CHINA’S STRATEGY TO develop the international use of its currency through a consistent and sequenced set of policies is unprecedented. It is the first developing country to actively drive the process of internationalizing its currency rather than letting it develop naturally. It is also the first country to attempt to do this in the era of true fiat money, when there is no link, even residual, between an international currency and gold or another physical asset.
1 This means that the renminbi’s credibility cannot be established by comparing its convertibility to gold with that of other currencies, as happened when the dollar took over from the pound.
Establishing the credibility of and an international reputation for the renminbi and making it acceptable in those parts of the world where the dollar dominates—even if just in Asia—are difficult objectives, but they are what the two-track renminbi strategy (the trade settlement scheme and the offshore solution) is designed to achieve. Nevertheless, this strategy faces many interrelated obstacles in building a market for the renminbi.
The first of these challenges is to channel the renminbi into the hands of foreign holders—a tricky feat, given China’s restrictions on capital flows and on the convertibility of the renminbi. With China’s preference for maintaining a surplus in the current-account—presently down to approximately 3 percent of gross domestic product but higher, at approximately 5 percent, at the beginning of the renminbi strategy in 2010—and managed exchange rate, pushing the overseas demand for renminbi means accumulating dollars on the asset side of the central bank’s balance sheet. As I discussed in
chapter 5, managing the exchange rate means that the People’s Bank of China (PBoC) has to hold dollars in its reserves and release renminbi. In other words, in order to keep the exchange rate stable, it needs to intervene to absorb dollars while supplying renminbi to the market; as a result, it ends up piling up more dollars in the official foreign exchange reserves and thus further enlarges the “dollar trap.” (The alternative to accumulating dollars would be moving to a truly flexible exchange rate, but as we’ve discussed and will consider further in
chapter 9, China is not prepared to do this.)
Assuming that China succeeds in creating traction for the renminbi, another challenge is to respond to and expand the foreign demand for renminbi funds and renminbi-denominated assets while maintaining domestic financial stability. The authorities believe that this can be preserved as long as the channel through which offshore renminbi get back to the onshore market is restricted. But restrictions on flows—both inward and outward—curb market demand, thus acting as a counterforce on the internationalization of the renminbi. Also, the Chinese authorities must carefully sequence the policy measures that are part of the renminbi strategy to avoid creating opportunities for arbitrage and carry trade between the offshore and onshore markets.
Finally, there is no guarantee that the market participants will use renminbi, once China has implemented the renminbi strategy and “facilitated” the functioning of the market. The authorities assume that once they have put the critical infrastructure in place, the process can get enough traction to drive the market, and then the internationalization of the currency will follow—especially given the scale and scope of the country’s trade. Policies can certainly support currency internationalization, but can they drive it? China can set the stage but cannot force market participants to use the renminbi. For this to happen, they need to feel confident about the currency’s liquidity and credibility.
The challenges China faces can be boiled down to liquidity, market infrastructure, and the relationship between the two. Well-designed and well-implemented infrastructure will help ensure that there is plenty of renminbi liquidity outside mainland China, which will in turn support the demand for renminbi and encourage market practice. Therefore, the key element of such market infrastructure is the liquidity channel between the offshore market and the onshore market. In this chapter, I will take a closer look at what has been done in order to build a market for the renminbi and the infrastructure that underpins such a market.
SUPPLYING RENMINBI TO THE OFFSHORE MARKET
Liquidity is critical to establishing a well-functioning renminbi market. Foreign companies that may be able and willing to use the renminbi in their trade with China need to be sure that the currency is easily available in the offshore market when it is needed and, above all, that it is swiftly exchangeable with any other currency. They need to be assured that China’s constraints on capital flows will not affect the pool of the renminbi in the offshore market and hinder transactions.
There are two common ways to supply liquidity for the offshore market. First, market participants deposit the money they have earned from trade transactions in offshore bank accounts. This helps create a “reservoir” outside the country that issues that currency. This liquidity can then be used in international transactions outside the jurisdiction of the issuing country. Because of its dominance in the international payment system, the dollar, for instance, is extensively used, accumulated, and intermediated outside the jurisdiction of the United States by people who do not reside in the United States. A German firm that operates in a number of different countries and markets around the world may decide to hold a dollar account in London—the world’s largest dollar offshore market—which it uses to make and receive payments around the world without sourcing funds from or deploying funds into the United States. Dong He and Robert McCauley call this a “pure” offshore market.
