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Building new investment opportunities with China's Renminbi

Philip Poole - is Global Head of Macro and Investment Strategy at HSBC Global Asset Management

Already the world's second largest economy, China is likely to be the biggest by the 2030s. It is already the world's largest exporter. Yet to date, its currency has lagged in global trade and capital markets. Prior to recent reforms the RMB was strictly a domestic currency with few international characteristics. Things are now changing the currency is internationalising at pace with the Chinese Government's ultimate ambition to make the RMB a global reserve currency for investment, trade and settlement purposes.

This push is partly because China feels trapped by relying on the US dollar as the principal unit of exchange for its exports and the store of value for the lion's share of its accumulated foreign exchange reserves holdings but also because - like the US and the UK in the past - policy makers have come to appreciate the benefits of having a global reserve currency.

Reserve currencies

Reserve currencies play a crucial global role for both the private and official sectors. As trade vehicles they facilitate processes such as the on-going globalisation of the supply chain and are dominant as stores of value for accumulated wealth holdings, particularly emerging markets central bank holdings of foreign exchange reserves. The on-going internationalisation of the RMB is fortuitous because the world is keen to acquire new reserve assets and the spectrum of investors from retail to central banks and sovereign wealth funds is looking to diversify away from the US dollar over time, particularly given concerns raised over potential debasement as a result of quantitative easing.

Chinese policy makers have also mentioned the IMF's Special Drawing Right (SDR) as a potential alternative reserve currency but this looks like a low-probability event. In terms of other emerging markets currencies playing such a role, the potential also seems to be limited. Russian politicians want a group of regional reserve currencies to replace the dollar in regional trade but little has been achieved so far. There has also been some discussion regarding using the Brazilian real to settle trade between Brazil and some of its trading partners but we are not optimistic about significant progress in the near term.

China has no aversion to the dollar per se but to potential dollar weakness and particularly its implications for accumulated external savings, much of them held in US treasuries and other dollar-denominated assets.

The authorities in China fear that dollar weakness could lead to substantial losses in the local currency value of these dollar assets. This also explains their vocal opposition to quantitative easing from the Federal Reserve, given the belief that it would serve only to drag the dollar lower.

China owns so many dollars that it can't sell them without driving the price down against itself. Given the nature of this starting point and liquidity constraints, the shift away from the dollar's global dominance will necessarily take time. However, with such high stakes, China has been at the forefront of the reserve currency debate, actively looking for possibilities to diversify away from the dollar. Gold and commodities have been beneficiaries and, in our view, will continue to be.

Gold and other precious metals are the only financial assets that are not someone else's liabilities. China has increased its gold holdings rapidly in recent years and last year China and India together accounted for more than half of gold demand globally. But the gold market and flows into it are relatively small in relation to global FX reserves. Less than 5% of China's reserves are equivalent to a full year of global gold production. In other words, size will limit the extent to which international reserves can be parked in gold.

Work to be done

China is on track to become the world's largest economy and historical parallels imply a role for the RMB as an important reserve currency at some point in the future. But there is much work still to be done for the RMB to achieve reserve currency status. China needs to open up the capital account for international transactions and make the RMB fully convertible for such transactions and it needs to make its bond markets more liquid.

Like most of China's economic policy, changes in the approach to the currency have for the most part been unfolding gradually. The current foreign exchange regime now has greater flexibility and the authorities appear to be a little more prepared to allow the currency to appreciate than in the past. Recently, on the regulatory front change seems to have gathered pace. China has set up currency swaps with many other countries including in Latin America and Asia and RMB bond issuance in Hong Kong (so-called 'Dim Sum' bonds) is growing as a first step towards creating a deep investable bond market for the Redback. Projects for RMB settlement have been in place for sometime. In 2009 RMB trade settlement schemes began in a number of mainland cities and Hong Kong participating banks were allowed to provide trade finance to foreign traders settling trades in RMB.

As such changes proceed they will have the immediate advantage of reducing foreign exchange risk for Chinese companies that switch to RMB settlement. Last year there was a global roll-out of RMB trade settlement and an offshore RMB products platform was launched in Hong Kong.

The RMB interbank market was also opened to selected offshore RMB holders and an RMB Overseas Direct Investment trial launched. In the coming years we expect to see a significant increase in global RMB trade settlement and increasing liquidity in the off- shore RMB bond market as Dim Sum bond issuance increases.