The rise of China's redback

Despite a slowing economy, China continues to press ahead with its ambitious program of financial reform and opening up, and the process is entering a critical phase.

At the heart of the next stage lies interest rate reform. Market-determined rates will open the way for a fully convertible currency within three years and revolutionise China’s RMB 9.3 trillion domestic bond markets, which we believe will double in size.

In a developing economy with heavily regulated domestic interest rates, capital controls and a non-convertible currency, a normal sequence of financial liberalisation would be to firstly deregulate domestic interest rates, then liberalise the capital account, and finally push the international use of its currency for trade invoicing and debt issuance. China has reversed this order by promoting renminbi internationalisation despite maintaining a closed capital account and regulated domestic interest rates. It has allowed the renminbi to internationalise gradually outside the mainland from the current account, which will slowly expand to the capital account.

Deep and liquid domestic financial markets are a precondition for any currency to go global. China’s economy has grown dramatically but its financial markets have remained underdeveloped and mostly closed off from the rest of the world.

The drive to internationalise the renminbi began in 2004 when banks in Hong Kong were allowed to offer renminbi deposit accounts. But the process got underway in earnest in 2010 when China started to encourage the invoicing and settlement of China’s foreign trade in renminbi, and created markets for the issuance of renminbi-denominated bonds, initially in Hong Kong and later in Singapore, London and Taiwan.

Despite the continuing restrictions, particularly on the capital account, the renminbi has already become a global player. It is the world’s second most popular trade finance currency, seventh most-used currency for payments worldwide, and is used to settle around 18 per cent of China’s total trade, up from just 3 per cent in 2010. But there is still significant room for growth: 50-60 per cent of Europe’s external trade is settled in euros, and 30-40 per cent of Japanese trade is settled in yen. We expect the renminbi to account for 30 per cent of total China trade by the end of 2015.

Some investors already see the renminbi as a potential reserve currency -- sovereign investors represent around 23 per cent of the Qualified Foreign Institutional Investor quota, or around $US12 billion. There is a strong interest in an underlying demand for reserve asset diversification into renminbi once the onshore market opens up.

The speed of capital account liberalisation suggests that full renminbi convertibility may come earlier than many expect; we believe in two to three years. The renminbi is already more convertible than anticipated -- of the 40 criteria the IMF uses to assess convertibility, the renminbi is fully convertible on 14 points, partially convertible on 22 and only blocked on four.

We expect controls on items that are not convertible will be gradually removed, while those that are partially convertible will move towards basic and full convertibility. Regulatory requirements in areas where the renminbi is already convertible, such as trade payments for goods and services, direct investment, cross-border payments and remittances will be simplified and streamlined.

Before the People’s Bank of China can open the capital account, they will have to relinquish control of interest and exchange rates. A dual system of controlled mainland rates and market-driven offshore renminbi interest rates would create opportunities for arbitrageurs to profit from the difference, creating the potential for large and destabilising flows of hot money between the markets.

Historically, China has kept interest rates artificially low to encourage investment and reduce financing costs for large state-run companies. This has repressed the development of financial services and reduced the efficiency of capital allocation. Credit does not always flow to where it is needed most.

The People's Bank of China eliminated the floor on bank lending rates in July last year to allow banks to offer better rates to more credit-worthy firms. Removing the floor has allowed banks to respond to market forces and loan demand conditions -- a clear sign of the new government’s commitment to financial liberalisation and market-oriented reform.

We expect interest-rate liberalisation will be a step-by-step process that could be completed within three years. The benefits of free interest rates are numerous and include a more transparent financial system, a shift away from property as a store of wealth, and more efficient allocation of capital. This will support rebalancing of the economy away from an over-reliance on investment towards a more sustainable consumption-driven model.

The process of liberalisation will have to be carefully paced. Moving too fast could provoke problems as debtors adjust to paying more for their loans. To avoid this, the deposit insurance system is considered a precondition for freeing deposit rates, the last and most important step of interest rate liberalisation.

Some commentators argue that China should make its currency fully convertible only after financial reforms are completed. International experience shows that there is no predetermined sequence for the introduction of interest rate and exchange rate reforms and convertibility, but we believe convertibility and financial reforms are complementary and should be pursued simultaneously.

China has established a pattern of test-driving major reforms in carefully controlled environments before rolling them out across the country, and we expect many of these latest reforms to be trialled in the Shanghai Free Trade Zone.

China's economic reform is a colossal project. A fast capital account liberalisation entails the risk of increased financial stress. It is particularly risky to open too fast without a sound domestic financial sector and a well-developed capital market. The ongoing financial reforms require China to build a financial safety net to protect public interests and to enable failed financial institutions to exit the market without causing systemic turmoil.

Candy Ho is Global Head of RMB Business Development in Markets for HSBC.