China is determined to ensure that its currency, the renminbi, becomes fully internationalized and a reserve currency for

other nations in ten years. Is this possible, and if so what would be the ramifications? A. Richard Brown, head of treasury services, Asia Pacific for BNY Mellon offers his view.

Making Sense of Renminbi Internationalisation

By A. Richard Brown

In recent years the potential for the renminbi (RMB) to become a fully convertible, international currency has been much discussed. The initial consensus is: not anytime soon. But Chinese president Hu Jintao begs to differ. He said the renminbi will replace the US dollar as the international reserve currency within a decade. Could it happen? China can create deep, liquid markets. Its trade flow and foreign direct investment volumes provide a large base for renminbi-denominated transactions. What is missing? Ample offshore renminbi-denominated accounts. But that is changing: China has piloted a programme allowing exporters in Shanghai, Guangzhou, Shenzhen, Zhuhai, Dongguan and other regions to settle cross-border trade deals in RMB. Malaysia and Belarus adopted the RMB as their reserve currency; China signed currency swap agreements with eight countries and regions. China allowed overseas financial institutions to invest in the interbank bond market on a trial basis; the State Administration of Foreign Exchange (SAFE) allowed export companies to deposit export revenues overseas. Chinas central bank expanded cross-border RMB trade settlement to 67,359 domestic exporters from the original 365 firms; RMB-to-ruble trading in Russia was initiated, and China and Russia began to settle bilateral trade in RMB and ruble; Bank of China (Hong Kong) launched the Bank of China (Hong Kong) Offshore Index, representing 90% of the market in terms of value. The index will include 28 constituent offshore RMB bonds worth some Rmb54 billion (US$8.1 billion, according to Chinaviews, January 6, 2011). The Bank of China has begun offering renminbi trading on a limited basis within the US, through its US branches and western banks.

This article first appeared as a co-published feature in AsiaMoney, May 2011

Creating a Bond Market

Internationalisation has spurred a new renminbi-denominated bond market. Beginning in 2009, China allowed HSBC and some foreign banks to issue renminbi-denominated bonds in Hong Kong. Soon after, the mainland government issued Rmb6.3 billion in sovereign bonds, creating a benchmark for future bond issues.

In recent years the potential for the renminbi (RMB) to become a fully convertible, international currency has been much discussed. The initial consensus is: not anytime soon.

In 2010, the Asian Development Bank issued Rmb1.2 billion in renminbi-denominated bonds, and Hopewell Highway Infrastructure, a Hong Kong construction firm, became the first non-financial institution to issue renminbi-denominated bonds in Hong Kong. Multinationals McDonalds and Caterpillar followed suit. In August 2010, the Peoples Bank of China allowed select clearing banks in Hong Kong and Macau, and some overseas banks, to invest offshore renminbi funds in Chinas onshore bond market. These banks could expect higher returns on onshore balances, generating higher interest rates on renminbi accounts, and making it attractive for foreign exporters to accept payment in renminbi and thereby increase offshore holdings. In January 2011, the World Bank priced Rmb500 million of fixed-rate two-year bonds with a coupon of 0.95% in Hong Kong, and China targeted the RMBs value to rise about 5% against the US dollar in 2011. In February Monex, a Japanese on-line securities broker, began offering RMB-denominated bonds in Japan to individuals. These bonds will have a three-year maturity and are intended for investment rather than for trade.

What Does it Mean?

What does it mean to internationalise a currency that is essentially non-convertible? Whats the significance of creating an offshore market and for investors to enter it, when the Chinese tightly control the currency? Are there parallels to the beginnings of the Eurodollar market? What will it mean for the world if a second reserve currency emerges? By internationalising the renminbi, China aims for it to serve first as a currency for: (1) trade settlement, (2) investment, and (3) international reserves. For that to happen, a pool of sufficient offshore holdings in the currency must be created.

Hong Kongs Role

The role China allowed Hong Kong in developing an offshore renminbi market has been crucial. Hong Kong banks have accepted deposits in renminbi on a restricted basis since 2004; but in 2010, following mainland government approval, the Hong Kong Monetary Authority loosened supervision of renminbi-denominated business, allowing virtually any company to open a renminbi-denominated account. These accounts facilitate funds transfer among accounts in Hong Kong, creating an interbank market in Chinese currency and permitting banks to invest on their own accounts. Chinas effort to settle trade in renminbi has suffered from the lack of a futures market or other means to diminish exchange risk. The opening of the Hong Kong offshore market has given individuals and corporations trading with China and long blocked from purchasing hedge instruments on the mainland market access to various instruments free of mainland restrictions.

The result was that cross-border trade settlement in the renminbi rose from an average of Rmb4 billion/month in the first half of 2010 to Rmb68 billion in October. Deposits by the end of November 2010 were at Rmb280 billion (according to Reuters, January 12, 2011). Further, indications show the currency is being held for long-term value. It appears the renminbi is materialising as an investment instrument. Chinas initiatives to create an offshore market in renminbi have occurred amid strict currency controls on the mainland, an approach without precedent and considered unfeasible by some. But the Chinese believe in their strategy of two different renminbis.

