Renminbi internationalisation and China’s financial development

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  Robert McCauley Renminbi internationalisation and China’s financial development 1 For now, effective capital controls allow the Chinese authorities to retain regulated deposit and lending rates, quantitative credit guidance and bond market rationing. Relaxation of the capital controls would put these policies at risk. Reserve requirements can be extended to bank inflows from the offshore market, but only at a price. JEL classification: E4, E5, F3, G1, O16, P2. A currenc
    BIS Quarterly Review, December 2011 41   Robert McCauley    Renminbi internationalisation and China’s financialdevelopment 1   For now, effective capital controls allow the Chinese authorities to retain regulated deposit and lending rates, quantitative credit guidance and bond market rationing.Relaxation of the capital controls would put these policies at risk. Reserve requirementscan be extended to bank inflows from the offshore market, but only at a price. JEL classification: E4, E5, F3, G1, O16, P2. A currency is internationalised when market participants – residents andnon-residents alike – conveniently use it to to trade, to invest, to borrow and toinvoice in it outside the currency’s home country (“offshore”). The Chineserenminbi has just begun the process of becoming an international currency.Economists have long considered the international use of a currency as amarket outcome that is subject to inertia as a result of network externalities(“I use it because others use it”). Against this, Eichengreen and Flandreau(2010) find that it took the dollar just 15 years to overtake sterling in officialreserves after the Federal Reserve Act promoted the US dollar’s challenge tosterling in global trade and finance. Frankel (2011) argues that a “tiny elite”promoted the dollar at the Federal Reserve’s founding and that German andJapanese industrialists resisted international use of the Deutsche mark and yenin the 1970s and 1980s. 2  However one interprets the dollar’s ascent, there is no precedent for themanaged availability of the renminbi offshore. In the late 1950s, US officialswere taken unawares by the spontaneous rise of London’s eurodollar marketas UK banks sought to avoid sterling exchange controls, US banks sought toavoid US regulation and central banks sought to invest at higher yields (Schenk(1998), McCauley (2005)). 1 The views expressed are those of the author and not necessarily those of the BIS. The author thanks Woon Khien Chia, Tim Condon, Dong He, Daniel Hui, Thomas Liu, Andy Lui, GuonanMa, Sebastian Mallaby, Miranda Tam, Olin Wethington and Haibin Zhu for helpful discussionsand Agne Subelyte and Emese Kuruc for research assistance. A longer version is 2 See Funke (1999, pp 246–8), Ito (2011) and Takagi (2011).    42 BIS Quarterly Review, December 2011   The Chinese authorities have begun to internationalise the renminbi before fully liberalising China’s capital account. More broadly, the renminbi iscrossing borders at a transitional stage in China’s financial development. In thecountry’s banking system, the net interest margin is still regulated, lending isstill subject to quantitative guidance and foreign banks are still limited toplaying a small role. Similarly, in the corporate bond market, issuance is stillrationed. Backed by capital controls, these reinforcing restrictions provide theauthorities with direct leverage over credit growth and its allocation.How does the managed internationalisation of the renminbi square withthis transitional stage of financial development? Can the Chinese authoritiescontinue to manage the internationalisation of the renminbi within the regime of capital controls, and this without depriving themselves of direct levers oncredit? Or is internationalisation likely to take the levers out of their hands?As long as capital controls remain effective, renminbi internationalisationleaves the levers intact. Relaxed capital controls would put at risk bond marketrationing, regulated deposit and lending rates, and quantitative credit guidance.Reserve requirements can be extended to inflows from offshore, but at a price.This special feature first sketches the role of offshore markets in the multi-track strategy for China’s financial development. The next section shows thatoffshore markets in renminbi are growing within a regime of capital controls.The following section traces the flow of funds from onshore to offshore and viceversa. The penultimate section contrasts the existing renminbi offshore marketswith offshore markets in major currencies in order to highlight future challengesfacing Chinese policymakers. The last section concludes. The three-track strategy of financial development A generation ago, China gradually shifted from central planning to a socialistmarket economy. But instead of a big bang, as in Poland, price controlsremained in place over the medium term for certain quantities of goods, andflexible market pricing applied to output beyond those quantities. In thetransition, market prices served as shadow prices for the set quantities.By analogy, the authorities have continued to set maximum deposit ratesin the Chinese banking system, to exercise window guidance on loan growthand to ration access to bond markets. This is the first track. At the same time,the authorities have allowed market-set money and bond yields to signal thescarcity of funds. This is the second track. Banks heed these signals when theynegotiate liberalised loan spreads with customers. Thus, over time, the twotracks can converge (He and Wang (2011)).The offshore markets can serve as a third track. Renminbi accumulateoffshore when Hong Kong SAR residents buy limited amounts of renminbiagainst