Recent data releases and the transition to new political leadership have created some uncertainty about China’s short-term economic outlook. While positive growth surprises are unlikely in 2013, we still think nothing can stop the long-term appreciation of China’s currency, the renminbi (RMB).
The reason we expect the RMB to continue to appreciate lies in the strength of the structural, as distinct from cyclical, factors which should continue to support it in the medium to long term. The currency’s prestige, tradability and valuation bolster our expectations that the RMB will:
- Appreciate by 2% to 3% a year on average, just to keep pace with the country’s persistent trade surpluses, and by up to 5% a year once economic rebalancing is factored in
- Become fully convertible by the time the current five-year economic plan expires in 2015—much faster than widely expected
- Emerge as a core reserve currency, especially in the Asia-Pacific region and other emerging markets
China is the second-largest economy in the world. It’s also one of the most dynamic, with the gap between the Chinese and US economies in purchasing power parity terms expected to close in just a few years (Display). Global trade flows don’t yet reflect this reality and continue to be settled mostly in US dollars.
But there are signs of change. In July 2010, the Chinese government began a move to internationalize the currency by opening an offshore currency (CNH) market based in Hong Kong. Taiwan followed recently, and Singapore and London are next on the list. This will help facilitate RMB trade settlements in time zones around the world.
The proportion of China’s global trade settled in RMB has grown to 11% and continues to rise. China’s banks are supporting the trend through the provision of trade finance: letters of credit denominated in the onshore currency (CNY) now account for the third-largest share of the global total, behind US dollars and euros and ahead of yen. By 2015 one-third of China’s exports are likely to be denominated in RMB, with annual trade-settlement volume expected to hit nearly US$2 trillion, according to HSBC.
RMB-denominated trade flows are increasing in strategically important markets, in Africa and Latin America in particular. They’re also rapidly becoming institutionalized. To date, 20 central banks have agreed on CNY swap lines with the People’s Bank of China (PBOC) totaling RMB2 trillion or US$320 billion.
Portfolio flows are another potential driver of the RMB’s internationalization, as China’s capital markets open up. For example, the Chinese government bond market is capitalized at around US$2.5 trillion. It’s the third largest in the world, equivalent to the German and French bond markets combined. If included in a traditional bond index, investors would be forced to commit 10% to 12% of their fixed-income allocation to Chinese government bonds. This, together with the continuing strength of overseas direct investment into China, further facilitates the RMB’s internationalization.
We expect China will do what it can to make full internationalization of the currency a reality. This will include maintaining the RMB’s credibility as a steadily appreciating currency. Given that the RMB’s appreciation sharply lags the US$2.5 trillion growth in China’s foreign exchange reserves since 2005 (Display), we think this is a realistic goal.
The RMB already fulfills two of the three criteria necessary to become a reserve currency—the size of the underlying economy and the credibility of the currency itself. It is progressing steadily towards fulfilling the third criteria, which is openness and financial-market depth. Internationalizing the currency is one of the goals under the country’s five-year plan and, in early September 2012, Dai Xianglong, a former PBOC governor, said that China could liberalize its capital account as early as 2015. While the precise timing will depend somewhat on global economic and financial-market conditions, we think the RMB is likely to be internationalized much faster than widely expected.