2The second way to ensure plenty of liquidity for the offshore market is for market participants to exchange dollars or other international currencies into the offshore currency, using the clearing bank in the offshore center or a correspondent onshore bank, and for onshore banks to lend to their offshore subsidiaries through the clearing bank offshore. The German firm in the example above can exchange its euros into dollars and wire that money into its dollar bank account in London.
China cannot pursue either of these common paths. The use of the renminbi in international trade is not yet sufficiently developed to provide enough liquidity to the offshore market,
3 and restrictions on China’s capital account limit the liquidity that can be generated by market participants. Because of these constraints, the renminbi market—at least for the time being—is not a pure offshore market. It is better characterized as net international lending in renminbi.
4 This means that the renminbi offshore market works mainly as a conduit of funds from mainland China to the rest of the world rather than as a vehicle for the circulation of renminbi outside China’s jurisdiction. Using renminbi bank deposits as a proxy, the size of the renminbi offshore market has been estimated to be around 2.2 trillion renminbi.
5 This is only about one-tenth the size of China’s total foreign exchange reserves and approximately 3 percent of its gross domestic product. This means that the liquidity generated by market participants—that is, the private sector—is not, on its own, sufficient to underpin the development of a market for the renminbi that is significant enough to, in turn, expand the international use of the Chinese currency.
Thus, the policy of controlling the currency runs counter to China’s policy on the development of the renminbi. Foreign holders of renminbi face several restrictions on the repatriation of the funds that they raised in the offshore market in order, for example, to invest them in the mainland, so they may find holding renminbi in the offshore market unattractive.
6 At the same time, relaxing controls on capital outflows may run counter to the need to maintain plenty of financial resources for the domestic banks. As China’s economic growth slows and the Federal Reserve’s monetary policy becomes less accommodative—providing better returns for dollar-denominated assets—outflows have begun to outnumber inflows. In 2015, China’s net capital outflows reached a record high of $676 billion.
7The PBoC therefore has found a third way to provide liquidity—by actively supplying it. The role of the central bank as supplier of renminbi liquidity is what sets the renminbi offshore market apart from the dollar offshore market. In deciding how much liquidity to inject into the offshore market, the Chinese central bank must consider market demand, policy goals, and the risks to domestic financial stability that excessive liquidity might generate. In line with the country’s gradual approach to policy making, liquidity is carefully increased and decreased. With this “proactive, controllable and gradualist” approach,
8 China aims to minimize the risk of developing an oversized offshore market beyond the authorities’ control.
9 And by controlling the amount of liquidity in the offshore market, its monetary authorities de facto control the pace of its development.
MANAGING THE SUPPLY OF RENMINBI
Liquidity is largely in the hands of China’s central bank, so how does it ensure that there is a sufficient supply of renminbi? One way is through currency swaps, such as those initiated between Brazil and China in 2013. These bilateral agreements are devised as a safety net to ensure the availability of currencies that are critical for a country’s trade relations and to avoid disruption to trade from a temporary scarcity of liquidity. Swaps also, crucially, create renminbi liquidity in the offshore market.
10 The argument that currency swaps could be used to provide renminbi liquidity and thus encourage its international use was first put forward in 2009 by Ma Rentao and Zhou Yongkun, two researchers at the Graduate School of the PBoC.
11 Since then, the Chinese monetary authorities have been experimenting with using swap agreements to increase the pool of the currency outside China. As more renminbi become available outside the country and in the foreign exchange markets, it becomes easier for foreign firms to use them to settle trade. Currency swaps should also assist China’s trade partners by reducing the many costs that are normally associated with financial transactions—such as commission fees, interest rates, loan origination fees, and taxes.
Currency swap agreements have thus become a key component of China’s renminbi strategy. They are a way to deepen its financial and monetary integration with the signatory countries
12 and to create offshore pools of renminbi around the world. Since 2009, more than 3 trillion renminbi have been committed through bilateral currency swap agreements that China has signed with thirty-two countries—most are in Asia, including Thailand, Indonesia, and South Korea, but Britain, New Zealand, Switzerland, and Argentina also have entered into agreements.