dollars or when renminbi payments for China’s imports exceedrenminbi receipts for China’s exports. Using these offshore renminbi, banksand underwriters build offshore foreign exchange, money and bond markets.So far, the authorities have permitted relatively narrow channels from (third-track) offshore markets to the (second-track) currency, money and bondmarkets in China. As a result, offshore price signals differ from those onshore. Offshore marketprices can helpguide pricing byChinese banks    BIS Quarterly Review, December 2011 43   That said, the Chinese authorities do not delude themselves that the third trackcan be permanently isolated from the second and first tracks. Instead, offshoreprices can complement the domestic market-determined yields in sendingsignals to the still regulated banking system. The third track thus helps toexpand the ambit of flexible prices. If the offshore markets put pressure on thepace of development of the domestic money and bond markets, within limitsthis would be welcome. Internationalisation within capital controls Renminbi are accumulating outside the mainland via carefully drilled holes inChina’s capital controls. However, currency, bond and equity markets showthat these controls nonetheless continue to bind. 3   Exchange rates The renminbi’s internationalisation has produced a second spot exchange ratefor the renminbi, dubbed the CNH, for delivery of renminbi against dollarsoutside the mainland, largely in Hong Kong. And this spot renminbi exchangerate in Hong Kong differs from that in Shanghai (CNY), a clear sign of segmentation. From its inception on 11 July 2010 to November 2011, thepremium on the Hong Kong CNH relative to the Shanghai fixing rangedbetween –1.9% and 2.6% and averaged 0.2% in absolute value (Graph 1, left-hand panel). In September and October 2011, with heightened risk in globalequity markets (“risk off”) and associated weakness in Asian currencies againstthe dollar, the renminbi traded substantially more cheaply in Hong Kong than inShanghai. Global financial strains exposed the limits of arbitrage.With the introduction of a CNH forward in late 2010, three differentmarkets trade forward rates for the renminbi (see box). For more than 10 years,a forward contract for difference, a so-called non-deliverable forward (NDF), 3 For money markets, see Ma et al (2004), Ho et al (2005), Ma and McCauley (2008a,b) andMcCauley (2011). Chinese renminbi/dollar spot and forward exchange rates, onshore and offshore Spot rates One-year forward rates 2010Q4 2010Q1 2011Q2 2011Q3 2011Q4 2011CNY onshoreCNH onshoreCNHCNY NDF Sources: Bloomberg; HSBC. Graph 1 … forward foreignexchange…   … spot foreignexchange …Offshore pricesdiffer fromonshore prices in …    44 BIS Quarterly Review, December 2011   has traded offshore. In this market, counterparties take a position on thedomestic renminbi exchange rate fixing at some date in the future, butsettlement involves dollars only. Then, in October 2005, after the unpegging of the renminbi from the dollar in July 2005, a deliverable forward began to tradeonshore. From then until late 2010, the offshore NDF and the onshore forwardtraded at strikingly different rates (Graph 1, right-hand panel). In particular, thegap between the onshore forward and the offshore NDF rate ranged between –5% and 4%, and averaged 1% in absolute value. During this period,multinational firms arbitraged these two markets within the limits set by China’scapital controls. From the start of forward CNH trading to August 2011, its pricediffered from its onshore counterpart and the NDF by no more than+/–2%. In this period, the gap between the onshore forward and the NDFnarrowed from an average absolute value of 1% to 0.6%. Again, in September and October 2011, the forwards in Hong Kong depreciated relative to their Shanghai counterpart, resembling in sign if not extent the pattern observedafter Lehman’s failure in 2008. Government bond yields The natural experiment of the sale in Hong Kong of Chinese government bondshas produced fresh and strong evidence for the effective segmentation of thedomestic and offshore markets. When the Chinese government first issuedrenminbi bonds in Hong Kong in 2007, it paid a higher yield than thatdemanded in domestic markets. However, with the subsequent build-up of  The trifurcated renminbi foreign exchange markets: a transactions perspective To complement the point made in the main text – that, in terms of pricing, the renminbi trades in atrifurcated market – this box gives a transactions perspective. According to the triennial central banksurvey of April 2010, the largest share of trading in the renminbi was the $23 billion per day virtual tradingof the NDF outside China (Graph A, left-hand pie chart). The onshore deliverable market in April 2010reported only $10 billion (though this may have been an undercount). By centres, trading volume wasabout $10 billion per day on the mainland and in Hong Kong SAR, with another $7 billion per day inSingapore and London and $3 billion per day in New York. Market estimates for August 2011 put tradingoffshore in the deliverable renminbi, CNH, at $4 billion per day. If turnover on the mainland and that innon-deliverable forwards outside China are assumed to have continued at the April 2010 rate, then thetrifurcation of activity would be as portrayed in the right-hand pie chart in Graph A. Geography of currency trading: estimated distribution of renminbi turnover  Strictlyoffshore (NDF)OnshoreOnshore-offshore April 2010   Strictlyoffshore (NDF)OnshoreOnshore-offshoreCNH tradedin Hong Kong August 2011 Sources: Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity; HSBC; author’s estimates. Graph A … Chinesegovernmentbonds …
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