Yves Mersch: China - progressing towards financial market liberalisation
and currency internationalisation
Speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank,
at the Renminbi Forum Luxembourg, Luxembourg, 26 February 2014.
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Ladies and Gentlemen,
It is a pleasure to be the keynote speaker at the first-ever Luxembourg Renminbi Forum. I
would like to thank Luxembourg for Finance for this opportunity to say a few words on the
recent, rapid emergence of the renminbi as an international currency. Its new-found status is
the result of China's economic performance and part of a wider ongoing reform process in
the country. So how will the internationalisation of the renminbi affect China, as well as the
rest of the world? These are the issues I will address now.
China's economic rise
The opening-up of China and the reforms pursued by its leaders since 1978 have brought
about astonishing economic progress. The Chinese economy has become the third largest in
the world, after the US and the euro area. China's GDP per capita in real terms has
undergone an 18-fold increase, massively reducing poverty and increasing purchasing
power. But economic development has brought its own challenges, such as income
inequality and environmental degradation. The authorities are increasingly responding to the
concerns stemming from these problems and have made their resolution a policy priority.
China's domestic development has taken place in parallel to its growing economic integration
with the rest of the world. Its goods trade has increased about 20-fold over the last 20 years.
Cross-border investment is growing again after retreating during the global financial crisis.
Flows are also becoming more balanced: the current account surplus last year was slightly
over 2% of GDP, a far cry from the surplus of more than 10% recorded in 2007. In addition,
since 2012, investment coming from China has caught up with investment flowing into China,
accounting for 15% and 17% of GDP respectively.
As its economic importance has grown, China has taken on a larger role in global institutions.
Notably, it joined the World Trade Organization in 2001. The IMF has also agreed on an
increase in its quota, although this still has to be implemented. Bilateral relations between the
EU and China are also intensifying. Following on from the EU-China summit in Beijing on
21 November 2013, the European Commission and the Chinese Ministry of Commerce
started talks last month on a comprehensive investment agreement to increase market
access and provide better protection for investors.
Renminbi internationalisation as part of China's wider reform process
As China has gained in international stature, some people have asked whether it can
maintain its economic dynamism. A decline in growth (from over 10% in 2010 to slightly
below 8% at the end of 2013) coupled with the persistence of domestic imbalances suggests
that further reforms are needed. In particular, the composition of domestic demand continues
to be highly skewed towards investment (now standing at 47% of GDP). At the same time,
growth has become increasingly reliant on credit, with total financing to the private sector
growing to about 180% of GDP at the end of 2013 from 115% in 2008. Financial leverage on
this scale is much higher than in other countries with a similar level of development.
Moreover, much of the credit growth has taken place outside the formal banking system, a
development which needs to be monitored closely to minimise risks to financial stability.
The Chinese authorities are well aware of these challenges and, in November 2013,
presented a comprehensive reform programme aimed at making growth more sustainable.
An essential element is the progressive development and liberalisation of domestic financial
markets so as to give a greater role to market forces in determining interest rates and
allocating credit. Allowing those forces to play a more important role will increase the liquidity
of China's financial markets as well as the variety of instruments traded. Over the last few
years, we have already seen a rise in the number and variety of financial instruments that are
being traded on China's domestic markets, be they bonds, at various maturities and with
different ratings, derivative products or different currencies.
As for currencies, China's decision to introduce direct trading between the euro and the
renminbi in the Shanghai foreign exchange market could, beyond its symbolic value of
signalling stronger relations, bring benefits for the euro area and China. It could do several
things - enhance price discovery for the currency pair, encourage a decline in transaction
costs, facilitate the access of European banks to the Chinese onshore foreign exchange
market, and it could allow the euro area to benefit from the rising importance of the renminbi.
However, should trading volumes remain low, some of these advantages, such as lower
trading costs, might prove elusive.
An expansion of the country's domestic financial markets should allow for a more efficient
allocation of capital, which should benefit China's long-term growth prospects. These
measures, together with others aimed, for instance, at increasing competition in product
markets, or at making it easier for rural residents to move to China's cities, should help the
economy to rebalance away from investment and towards domestic consumption. From a
global point of view, that is a welcome step.
Efficient domestic financial markets are also a prerequisite for a further liberalisation of
crossborder financial flows, in particular investment flows. Currently, opportunities are limited to a
number of quota-based investment schemes. In December 2013, the Governor of the
People's Bank of China (PBoC), Mr Zhou Xiaochuan, confirmed that cross-border investment
transactions will be gradually liberalised and the quota-based system in use today ultimately
abolished.