13The PBoC signed the first of these agreements with the Bank of Korea in December 2008, in the aftermath of the global financial crisis. This agreement allowed the PBoC and Bank of Korea to swap 180 billion renminbi over a three-year period; that is, it allowed these two countries to purchase currencies from each other in case of a liquidity crisis. In 2013, the PBoC signed a 500 billion renminbi swap agreement with members of the Association of Southeast Asian Nations under the Chiang Mai Initiative
14 to promote regional financial stability and a 200 billion renminbi swap agreement with the Bank of England. That China has signed agreements with so many countries despite the fact that the renminbi technically is a nonconvertible currency, is evidence of the leverage that it has, especially with developing countries.
In many countries, these renminbi swap agreements are of limited use because the size of the renminbi business—and trade with China—is not large enough to trigger a liquidity crisis. According to the PBoC, in 2014, only about 81 billion renminbi of the accumulated swap amount of 2.3 trillion renminbi were used.
15 But the situation is different in Hong Kong, for instance, where having a renminbi safety net really matters (Hong Kong, as I discuss later in this chapter, is the key offshore market for the renminbi). In January 2009, Hong Kong set up a three-year swap agreement with the PBoC for a total of 200 billion renminbi. This agreement was then renewed twice, in November 2011 and November 2014, and increased to 400 billion renminbi for the specific purpose of facilitating the development of the renminbi offshore market. Norman Chan, chief executive of the Hong Kong Monetary Authority (HKMA), welcomed the agreement as “crucial in helping us to provide liquidity, when necessary, to maintain the stability of the offshore renminbi market in Hong Kong.”
16The importance of such an agreement was demonstrated in June 2012, when the swap line was activated to ease the temporary scarcity of liquidity created by strong demand for renminbi from banks in the Hong Kong offshore center and to avoid destabilizing the offshore renminbi market.
17 By allowing banks to obtain renminbi from it, the HKMA, the de facto central bank, sent a strong message that helped calm nerves and relieve market pressure.
18China’s monetary authorities have not limited the creation of liquidity to the provision of currency swaps. In recent years, they have begun to encourage the policy banks to offer competitive loans in renminbi to countries that have limited borrowing capacity in the global capital market. In March 2012, at the BRICS Summit in New Delhi, the China Development Bank announced the signing of memorandums of understanding with the development banks of Brazil, Russia, India, and South Africa, in which they agreed to make their currencies available for invoicing trade and lending with each other.
19 In addition, in 2011, the China Ex-Im Bank began cooperating with the Inter-American Development Bank for the purpose of setting up a fund denominated in renminbi that would support infrastructure investments in Latin America and the Caribbean and through which China could expand lending in renminbi to commodity-rich countries in Latin America.
The New Development Bank and the Asian Infrastructure Investment Bank, in which China is a significant shareholder, are also seen in Beijing as potentially instrumental in the promotion of the renminbi to large regional and international projects. Although the subscribed capital for both banks is in dollars—$50 billion and $100 billion, respectively—these amounts are rather small for large development projects. The total capital of the World Bank, by comparison, is about $223 billion. It is therefore plausible to think that both banks will eventually need to expand their capital, and China may be eager to contribute with renminbi instead of dollars.
These developments—from currency swaps and bilateral loans to the creation of new development banks—carry important implications for the renminbi offshore markets. Companies in those countries with which China has signed swap agreements can establish entities in the offshore centers—notably, Hong Kong—in order to carry out trade business in renminbi. Ultimately, they can use the offshore centers as hubs from which to conduct back-to-back trade. In this context, swap agreements with the PBoC equate to an “official endorsement,” intended to reassure market participants that renminbi will remain available in the event of a shortage of offshore renminbi—the CNH.
BUILDING A PAYMENT SYSTEM
The other key consideration for a well-functioning offshore market is infrastructure—in particular, the payment system. This is the means by which banks and firms in mainland China connect with their counterparts overseas, and, thus, it entails the conversion of the flows of renminbi into and from mainland China (an essential bridge because the China National Advanced Payment System does not support international payments). Designated clearing banks act as conduits with the onshore interbank payment system, and it is through these channels that renminbi are repatriated to China.
