Gaining Currency

Book by Eswar S. Prasad

Article & Review by GlobalMacroForex

The author of this book works for the IMF, an institution with the policies of, for example, funding slavery. It’s therefore amusing when IMF authors criticize local central banks but assure us we can trust secretive non-democratically elected world governments. However, despite that, this book has a lot to offer on understanding China.

Eswar Prasad lays out the progress China has made so far in liberalizing its economy and turning the Renminbi (RMB) into an international settlement currency. He clearly states what China would have to do to have the RMB included in foreign central bank reserves.

In this article we’ll review the progress China has made in:

o Cross-border trade settlement

o Offshore clearing centers

o Capital Account Liberalization

o Equity Market liberalization (A-Shares vs B-Shares)

o Interbank Settlement Systems

o International Aid Agencies

o Getting included in Foreign Central Bank Reserves

o IMF SDR inclusion, and

o Accusations of exchange rate manipulation

Let’s begin…

Internationalization

The internationalization of a currency could refer to many things but the #1 factor is usually trade settlement. Importers and exporters have to agree on a settlement currency for their contracts, which is what currency the product is priced in and paid for it. For example, right now oil is typically sold in US Dollars.

How much progress China has been making in having trade settled in RMB depends upon what criteria you are judging it by. Compared with the period from the start of the financial crisis in 2008 to 2015, the RMB has made significant strides forward as investors were a bull on the overall Chinese economy and the government was taking steps to liberalize the capital account. This chart from the Reserve Bank of Australia illustrates the point:

However starting in 2014-2015 things started to deteriorate for the overall outlook of the Chinese economy and RMB, as this chart from Euromoney magazine presents:

Offshore Clearing Centers

Before reading this section, please refer to my previous article on the difference between China’s onshore and offshore currencies.

To facilitate international trade settlement, foreigners are going to need not only easy access to Renminbi but an offshore clearing center that has the technical and legal facilities in place to handle a liquid market.  Naturally, with its political, cultural, and physical proximity to the Mainland, Hong Kong has emerged as the birthplace of the offshore RMB market.  China’s government has allowed Hong Kong banks to accept RMB deposits and make loans.  This is a huge step towards internationalization, as it promotes use and trade settlement outside of mainland China.  In addition, the Chinese central bank has set in place swap lines with the Hong Kong Monetary Authority to give the central bank the necessary means to facilitate and regulate a smooth offshore market.

Many would consider the total Hong Kong RMB deposits to be a great forward-looking indicator of the onshore RMB strength.  As we can see from this chart from the asset management firm Matthews Asia, RMB deposits in Hong Kong have grown significantly since 2004:

The growth has occurred not only in Hong Kong but in Singapore and Taiwan, as this chart from the Reserve Bank of Australia shows:

However just as the total RMB trade settlement declined in 2014-2015, recently Hong Kong’s RMB deposits have also plunged, as this chart from the South China Morning Post demonstrates:

By allowing both the central bank and Hong Kong commercial banks to access RMB liquidity, it’s spawned into the gateway between China and the rest of the world.   In addition to allowing banks to make RMB loans and receive RMB deposits, Hong Kong has better access to mainland China’s equity markets.  With the new ‘Shanghai-Hong Kong Stock Connect’ program, investors in Hong Kong can purchase A-shares on China’s market.

Swap Lines

With the success of Hong Kong, China’s central bank has set up swap lines with other financial centers throughout Southeast Asia, Europe, and Africa to facilitate offshore trading, including London, Tokyo, Singapore, Taipei, and many others, as this map from Prasad demonstrates:

International Payment Systems

An interbank payment system has two separate components.  The first is the communication between the banks and the second is the actual transfer of the funds.

For the communication part, most banks use SWIFT;

for the actual transfer of funds, the choices are Fedwire or CHIPS.

So first a bank contacts the other one using SWIFT, then actually sends the money though CHIPS or Fedwire.

SWIFT

SWIFT (which stands for which stands for Society for Worldwide Interbank Financial Telecommunications) is a nonprofit member-owned cooperative association of 9,000+ banks worldwide. Basically SWIFT is a messaging system that allows a network of banks to communicate about financial transactions in a secure and standardized format. Imagine a “text messaging service” for trillions of dollars of secure information. While SWIFT lets banks communicate, there needs to be an actual clearing of the transaction.

