The Internationalization of China’s Currency Continues to Evolve

On November 17, Mark Noble will be speaking on a webinar about the evolving CNH market.
Please register here if you would like to listen in.  

As the last quarter of the year begins, the financial markets again find themselves in turmoil. The problems in Europe continue to focus on the sovereign debt problems of its weaker member states; the U.S. is facing the possibility of another major slowdown; and even Asia looks to be at risk of feeling the adverse effects of the over-leveraged West this time around. China in particular is in a tough spot given its overheated economy of the last few years and related inflationary pressures from labor and food costs. It faces these challenges against the backdrop of an uncertain global economy in 2012, reminiscent of the last global recession of 2008–2009. Until recently, one of China's most effective monetary policy tools to cool its elevated inflationary pressures has been an aggressive currency appreciation program, now projected to be nearly 5 percent by year end. The other major theme surrounding China's currency this year has been the rapid development and "internationalizing" the RMB (renminbi), which many see as a major step towards truly opening its domestic markets to foreign investors and improving international trade-related flows well beyond the current negative economic environment.

A quick recap of the currency picture  

The renminbi (RMB) is the official currency of China, whose principal unit is the yuan, commonly abbreviated as CNY. Historically it has served as the domestic currency, is highly regulated within China, and hasn't been allowed to freely float in the global currency markets.

Because of its highly restrictive nature, mainland (onshore) CNY activities such as foreign exchange, domestic/international payments, and various global trade flows have been highly monitored by China's central bank (PBoC). Its restrictive nature has forced global transactions outside the Mainland (offshore) to be limited in scope and disconnected from onshore markets.

For the last few years, China has taken a localized and measured approach to making the CNY fully convertible by creating an offshore CNY market in Hong Kong . This new CNH structure will ultimately enable two-way, fully deliverable FX conversions (spot, forward, and options) for either local, Hong Kong-based transactions or as a conversion gateway to/from the Mainland.

CNH developments this year  

Hong Kong's CNH market celebrated its first anniversary in July and local acceptance has exceeded expectations as evidenced by the daily volumes and expanded liquidity. In August, China's Vice-Premier Li Keqiang visited Hong Kong to further promote RMB cross-border settlement. The Mainland's pre-approved 20-city and province scheme is expected to expand nationwide.

FX liquidity in the CNH market has steadily improved. The year started with spot transaction turnover of $600 – $700 million a day and has grown to now nearly $1.5 billion. The CNH deliverable forwards have also grown from $300 – $500 million to approximately $1.0 billion a day. As impressive as the increased volumes have been this year, when compared to the onshore CNY market volumes of approximately $15 billion a day in the spot market, this newly formed market is clearly in its infancy. The trading relationship between the CNY and CNH has tracked closely via CNY's PBoC-controlled "stair-step" appreciation, as the bid-offer spread has been tightening. However, the recent flight-to-quality status of the U.S. dollar and corresponding risk-aversion trading patterns into U.S. Treasuries has tested the limits of the monetary authority-related liquidity limits.

Next steps  

The full implications of internationalizing the RMB are still not clear, but to date, there appears to be four major areas of concern for China, as it moves forward with its RMB initiatives:

1. Additional central bank policy liberalization measures will continue to evolve
2. Closer integration of China with the international financial community and the automation of RMB transaction flows are needed
3. Continued promotion of its liberalized currency to the global audience should ensure faster acceptance
4. Increased/improvement of market liquidity via offshore market

While the international usage of the RMB is still in its early days, many benefits will be achieved through the promotion of its currency beyond its borders, and will be vital for future growth. Local/onshore corporates are now beginning to use RMB-derived pricing for cross-border trade instead of a foreign currency (primarily the USD), avoiding FX costs and exchange risk. Foreign/offshore corporates can now pay in RMB (with the necessary governmental approvals), opening up business opportunities with more mainland/onshore companies, thus further increasing the overall size of trade flow. Larger offshore corporates can now actively manage their RMB risk on an increased global basis, and over time, diversify assets and protect against depreciation of one currency.

China's determination to develop this new market and establish Hong Kong as the major RMB offshore center will continue to be the focus of the central government in the near term, with an eye on the bigger prize of propelling the RMB to reserve currency status.