How does the system work? Each offshore market has its own clearing bank, designated by the PBoC. Let’s take the example of Hong Kong. Here the Bank of China (Hong Kong) is the designated clearing bank. (Other clearing banks include the Industrial and Commercial Bank of China and China Construction Bank, which are the clearing banks in Singapore and London, respectively.) The Bank of China (Hong Kong) maintains an account with the Shenzhen branch of the PBoC, into which it deposits renminbi collected from nonmainland banks that participate in the trade settlement scheme. Through the link between the onshore interbank payment system in mainland China—called the high value payment system (HVPS)
20—and the offshore renminbi real-time gross settlement (RTGS) system in Hong Kong,
21 the clearing bank settles renminbi payments outside mainland China. Thus, a nonmainland bank can engage with a correspondent bank in mainland China, which, in turn, clears the payment with the clearing bank, or it can engage directly with the clearing bank, or it can use both the correspondent bank and the clearing bank. In addition to taking renminbi deposits from its own customers, a nonmainland bank can obtain renminbi funds by converting or borrowing through the clearing banks or mainland correspondent banks.
The RTGS system allows cross-border payments (for example, in Hong Kong dollars and U.S. dollars between banks in Hong Kong and their counterparts in Shenzhen and Guangdong) to be settled efficiently and safely. It pays interest to participating banks, determined on the basis of the interest rate on deposits that the PBoC, in turn, pays to the clearing bank. The clearing bank is also entitled to a special membership in the China Foreign Exchange Trade System, where it can clear the renminbi positions from the exchange business of participating banks. At the end of April 2016, there were 214 direct participants in the RTGS system that were clearing transactions with a total value, on average, of 700 billion renminbi a day.
22Participating banks can set their own conditions on renminbi deposit accounts in the offshore markets. In Hong Kong, for instance, residents—such as Hong Kong identity card holders—face no limit on deposit or withdrawal amounts. They face some limitations, however, on the amount of renminbi they can exchange into Hong Kong dollars, or vice versa,
23 and can remit renminbi from Hong Kong to “personal savings accounts” at banks on the mainland.
24 Participating banks can issue debit and credit cards to Hong Kong residents for use on the mainland, subject to the usual maximum credit limit of 100,000 renminbi. In addition, since 2010, measures have been introduced to facilitate transactions between the onshore and offshore markets—allowing, for instance, transfers of renminbi deposits between banks.
25 Also, firms can set up accounts in renminbi with no limit on the amount that can be held or transferred into and out of those accounts.
There are significant limitations to using the RTGS system to deal with the renminbi payments in the offshore market—notably, the hours of operation and the restricted use of Roman characters—making it difficult for the renminbi’s development as an international currency. To advance China’s ambitions for its currency, the PBoC has been developing a new payment system—the Cross-Border Inter-bank Payment System (CIPS)—that connects all renminbi users through a single platform, specifically supports cross-border clearing among both onshore and offshore participants, operates twenty-three hours a day (useful for both Asian and European markets), and supports both Chinese and Roman characters. It is intended to provide the infrastructure to facilitate direct international renminbi payment clearing, cut transaction costs and processing times, and put the renminbi on an even footing with key international currencies, thus offering a further incentive to use the renminbi in international payments. A total of nineteen banks have been selected to participate in CIPS, eight of which are Chinese subsidiaries of foreign banks, including Citi, Deutsche Bank, HSBC, and ANZ. In October 2015, Standard Chartered (China) became the first bank to complete a transaction through CIPS, sending a payment from China to Luxembourg for Ikea, the Swedish retailer.
26Another benefit for China of using its own clearing system is that it can rely less on the Belgium-based payment system provided by the Society for Worldwide Interbank Financial Telecommunication (SWIFT). Dominated by U.S. and European banks, SWIFT has indirectly become a tool of international politics. For instance, in January 2015, because of the conflict in Ukraine, the European Union threatened to exclude Russian banks from SWIFT. Even without strong geopolitical risks for China at the moment (although there is significant tension between China and the United States and between China and Japan), the Chinese leadership would probably prefer to avoid being in a potentially vulnerable position, in which a retaliatory move due to political pressures could cut off payments in renminbi.