Nonetheless, market participants should not expect the opening-up process to be absolutely
smooth, and neither should they think that periods of increased volatility can be entirely
avoided. They should keep a close eye on and adequately provide for the risks inherent in
the onshore renminbi asset exposures they take.
Integrating the renminbi in the global financial system
Let me now turn to the internationalisation of the renminbi. The scope for its usage in
international trade transactions is significant as China accounts for around 9% of global trade
in goods and services, surpassed only by the United States, which accounts for around 12%.
According to market participants, a third of China's total trade will be settled in its currency by
2015.
In addition, several other important developments have increased the usage of renminbi for
investment purposes: (i) the currency is already available to the corporate sector. Apart from
accumulating the currency through trade, companies can also issue renminbi-denominated
bonds in Hong Kong (also known as dim sum bonds) and borrow renminbi directly from
banks in Hong Kong; (ii) the PBoC has already concluded currency swap agreements with
24 foreign central banks, totalling about CNY 2.6 trillion (around €317 billion). On 8 October
2013 the ECB and the PBoC established a bilateral currency swap agreement with a
maximum size of €45 billion; (iii) offshore renminbi centres are progressing quickly; and
(iv) domestic financial markets are continuing to develop. The large state banks have all
been listed, the number of institutional investors is rising and the market is becoming more
diversified and liquid, paving the way for further participation by foreign investors.
Its use in global finance is closely linked to the opening-up of China's domestic financial
markets. Foreign investors are unlikely to issue large amounts of renminbi-denominated
financial instruments as long as they cannot easily transfer financial assets into and out of
China. In addition, Chinese investors who are keen to diversify their assets internationally
currently face difficulties in doing so, restricting the availability of renminbi outside of China.
In spite of existing restrictions, the international use of the Chinese currency has already
risen very quickly, albeit from a low base. The volume of Chinese goods trade settled in
renminbi increased from virtually zero in early 2010 to 15% at the end of 2013. In parallel, the
use of renminbi-denominated investment products, such as the issuance of offshore bonds in
Hong Kong, has grown. Nonetheless, the outstanding amount of renminbi-denominated
bonds only represents a small fraction of the global total. Moreover, in November and
December last year, according to data from SWIFT, the renminbi was for the first time among
the top ten currencies used for payments in terms of value. Over the past three years it has
overtaken 22 other currencies, including the Russian rouble, the Turkish lira and the Mexican
peso1.
Since the inception of the offshore market for renminbi the combined daily turnover in the
spot foreign exchange and forward markets in CNH (for offshore trading) has risen sharply to
above USD 12 billion. In the fixed income market, the size of CNH debt rose from
CNH 69 billion at the end of 2010 to CNH 500 billion in the third quarter of 2013. Additionally,
a broad range of instruments has been introduced, including investment funds, equities and
structured products.
Liberalising financial flows will allow for a further integration of onshore and offshore markets
and should reduce the risks related to market fragmentation. Due to restrictions on financial
flows, offshore and onshore renminbi markets are only partially integrated2. This results in
small but persistent discrepancies in the exchange rate and interest rates in the Shanghai
market and offshore markets such as Hong Kong, which are not fully arbitraged away. This is
not only economically inefficient but also poses certain exchange and interest rate risks for
financial market participants, and in turn complicates the use of the renminbi in international
finance.
Market segmentation also creates other risks, such as liquidity risk, when offshore corporates
and investors are faced with a sudden and temporary renminbi liquidity shortage which
cannot be met by rapidly transferring liquidity from the mainland. The three-year currency
swap agreement between the ECB and the People's Bank of China, which I just mentioned,
specifically aims to prevent such risks, i.e. to serve as a backstop liquidity facility, reassuring
euro area banks of the continuous provision of renminbi in the euro area. Having such a
backstop in place makes sense in view of the rapidly growing bilateral trade and investment
flows between China and the euro area, and in view of China's major role in the global
economy. This rationale is also supported by the rapidly increasing use of the renminbi as a
payment currency.
From the perspective of the euro area supervisory authorities, renminbi internationalisation
calls for a monitoring from a macro-prudential perspective, including those risks arising from
increased exposure to renminbi-denominated assets and liabilities in euro area banks.
Furthermore, the increasing presence of Chinese banks within the euro area also brings its
own challenges regarding banking supervision, including the need for greater cooperation
and exchange of information between home and host authorities.
