investment and exports towards consumption. Should the government manage this transition effectively, the impact on global rebalancing might be as pronounced as anything currency appreciation might achieve.