THE DIM SUM MARKET
Along with sufficient liquidity and an infrastructure for payments, sufficient international activity in the Chinese stock and bond markets is especially critical the international use of the renminbi. This is for two reasons. First, by adding another group of financial assets, it further encourages the accumulation of renminbi funds for investments and loans. For instance, Chinese companies can borrow in the debt market and then use the funds that they raise for their overseas investments, or they can even repatriate the funds and invest them domestically. Foreigners, in turn, are more likely to hold renminbi if there is a market for renminbi assets beyond just parking renminbi in deposits in the offshore banks. The more renminbi-denominated instruments available, the less onerous and constraining it is to hold renminbi. Lending and borrowing in renminbi are therefore critical for the development of the Chinese currency.
The second reason for building a renminbi-denominated debt market is that such a market helps “discover” the prices of other assets that are denominated in renminbi, and, thus, it further supports market diversification. As different organizations—sovereign, intergovernmental, and corporate—issue bonds denominated in renminbi, each with its own yield and length, a yield curve and benchmark interest rates are established. Other issuers then follow, each contributing to make the yield curve less blurred. Once a market for renminbi-denominated bonds is established, other financial instruments can be developed—for example, insurance policies that need bonds to cover their policy exposure and investment and pension funds that need bonds to provide an income stream. A well-developed bond market is also critical to the development of the asset management business. They are, in fact, mutually reinforcing: asset management supplies funds to the bond market, and the latter offers investment opportunities through the asset management products. Furthermore, a liquid and diversified bond market supports the development of hedging instruments, such as derivatives. A range of hedging instruments makes it more attractive for foreign companies to use renminbi to invoice and settle trade transactions.
The most developed offshore market for renminbi-denominated bonds is the one in Hong Kong, which is nicknamed the “dim sum” market and issues “dim sum” bonds—to differentiate it from mainland China’s onshore “panda” market. The dim sum bond market got its start in 2007 (before the launch of the renminbi trade settlement scheme), when the PBoC and the National Development and Reform Commission made it possible for commercial banks and companies based in mainland China to issue renminbi-denominated bonds in Hong Kong. In the same year, the China Development Bank issued a renminbi-denominated bond in Hong Kong worth 5 billion renminbi. Big commercial banks in mainland China followed suit and issued renminbi bonds in Hong Kong. In 2007, for example, the Bank of China launched a bond offering that amounted to 3 billion renminbi.
27 In October 2009, China’s Ministry of Finance issued sovereign bonds worth 6 billion renminbi in Hong Kong, the first such issuance outside the mainland.
28These were experiments (all controlled, to some extent, by the state) to test the reaction and the interest of market participants. The real breakthrough, however, came in August 2010, when McDonald’s, the multinational fast-food chain, issued a bond worth 200 million renminbi, with a coupon rate of 3 percent and a maturity of three years. It was the first foreign company and the first nonfinancial company to issue a bond in the dim sum market. This marked the beginning of an intense period of bond issuance by Hong Kong–based and foreign companies.
From 2007 to November 2015,
29 the total issuance of dim sum bonds exceeded 443 billion renminbi. Issuers came from a broad range of industries—from consumer goods and financial products to tools and machinery—and countries, including Hong Kong (Hopewell Highway), Japan (Hitachi Capital, Mitsubishi UFJ, Mitsui & Co.), South Korea (Korea Eximbank, CJ Global), Malaysia (Khazanah’s Sukuk), Taiwan (New Focus Auto Tech, Solargiga Energy), and the United States (Caterpillar, Ford Motor) as well as a number of European countries (HSBC, Unilever, VTB Capital, Volkswagen, Tesco).
In 2009, in the early days of the dim sum bonds, the Hong Kong bond market was mainly driven by the local currency, with 98 percent of the bonds issued in Hong Kong dollars. Dim sum bond issuances now amount to more than 60 percent of Hong Kong’s total bond market.
30 This has shifted Hong Kong’s financial center toward more trading in renminbi instruments.
The logic of issuing renminbi bonds is clear. The issuer finds it advantageous to tap into a market with lower borrowing costs—issuing dim sum bonds is cheaper than issuing panda bonds when interest rates are lower in Hong Kong (as has been the case since the global financial crisis). In the case of McDonald’s, for instance, fundraising in Hong Kong allowed the multinational fast-food chain to take advantage of cheaper rates than the ones prevailing in the onshore market. Funds raised this way were then repatriated to mainland China through the newly established clearing bank channel. (Recall that multinational firms like McDonald’s that make direct investments in mainland China have significant freedom to move money into and out of the country.)
