August 24, 2011
Economics Group Special Commentary
Jay H. Bryson, Global Economist jay.bryson@wellsfargo.com ● 1-704-383-3518
Will the Renminbi Eventually Rival the Dollar? Executive Summary
There has been much negative news recently surrounding the U.S. dollar that includes a downgrade to U.S. government debt and record lows on a trade-weighted basis. Meanwhile, the Chinese renminbi seems ascendant with increasing volumes of Chinese trade being invoiced in yuan and Hong Kong residents flocking to open yuan-denominated bank accounts. In our view, however, it will be a number of years before the Chinese renminbi becomes a true international currency. Although the issuance of so-called dim sum bonds—yuan-denominated bonds issued in Hong Kong—is up significantly this year, capital controls severely limit the availability of yuan assets to foreign investors. The Chinese government will likely continue to relax capital controls very gradually in the years ahead, but wholesale dismantling of controls will probably not happen overnight. Until yuan assets become more widely available to foreigners, the Chinese renminbi will have limited appeal to foreigners, especially to foreign central banks that require deep and liquid financial markets in which to invest their foreign reserve holdings. In our view, the renminbi will eventually become a true international currency, but we think that status will be achieved in a decade or two rather than in a year or two.
Are the Dollar’s Days Numbered?
A casual reader of the financial press could be excused if she thought the dollar’s days as a major international currency were strictly numbered. For starters, Standard and Poor’s recently downgraded U.S. Treasury debt to AA+ status, and the other two major agencies have a negative watch on their own ratings of Treasury securities. With Treasury securities no longer universally rated AAA, some observers have questioned how long the U.S. dollar can maintain its status as a major international currency. Adding to the sense of gloom surrounding the greenback, the trade weighted-average value of the dollar, as measured by the Federal Reserve’s “Major Currency” index, continues to plumb new lows (Figure 1).
The trade weighted-average value of the dollar continues to plumb new lows.
Meanwhile, the Chinese renminbi seems ascendant. 1 The renminbi has strengthened more than 3 percent vis-à-vis the greenback this year, bringing its total gains over the past six years to 30 percent (Figure 2). As we discuss below, yuan-denominated deposits in Hong Kong banks are growing exponentially, and the issuance of so-called dim sum bonds, which are yuandenominated bonds issued in Hong Kong, has jumped sharply this year. Hong Kong banks already have the ability to clear current account transactions with the mainland in yuan, and Beijing may soon extend the arrangement to Singapore. Is the renminbi becoming an international currency? Will the renminbi soon rival the U.S. dollar as the world’s principal reserve currency?
The Chinese renminbi seems ascendant.
1
“Renminbi” is the official name of the currency of China, and “yuan” is the unit. In practice, the two terms are used interchangeably, a convention that we follow in this report.
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Will the Renminbi Eventually Rival the Dollar? August 24, 2011
WELLS FARGO SECURITIES, LLC ECONOMICS GROUP
Figure 1
Figure 2 Trade Weighted Dollar
Chinese Exchange Rate
March 1973 =100
150
150
140
140
130
130
120
120
110
110
100
100
90
90
80
80
70
70
8.00
7.50
7.50
7.00
7.00
6.50
6.50
CNY per USD: Aug @ 6.42 60
1978
1983
1988
1993
8.50
8.00
TWD Major Index: Aug @ 69.1 60 1973
CNY per USD
8.50
1998
2003
2008
6.00 2005
6.00 2006
2007
2008
2009
2010
2011
Source: Federal Reserve Board, IHS Global Insight and Wells Fargo Securities, LLC
A means of payment is the first function of an international currency.
What Is an International Currency?
Like a currency that is used solely for domestic purposes, an international currency has three functions: as a means of payment, as a unit of account and as a store of value. 2 In terms of its first function, an international currency can be used as a so-called vehicle currency to facilitate payment between buyers and sellers located in different countries. Consider a situation in which an importer in South Africa must pay an exporter in Thailand. The importer must sell South African rand and buy Thai baht to make the payment. Because the number of people who are willing to sell Thai baht for South African rand is limited, the market is very thin and bid/ask spreads could be very wide. In other words, the South African importer could end up paying a very high price for the Thai baht if he does so directly. It may be cheaper to break up the transaction into two legs. In the first leg of the transaction, the importer sells South African rand for, say, U.S. dollars. He then uses the dollar proceeds from the first leg to buy Thai baht that are used to pay the Thai exporter. Because the U.S. dollar tends to be widely traded versus many other currencies, the bid/ask spreads are narrow and the total cost of the two-legged vehicle transaction may be lower than the direct, albeit less liquid, transaction.
International currencies act as a unit of account.
In terms of its second function, an international currency can be used as a unit of account. That is, it can be used as the principal currency in which to invoice transactions. In the example above, the Thai exporter invoiced her goods in baht. However, she could choose to invoice her goods in another currency, such as U.S. dollars. In that situation, the greenback would be serving its role as an international unit of account. Historically, Chinese trade transactions were invoiced in currencies other than the renminbi. However, starting in 2009 the Chinese government allowed exports and imports to be invoiced in yuan, and less than 1 percent of Chinese trade transactions were invoiced in yuan in the first quarter of 2010. However, invoicing in yuan has jumped sharply in recent quarters. By the second quarter of 2011, trade transactions worth about 600 billion yuan, representing about 10 percent of total Chinese exports and imports during the quarter, were invoiced in yuan.