CNH and CNY

Although a single currency, the renminbi trades onshore and offshore under differing controls; supply and demand and market clearing exchange rates also differ. Therefore, it trades under: CNY on the mainland, and CNH offshore in Hong Kong. The CNH market is allowed to respond freely to a variety of market demands; the CNY market is determined largely by trade flows and is subject to regulation and government intervention. By splitting its currency, China hopes to allow an offshore pool of renminbi to grow while protecting domestic markets and governing development at their own pace.

Asian Eurodollars?
Eurodollars are US dollars that circulate and are held outside the US. The market began when European banks held US dollars for corporate customers on account with New York correspondent banks. When customers directed banks to pay a European client in dollars, dollars moved out of the US through the clients bank, into the payees account.

Chinas effort to settle trade in renminbi has suffered from the lack of a futures market or other means to diminish exchange risk.

The pool of Eurodollars grew and European banks began lending US dollar holdings. These dollars entered the holdings of other banks; the process repeated. The huge market that now comprises Eurodollars resulted. What has begun in the offshore renminbi market is similar although the Eurodollar market wasnt controlled as the Chinese intend to control offshore renminbi. To offer an example, Hong Kong banks can extend credit to customers in offshore renminbi, but reserve restrictions of 25% provide a check on credit growth rates. Also, Hong Kong banks are subject to agreements with the mainland that set the amount of interest payable on deposits. Thus, the Eurodollar is a dollar in a way that the CNH-designated renminbi is not a CNY-designated renminbi.

Whats Next?
In Hong Kong, renminbi may be hedged in the new CNH market and the non-deliverable forward (NDF) market. A non-deliverable forward is a futures agreement used for hedging non-convertible currencies and in which the principal in an agreed-upon currency exchange is imaginary. The exchange rate is set at the beginning of an agreed-upon term. When the term comes due, the buyer or seller settles the difference in interest produced by any rate change, depending on the direction of movement. There is no exchange of the sum on which the agreement is based.

For the renminbi, exchange rates in NDF contracts are those that prevail on the mainland, not in Hong Kong. As more investment instruments emerge for the CNH, the NDF market may diminish or disappear, although because associated FX rates in the NDF market prevail on the mainland, thats not likely. Eventually mainland currency controls will cease and the CNH and CNY will trade as a single currency. In the meantime theres an imbalance in the way the renminbi is used and accumulated. Although there has been tremendous growth in renminbi deposits in Hong Kong in 2010, offshore corporations trading with China are more willing to accept the renminbi as a receivable than to amass renminbi for payments.

Is Internationalisation Good?
An internationalised RMB benefits China, enabling Chinese corporations and investors to reduce foreign exchange exposures and helping China better control monetary policy. A free-floating exchange rate should normalise currency mismatches in the holdings of banks and corporations in China and offshore.

Although a single currency, the renminbi trades onshore and offshore under differing controls; supply and demand and market clearing exchange rates also differ.

Should the renminbi become a reserve currency challenging the US dollar, the US will lose the foreign exchange advantage of having much world trade settled in dollars. Conversely, the ability to diversify reserves and reduce dependence on one countrys monetary policy would be welcome elsewhere. Its also feasible that the US and China would increase discipline and probity in their monetary policies, so a crisis like that weve just endured would be less likely. Finally, while interesting, these developments are just the beginning of a multistep process. The ten-year internationalisation period remains a prediction. Most international trade will continue to be settled in US dollars for some time. But as trade settled in renminbi increases, more investors and clients will also require banks to settle in RMB. Few banks can do both. BNY Mellon, for example, is a strong player in US dollar settlement in Asia, but our Hong Kong branch also has connectivity to CNAPS, Chinas clearing system, and is participating in the clearing and settlement of RMB business. We anticipate offering trade settlement in Hong Kong to corporations this quarter. Our Shanghai branch anticipates approval for a license to provide onshore RMB services, also in second quarter, and thereafter to provide cross-border trade settlement. Investors and corporations need partnering banks to handle transitions as they arise and to simplify associated challenges. Deciding to wait and see isnt an option. In Asia, change is constant.

About the Author

A. Richard Brown is head of Treasury Services, Asia Pacific, for BNY Mellon. In this role, he is responsible for managing and building BNY Mellons delivery of payment and trade services, including trade outsourcing USD clearing and cross-border payments, to clients in Asia. He can be reached in Hong Kong at +85228406637 or at Arichard. Brown@bnymellon.com.

About BNY Mellon Treasury Services

With locations in 34 countries on six continents and a network of more than 2,000 correspondent financial institutions, BNY Mellons Treasury Services group delivers high-quality performance in global payments, trade services, cash management, capital markets, foreign exchange and derivatives. It helps clients optimize cash flow, manage liquidity and make payments more efficiently around the world in more than 100 currencies. The Company is a top-five participant in both the CHIPS and overall funds transfer markets, and was recognized by Global Finance magazine earlier this year as the leading provider of white-label treasury products and services for banks and other large institutional clients.

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06/2011