At the same time, when renminbi-denominated bonds are available in the offshore markets, international investors can diversify their portfolios and—at least until recently—invest in an appreciating asset. The existence of a channel to move these funds between the offshore and onshore markets, and vice versa, makes the whole process easier and thus more attractive.
The forces that have propelled the dim sum market should continue to drive its growth. First among these is China’s economic growth and transformation, which is significant even if it is moving at a slower rate than in the past. The push for Chinese companies to “go out” (as discussed in
chapter 2) and bottlenecks in the banking sector ensure a steady demand for capital to support existing businesses and to establish new ones. In addition, expectations that the renminbi would steadily appreciate provided some further traction until 2014, when this trend began to change. Furthermore, investing in bonds issued in the offshore market is the easiest way for international investors to gain exposure to China’s debt market. Finally, the separation of currency risk from country risk is attractive to foreign investors and other market participants. When buying renminbi bonds in the offshore market, international investors avoid any risk, even political risk, that is related to mainland China. In the offshore market, investors also may be more protected from instability that could arise from operational bottlenecks if the PBoC becomes more active in and reliant on the securities markets for its access to liquidity. This is reflected in yield differentials between the offshore and onshore markets.
Despite the obvious boons, there are significant obstacles that the offshore debt market must still overcome. Although the dim sum bond market doubled its size in its first five years, the yield curve remains limited and the secondary market nonexistent. These two elements (a diversified yield curve that reflects a wide supply of bonds with different yields and different maturities and an active secondary market in which investors can trade bonds before they mature) are essential for a well-functioning bond market. Bond yields are on average just over 4 percent, and the average duration is around three and a half years. That these obstacles remain is not due to lack of efforts to address them—China’s Ministry of Finance has been actively selling bonds of different maturities to provide a pricing signal for other issuers, and in June 2013, it even issued the first thirty-year offshore sovereign bond. The obstacles are also not the result of lack of international investors. International financial institutions issued approximately 7 percent of the renminbi bonds in 2013; and overseas nonfinancial corporations are the largest group of issuers, with a market share of approximately 33 percent. China’s monetary authorities are well aware of the need to develop a more liquid and more diversified bond market, and, indeed, the reform and opening of capital markets featured prominently in the plan for reforms presented at the Third Plenum in November 2013 and reiterated in the Thirteenth Five-Year Plan, 2016–2020.
31 Such a development, however, is linked to the reform of the banking sector and, more generally, to the reform of the governance of Chinese companies and provincial governments.
CHANNELS TO MANAGE RENMINBI FLOWS
Once the critical market infrastructure has been created and liquidity has been provided by the PBoC, then international demand for renminbi and renminbi-denominated assets should pick up. But this is where things get complicated. Given the existing restrictions, who is allowed to invest in stocks and bonds listed in Shanghai and Shenzhen—and how can the Chinese invest in stocks and bonds listed overseas? In order to facilitate capital transactions and investments, Beijing’s monetary authorities have introduced (or expanded) an alphabet soup of programs: the qualified foreign institutional investor scheme (QFII), which, as described in
chapter 4, allows foreign investors to buy and sell renminbi-denominated “A” shares that trade on the onshore stock exchanges; the renminbi-qualified foreign institutional investor scheme (R–QFII), which allows foreign investors to use offshore renminbi funds and invest them in mainland China’s capital markets; the renminbi-overseas direct investment program (R–ODI), which enables enterprises in mainland China to invest onshore renminbi funds abroad; the renminbi-foreign direct investment program (R–FDI), the vehicle that “overseas enterprises, economic entities or individuals” can use to make foreign direct investment in the mainland with renminbi; and the qualified domestic limited partnership (QDLP), which launched in April 2015 and allows overseas asset managers to establish qualified domestic private renminbi funds to invest in offshore securities markets.