Use of the renminbi as a means of payment and as a unit of account remains limited on a global scale.
However, the use of the renminbi as a means of payment and as a unit of account remains limited on a global scale. Every three years, the Bank for International Settlements (BIS) conducts a survey on the size and composition of the foreign exchange market. In it most recent survey, conducted between April 2010 and June 2010, the BIS found that the renminbi was on one side of 0.9 percent of all the foreign exchange transactions that occurred during that period, up from 0.1 percent in 2004. 3 However, the U.S. dollar was involved in 85 percent of all foreign exchange 2 See Peter B. Kenen, “The Role of the Dollar as an International Currency,� Group of Thirty Occasional Paper #13, 1983. 3 There are two currencies involved in every foreign exchange transaction. According to the BIS, turnover in the foreign exchange market averaged $4.0 trillion per day during its survey period. See
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Will the Renminbi Eventually Rival the Dollar? August 24, 2011
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transactions between April and June 2010. Clearly, the Chinese renminbi has a long way to go before it starts to rival the U.S. dollar in its use as a means of payment and unit of account in private sector transactions. Moreover, it appears that central banks do not hold many, if any, Chinese yuan as part of their foreign exchange reserves. According to the International Monetary Fund, the U.S. dollar comprised 62 percent of foreign exchange reserves at the end of 2009 and the euro had a 27 percent share. The Chinese renminbi was not listed among the other three top currencies (Japanese yen, British pound and Swiss franc) that together held a measly 7.4 percent share. 4 In sum, the Chinese renminbi has made some strides over the past few years as a unit of account. That is, an increasing number of Chinese trade transactions are being invoiced in yuan. However, it does not play a significant role yet as a means of international payment because the renminbi is not widely traded. Indeed, only banks in China and a few in Hong Kong can deal in the currency. In addition, central banks do not hold yuan as part of their foreign exchange reserves because the renminbi has a very limited role in the third function of an international currency, namely, as a store of value, a topic to which we now turn.
In What Form Can One Hold Yuan Assets?
As noted above, Chinese yuan do not play a meaningful role in central banks’ holdings of foreign exchange reserves and it appears that private sector ownership of yuan is limited as well, although it is growing. The renminbi is not a freely convertible currency, which limits its appeal to central banks and foreign investors. Unlike the United States and other western countries where there are few impediments to capital flows, the Chinese government historically has sharply curtailed the amount of capital that can flow in and out of China via capital controls. Therefore, the investment options that are available to foreigners have been very limited. Figure 3
Figure 4
Yuan-Denominated Deposits in Hong Kong Billions of Yuan
¥600
Value of QFII Equity Holdings ¥600
Billions of Dollars
$24
$24
Qualified Foreign Institutional Investors: Apr @ $20.7 Billion
Yuan-Denominated Deposits: Jun @ ¥553.6 Billion ¥500
¥500
$20
$20
¥400
¥400
$16
$16
¥300
¥300
$12
$12
¥200
¥200
$8
$8
¥100
¥100
$4
$4
¥0
$0 2004
¥0 2004
2005
The investment options that are available to foreigners have been very limited.
2006
2007
2008
2009
2010
2011
$0 2005
2006
2007
2008
2009
2010
Source: CEIC and Wells Fargo Securities, LLC
However, the Chinese government is starting to relax its grip somewhat. Starting nearly a decade ago, the government allowed Hong Kong banks to issue yuan-denominated deposits. The amount of yuan-denominated deposits slowly trended higher in the first few years of the program’s existence, but it has exploded over the past year or so and currently exceeds CNY500 billion (Figure 3). Although Hong Kong banks pay essentially the same rate of interest on yuan deposits as they do on Hong Kong dollar deposits, expectations of renminbi appreciation versus the greenback and, by extension, the Hong Kong dollar have undoubtedly increased the attractiveness
“Triennial Central Bank Survey: Report on Global Foreign Exchange Market Activity in 2010,” Bank for International Settlements, December 2010. 4 See International Monetary Fund Annual Report 2010.
3
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to Hong Kong’s residents of holding yuan-denominated deposits. 5 Although yuan-denominated deposits are equivalent to about 9 percent of the Hong Kong M2 money supply, they represent less than 1 percent of the Chinese M2 money supply. In other words, yuan-denominated deposits in Hong Kong have grown very sharply recently, but they remain small in terms of the overall Chinese money supply. Foreigners hold only $20 billion worth of yuandenominated Chinese equities.
