Tuesday, November 29, 2011

The renminbi’s internationalisation: a reality check

There is a great deal of speculation around the rise of China’s economy and the eventual changes this will supposedly bring to the international monetary system.

The potential for such change undoubtedly exists as the Chinese economy continues to grow and catches up with more-developed countries. But is growth and size enough to effect fundamental change in the current global financial landscape?
When looking at the renminbi’s future role in the international financial system, analysts must take into consideration the reasoning of institutional investors when deciding where to hold liquid balances. Like China, such investors look for safety, liquidity and the preservation of the balance’s value. But can they find these characteristics in RMB-denominated markets — offshore or onshore? Currently, it would seem not. Onshore RMB deposits are simply not accessible due to China’s currency control regime. Offshore RMB deposits in Hong Kong and elsewhere are available, and have even given rise to a great deal of excitement among academics and bankers. But the reality of the situation is not favourable to investors looking to park institutional funds in such deposits. The return is minimal and purely dependent on expectations of a sufficient appreciation of the renminbi relative to the US dollar.
Those responsible for an international institution’s financial management are unlikely to risk their career by investing other people’s money in an asset class that is solely dependent on Chinese politics. But if the renminbi were to become freely convertible, how would it stack up against the US dollar and other currencies?
Trade volume is an important determinant for private transactors keeping a ‘working’ balance for convenient settlement in a particular currency. Given China’s significant role in international trade, its currency would be attractive for keeping balances, but investors would also incur unexpected receipts and disbursement requests. This is why everybody holds positive balance sheets, despite such balances often yielding very little and having to be funded through the capital resources of the institution concerned.
So, for a currency to be attractive, there needs to be safe and efficient opportunities to borrow or invest funds for short periods in order to minimise idle balances at the end of the business day. Currency systems compete in terms of an efficient money market — with many players and instruments — subject to reasonable and prudential supervision. But China is still a long way from offering facilities that can compete with the US financial markets.
Moreover, there are four other fundamental issues concerning the relative competitiveness of a fully convertible renminbi against current alternatives. First, the renminbi’s business day ends long before the other financial systems. Operating in the US, it is only possible to adjust renminbi balances with a one-day delay, thus severely limiting the ease with which it may be used as an international currency.
Second, investors may be reluctant to keep their working balances in a jurisdiction where property rights have not been held in high esteem for centuries.
Third, when it comes to central banks’ international reserve assets and private asset managers’ long-term investments, the considerations that govern the management of working balances abroad are more relaxed. Liberalised Chinese financial markets, overseen by a decent legal system and rules of corporate governance, may well attract a portion of the world’s savings. But that differs greatly from being an international reserve asset comparable with — or superior to — the US dollar. In any case, it is those who find a currency and its financial markets sufficiently attractive to entrust their savings that decide which currencies occupy such a role.
It seems the world, including China, is stuck with the US dollar. In this respect, the so-called US ‘balance of payments deficit’ is a chimera: nobody knows exactly how much is due to excess US consumption, and how much is due to official and private investors finding US financial markets the best place to store a significant part of their ever-growing savings. Interest rates on US bonds do not support the argument that investors are particularly concerned with the risks of a US default.
And finally, investment in ‘real’ assets is simply not the answer. Buying productive assets also requires expertise in their management across different foreign environments. Chinese executives are very competent at managing productive assets in their own unique environment, and many foreign investors in China underestimate Chinese business acumen to their detriment. But whether those skills will work outside China is less clear.
The solution to this issue must be found in a drastic change in China’s political economy; China must stop subsidising US consumption and do something for the average Chinese citizen, whose living standards are still significantly lower than elsewhere in Asia. Such a policy change would be highly beneficial for the Chinese — but less so for the US. Author: Gunter Dufey, Nanyang Technological University. Gunter Dufey is an Emeritus Professor at the University of Michigan, Ann Arbor. He is currently teaching at Nanyang Business School, Nanyang Technological University. East Asia Forum

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