32How do these schemes work? Let’s consider the R–QFII. In this case, China’s monetary authorities grant an investment quota to financial centers that have a renminbi offshore market. When the scheme was established in 2011, Hong Kong was granted a 270 billion renminbi investment quota; when the scheme was expanded in 2013, quotas of 50 billion renminbi and 80 billion renminbi were assigned to Singapore and London, respectively. The Hong Kong financial center has grown significantly since the launch of R–QFII, with over forty mainland Chinese companies now present there to manage money flowing out of the mainland and to engage in fund advisory businesses. Growth has been so brisk that the HKMA has been discussing the possibility of increasing the quota with the PBoC.
33 Other schemes have been similarly popular—between 2013 and 2014, the R–ODI doubled its size to approximately 187 billion renminbi, and the R–FDI almost doubled to 862 billion renminbi.
34New policies are introduced all the time. For instance, the Shanghai–Hong Kong Stock Connect went live in November 2014 (after some delay, which was allegedly due to Beijing’s irritation with the ongoing “Occupy Hong Kong” protest). Under this system, China’s domestic stock market is, for the first time, directly open to international investors—in particular, retail investors and global hedge funds—without the need for any license or official approval. It also gives China’s domestic investors access to international assets through the Hong Kong stock market.
As with the other schemes devised for the offshore market—and more generally with most new schemes in China—there are quotas. Hong Kong can buy up to 250 billion renminbi worth of stocks from the Shanghai Stock Exchange 180 Index and 380 Index and all “A” and “H” stocks listed in Shanghai. Similarly, mainland Chinese investors can buy and sell shares on the Hong Kong Stock Exchange up to a maximum value of 250 billion renminbi. Each day up to 13 billion renminbi can flow from Hong Kong into the mainland’s stock market, and a maximum of 10.5 billion renminbi can move daily from Shanghai to Hong Kong.
35 At the time of the launch, more than 150,000 investors based in mainland China registered their interest in trading Hong Kong–listed shares with the Shanghai Stock Exchange, but on the first day of trading, only 20 percent of the daily quota was used.
36 Demand for Shanghai-listed shares, on the other hand, was so strong that by 2 p.m. on the first day of trading, international investors had exhausted their daily quota.
37Despite the strong start, the scheme did not look particularly successful in the first few months of trading, with less than 3 percent of the daily quota for Chinese investors and slightly more than 20 percent of that for international investors used. But since then, activity has picked up significantly, creating a conduit for two-way portfolio investment.
38 In April 2016, more than half of the quota for the Shanghai Stock Market had been used, with total transactions of more than 350 billion renminbi and an average daily turnover of about 3 billion renminbi—down from 4 bn in March 2016.
39 Activity on the Hong Kong Stock Exchange has been less dynamic, with less than 50 percent of the quota used, total transactions of almost 350 billion renminbi, and an average daily turnover of about 2.9 billion renminbi.
40Ultimately, this system of gradually introducing new policies (each with its own associated quotas) allows the authorities to retain control of capital movements. It is worth repeating here that the way to make this system of quotas consistent with the policy of internationalizing the renminbi is by developing the offshore market. And which financial center would be a more appropriate renminbi hub than Hong Kong?
HONG KONG: ONE COUNTRY, TWO SYSTEMS
That Hong Kong has been so closely associated with China’s renminbi strategy is hardly surprising. The city is the entrepôt of China’s trade in the region and a leading international financial center.
41 It handles over 60 percent of foreign direct investment into mainland China, and its banks have been doing business with the mainland for years. But its legal, judicial, and regulatory systems are a legacy of its status as a British colony until 1997, and they are different from the systems prevailing in mainland China—“one country, two systems,” to use Deng Xiaoping’s description.
42Over the years, the Chinese authorities have been trying to combine the capitalist skills of Hong Kong with China’s transformation from a planned to a more market-oriented economy. The role of Hong Kong in the development of mainland China was such that Deng explicitly advocated the preservation of Hong Kong’s capitalist, free market system, wishing that it should continue for “a hundred rather than fifty years.”
43 Since Deng’s days, Hong Kong’s main strength has been in having an environment stable and free enough to attract and retain the most successful firms and a large number of the most educated and ambitious people—even the “Occupy Hong Kong” protest in 2014 does not seem to have diminished Hong Kong’s attractiveness or to have irreversibly damaged its relationship with Beijing.