The integration of the renminbi in the world's financial system will also require the continued
development of payment system infrastructures and international payment arrangements -
and, ultimately, the integration of onshore and offshore activities, so as to enable
crossborder renminbi-denominated payments to be processed quickly, safely and economically.
Work is already under way to modernise the domestic Chinese payment system and to
ensure its compliance with international technical standards. This is seen as a precondition
for establishing arrangements with other payment infrastructures worldwide and for
eventually providing banks with efficient and secured payment-versus-payment mechanisms.
Offshore renminbi markets have so far mainly come into being in East Asia. This forum and
similar events recently organised in Frankfurt and Paris testify however to the demand for
such markets within the euro area. Moreover, the economic size and well-developed financial
markets of the euro area inevitably mean that it will play a role in the internationalisation of
China's currency. The euro area is also home to global companies with extensive operations
in China and an evident interest in conducting operations in renminbi.
The currency's trade settlement scheme is the main link between both markets, on and
offshore. This scheme was initially developed to foster the development in offshore markets,
offering several benefits to foreign trading partners: (i) the possibility of negotiating better
trade terms when invoices are denominated in renminbi rather than the US dollar; (ii) a
natural hedge as both trade partners issue invoices in the same currency; (iii) access to
small and medium-sized Chinese firms that are unable to contract in foreign currency and
(iv) the scheme offers the possibility of benefiting from capital gains, as the renminbi is
expected to appreciate in the years ahead.
The main prerequisite for engaging in trade settlement is to involve a bank that can settle
transactions in the interbank market in mainland China and convert currency in the onshore
foreign exchange market. Typically, there are two channels through which renminbi trade
settlement is possible: (i) via a mainland correspondent bank, where the offshore bank of a
foreign trade partner settles trade invoices with Chinese firms via an account with that
correspondent bank, with the renminbi proceeds subject to Chinese regulations; ii) via
clearing banks licensed by the PBoC to operate offshore (BOCHK for Hong Kong), where the
offshore bank settles trade invoices via an account with that clearing bank, buying or selling
renminbi in the offshore market (at the CNH rate).
Since the expansion of the scheme, renminbi trade settlement has increased sharply,
accounting for around 15% of China's total foreign trade in the third quarter of 2013, with
prospects for further growth as more offshore centres open across the world.
Conclusion
In conclusion, the internationalisation of the renminbi offers many opportunities, both for
Chinese and international investors and corporates, including in the euro area. Nonetheless,
to fully reap the benefits of this process, China needs to continue reforming its economy, in
particular its financial sector, along a clear, well-sequenced path to minimise risks and
enhance confidence. Equally, Chinese and international investors and financial institutions
must make a realistic assessment of the risks involved in cross-border investment, and build
up commensurate buffers.
In view of these risks, the following considerations should be kept in mind:
First, the significant bilateral commercial relations between euro area and China should
support a steady increase in EUR/CNY trade volumes. This is because European
counterparties are interested in settling their trade invoices in renminbi to benefit from price
discounts and to access different suppliers. Chinese counterparties are also increasingly
keen to settle in renminbi to reduce their exchange rate risk and to simplify their cash
management.
Second, although they have not committed to a strict timetable, the Chinese authorities have
shown their commitment towards a more flexible exchange rate and increasing the
convertibility of the renminbi. In 2012, China widened the currency's floating band. In
addition, over the last few years, the scope for cross-border investment flows has been
enlarged through the setting-up of a number of investment schemes open to institutional
investors.
We are still in the early stages of this internationalisation, but it's a process that is rapidly
moving forward. Market participants expect trade settlements in renminbi to continue to
increase and new offshore markets to emerge, offering a broad range of products to attract
foreign investors. They also foresee a progressive liberalisation of the capital account,
including an increasing number of institutional investors operating in mainland China and,
ultimately, a fully convertible renminbi. Clearly, having become an important trading and
payment currency, the renminbi is now taking the first steps towards establishing itself as an
international investment currency. If it can do so successfully, it might one day become a
leading reserve currency.
Its internationalisation raises questions about the future shape of the world's monetary
system. In particular, due to the size of China's economy and its importance in global trade
and, potentially, finance, the renminbi might ultimately come to challenge the US dollar.
Although it is too early to say what the implications for international financial stability could
be, the authorities and investors need to prepare for a world in which the renminbi will play a
much more important role.
Thank you for your attention.