Yuan-denominated deposits may be attractive to some Hong Kong residents, but other investors, including central banks, would want other investment options for Chinese yuan. Starting in 2002, the government allowed foreign institutional investors to buy yuan-denominated equities, socalled A-shares, in Chinese companies via the Qualified Foreign Institutional Investor (QFII) program. QFII participation has grown steadily over the years, and holdings at present total about $20 billion (Figure 4). However, the market capitalization of all the A-shares listed on the Shanghai and Shenzhen stock exchanges totals about $4 trillion, dwarfing the size of the QFII program. In other words, the QFII program gives foreign investors only a limited ability to buy yuan-denominated equities. The market for so-called H-shares, which are Chinese equities that trade on the Hong Kong Stock Exchange, is much larger than the QFII program. Indeed, the amount of outstanding H-shares totals nearly $700 billion today (Figure 5), which obviously is significantly greater than the amount of equities available to investors via the QFII program. Unlike the QFII program, however, H-shares are denominated in Hong Kong dollars, not Chinese yuan. Therefore, investors would not be able to use Chinese yuan to purchase H-shares. Figure 6
Figure 5 Value of H-Shares Outstanding
Hong Kong Dim Sum Bonds
Billions of Dollars
$900
$900
Yearly Issuance, Billions of Yuan
¥120
¥120 Year to Date
$800
$800
$700
$700
$600
$600
$500
$500
$400
$400
$300
$300
$200
$200
$100
$100
¥100
¥100
¥80
¥80
¥60
¥60
¥40
¥40
¥20
¥20
H-Shares: Jun @ $654.3 Billion $0 2004
$0 2005
2006
2007
2008
2009
2010
¥0
2011
¥0 2008
2009
2010
2011
Source: CEIC, Bloomberg LP and Wells Fargo Securities, LLC
The dim sum bond market is small relative to the sizes of the Chinese and U.S. bond markets.
The rapidly growing “dim sum” bond market in Hong Kong is giving foreign investors increasing opportunities to own yuan-denominated fixed-income securities. In 2008, the issuance of dim sum bonds totaled only CNY12 billion (about $1.7 billion). But issuance has exploded this year, with CNY108 billion (nearly $17 billion) originated thus far in 2011 (Figure 6). However, the size of the dim sum bond market pales in comparison to the on-shore Chinese bond market, which is essentially closed to foreign investors, not to mention the U.S. bond market. So far in 2011, the issuance in the on-shore Chinese bond market has totaled almost CNY1.5 trillion (about $230 billion), and about $1.2 trillion has been originated in the U.S. bond market this year. In other words, the ability of foreign investors to own yuan-denominated fixed-income securities remains rather limited, at least relative to other options.
5
The Hong Kong Dollar (HKD) has been essentially fixed versus the U.S. dollar (USD) since 1983 at a rate of 7.8 HKD per USD. Therefore, appreciation of the renminbi versus the USD would translate into appreciation of the renminbi against the HKD.
4
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Conclusion
The Chinese renminbi is more of an international currency today than it was just a few years ago. About 10 percent of Chinese trade transactions are denominated in yuan and Hong Kong residents are flocking to open yuan-denominated bank accounts. Foreign purchases of Chinese yuan denominated A-shares through the QFII program have increased over the past few years, and issuance in the dim sum bond market has exploded this year. These trends will probably continue for the foreseeable future. However, the renminbi is clearly not in the same league as established international currencies such as the U.S. dollar, the Japanese yen and the euro because, relative to those currencies, options for investors to hold yuan-denominated assets are severely limited. For example, foreign ownership of yuan-denominated Chinese equities via the QFII program totals $20 billion, which is dwarfed by the $18 trillion U.S. stock market. The size of the dim sum bond market is roughly $25 billion or so at present, whereas outstanding issuance in the U.S. bond market is approximately $30 trillion. The problem for the renminbi is not the size of the financial markets in China. Market capitalization of the Chinese stock market is roughly $4 trillion, and the size of the on-shore Chinese bond market is approximately $3 trillion. The problem is the capital controls that severely limit the ability of foreign investors to participate in these markets. Capital controls are a legacy of Maoist China, and they were put in place to insulate the economy from foreign influences. Although trade in goods and services has been liberalized over the past few decades, a system of capital controls still exists to limit foreign ownership of the means of production in China. In addition, it is easier for the Chinese government to manage the yuan exchange rate in the absence of massive inflows and outflows of capital that would become possible if the controls were eliminated. So, if capital controls retard the international use of the renminbi, will the Chinese government dismantle the controls? Although the government is slowing making it less difficult for foreigners to own Chinese assets, a wholesale dismantling of the controls in the near term is not very likely in our view. Allowing capital to flow freely in and out of China would entail a loss of financial control that we cannot envision the Chinese government willing to risk, at least not anytime soon. A loss of financial control could ultimately lead to economic and social instability that Chinese authorities seem loath to risk. Most economic policies in China proceed at a glacial pace and it is much more likely that the Chinese government will continue to open its financial markets to foreign investors at a very slow rate. Until Chinese financial markets become much deeper and more liquid for foreign investors and foreign central banks that need to invest billions of dollars worth of foreign exchange reserve, the Chinese renminbi will not really compete with the U.S. dollar, the euro and the Japanese yen for status as one of the world’s truly international currencies. In our view, the renminbi will eventually become a true international currency, but we think that status will be achieved in a decade or two rather than in a year or two. To paraphrase Mark Twain, reports of the dollar’s death as an international reserve currency are greatly exaggerated.
5
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