In the context of China’s renminbi strategy, Hong Kong’s special status provides the testing ground for the use of the renminbi outside mainland China. In fact, the renminbi offshore market has been developed for Hong Kong and with Hong Kong as a template. Through Hong Kong, Beijing can experiment with the gradual and controlled opening up of China’s financial market. And Hong Kong, though an integral part of China’s currency strategy and financial reforms, offers the necessary degree of separation between the onshore and offshore markets. Keeping these markets separated—but within the same country—in principle enables China’s monetary authorities to monitor the flow of external funds between offshore and onshore accounts and to avoid the huge influx of funds that could create instability in domestic financial markets.
44 At the same time, they provide the necessary renminbi liquidity for the offshore operations—and because of this, Hong Kong is not a pure offshore market.
As a ground for experimentation with the renminbi, Hong Kong has the opportunity to redefine its role vis-à-vis the mainland and shape its financial services sector more around mainland China’s renminbi strategy. The 2009–2010 Policy Address—the key policy document that sets out the Hong Kong government’s main guidelines—stated that “we can support the Mainland in promoting the regionalisation and internationalisation of the RMB. In the process, Hong Kong can help the Mainland enhance financial security and develop offshore RMB business.” The document resolved that “We should fully grasp the opportunities presented by ‘One Country, Two Systems.’ We will continue to develop Hong Kong as a global financial centre, asset management centre and offshore renminbi business centre attracting capital and talent from within and outside the country.”
45The majority of the renminbi business goes through Hong Kong. It handles almost 80 percent of the total renminbi cross-border trade settlement business and about 80 percent of global renminbi payments.
46 Renminbi funds flow in through trade payments or other channels and become renminbi deposits that can then be used, deployed, or exchanged freely with other currencies in the market. This development is not just about banks; over the years, Hong Kong has developed other streams of activity within the renminbi market, such as foreign exchange trading and wealth management. These streams reflect the main components of China’s renminbi strategy and are mutually reinforcing. The result has been the rapid development of the renminbi business. For example, Hong Kong’s renminbi offshore foreign exchange market has become a major currency market in Asia—after being nonexistent a few years ago. This has deeply affected, and gradually changed, the activities and operations of the city that is one of the world’s leading financial centers. According to SWIFT,
47 the renminbi is now the second-most-used currency for cross-border payments between the mainland and Hong Kong—with a share of approximately 12 percent of cross-border payments.
48However, despite many breakthroughs in recent years and the large expansion of the renminbi business, bank deposits in renminbi remain a mere 8 percent of total bank deposits in Hong Kong. In March 2016, according to the HKMA, total deposits were worth almost HK$11 trillion: more than half, or HK$5.3 trillion, were held in Hong Kong dollars, and the rest were held in foreign currencies.
49 Compared with total bank deposits in mainland China, which amount to more than 90 trillion renminbi, the size of the renminbi deposits in Hong Kong looks even smaller.
50There is clearly room for some further expansion of the renminbi offshore market in Hong Kong. In any case, due to its special relationship with mainland China, Hong Kong is already well ahead of all other international financial centers—even those that aspire to be a significant part of the renminbi offshore market in terms of the volume of renminbi deposits, as I discuss in the next chapter—and continues to enjoy first-mover advantage, especially in the banking sector. Because of its large offshore liquidity, Hong Kong offers a platform for primary bond issuance and secondary market trading of renminbi products, and this gives it a definite advantage over its competitors.
Hong Kong may not retain its leading position for long, however. The renminbi strategy, as I have stressed, is a work in progress. Beijing’s experimentation around the renminbi is already expanding in other directions—in terms of both policy and geography. The risk is that Hong Kong will become less central to this strategy. As I discuss in the next chapter, other financial centers have expanded their renminbi operations and increasingly compete with Hong Kong. This competition is likely to become stronger if and when the renminbi offshore market becomes a pure offshore market—that is, when China eventually fully liberalizes capital movements. In addition, China’s monetary authorities have been experimenting with other measures to open the capital account under “controlled conditions.” The free trade zones, as I will discuss in the next chapter, are set to develop an onshore renminbi market open to nonresidents, and I wonder whether this will eventually make the offshore market less relevant for China’s renminbi strategy. Being able to access China’s market directly through the free trade zones will allow many foreign investors and businesses to circumvent the renminbi offshore market in Hong Kong, and make it less critical to Beijing’s renminbi strategy.