Fedwire

Fedwire is run by the Federal Reserve and allows for the clearing of transactions sent through SWIFT.  Banks that are part of the Federal Reserve System have to keep reserves at the Fed.  Through Fedwire, banks can send each other money by having the Fed transfer funds on their behalf from one reserve account to the other.  Fedwire is a real-time gross settlement system, meaning a bank gets the funds immediately and is paid in full.  This is in contrast to CHIPS in which payments are netted.

CHIPS

While Fedwire is run by the government and SWIFT is a non-profit, CHIPS is a private for-profit international clearing house based out of New York City. CHIPS settles transactions at the end of each business day by netting the payments. This means it operates at a cheaper cost than Fedwire, but it works slower since parties have to wait until the end of the day to receive funds.

Use

Both systems use SWIFT to communicate. Most banks prefer to use CHIPS since it’s cheaper, but when money is loaned overnight it’s done through the Fed. This is where the Fed Funds Rate comes from. But when it’s not a loan but just a transfer of funds for their customers, banks prefer to use CHIPS because it’s cheaper and they get to still use the funds for the rest of the business day.

China’s New System

According to author Prasad, China was influenced by US sanctions against Russia to develop its own financial clearing system, independent of the United States.  When Russia annexed Crimea, the United States froze Russian access to CHIPS and SWIFT.  This had disastrous and destructive effects on the Russian economy, essentially freezing up their financial “plumbing.”

China developed the China Cross Border International Payment System (CIPS).  This system facilitates offshore RMB clearing and directly challenges the dominance of CHIPS.   However the Chinese system still currently uses SWIFT (the American communications system).  Eventually though, the Chinese could replace SWIFT with their own network.

Liberalization of the Capital Account

China currently has capital control restrictions in place that prevent and regulate transfers of Renminbi in and out of the country.  So when Mainland exporters or importers need forex transactions for trade purposes, they have to get the Chinese government to act as the market maker.

This has created a market for offshore Renminbi for trade as well as for speculative purposes.  Offshore Renminbi is the same currency as onshore but it’s done through America’s interbank system CHIPS instead of the mainland Chinese CIPS system.  The offshore Renminbi has significantly less regulatory/legal restrictions.  The mainland currency is labeled “CNY” while the onshore currency is labeled “CNH” by the Forex market.  For more information on this, check out my article on the mainland vs offshore currency markets.

China has been saying for years it’s going to liberalize the capital account but every time the date arrives (for when positive changes are going to be actually implemented), it seems to be postponed indefinitely.  According to Prasad, the capital account is much more regulated on paper than in practice.  But the biggest risk of liberalizing the capital account is harsh sudden capital flight.  Mr. Prasad points out how mainland Chinese companies have been already trying to get their funds out of the country/currency by having foreign entities overbill for goods.

How this works is first the foreigner “overbills” an importer for something.  Then the importer has a reason to get the Chinese government to let it exchange onshore RMB for USD.

Then the importer’s foreign friend has USD waiting for it in an offshore bank account.  The importer has to pay the foreigner for this service of course.

This overbilling can be calculated by subtracting the amount the Chinese mainland importer told the Chinese government the importer was paying for the product, compared with the amount the American or European company told US/Euro government he charged.

Capital Flight Overbilling = Chinese Government’s Import #s – (US + Euro Governments’ export #s)

Recently overbilling has been rising, as this chart from Chi Lo from the Renminbi Rises, a different book on China’s currency that I summarized demonstrates:

Another way Eswar Prasad evaluates capital flight is the ‘errors and omissions’ number from China’s trade balance.  Typically the current account (goods/services) and the capital account (investments/Forex) should equal.  If they don’t, this difference is captured in the errors and omissions.  As you can see this number is demonstrating significant unaccounted for outflows:

While Prasad acknowledges some benefits to controlling the capital account such as stability, he argues that the Renminbi’s progress toward internationalization is likely to stall unless significant liberalization reforms to the capital account are made.  In fact, he doesn’t think the Renminbi can ever displace the USD as a reserve currency until the capital account is fully opened.

Reserve Currencies

Central banks can print money and buy foreign currencies for a rainy day.  This buildup off foreign currencies is their reserves.  In the future, when their currency falls in the Forex market, they can use their reserves to buy up their own currency, which has an effect similar to as if actual foreigners liked the currency (by temporarily raising its value).  However, in the long run, the central bank will run out of reserves if the fundamentals do not change to improve the underlying reason the currency is dropping.  Central banks can only fight the Forex market for a limited time.

This chart from BullionStar.com shows China’s quite large reserves:

Prasad points out what qualities central banks look for in making their reserve investments.  These include stability, trust, and liquidity.  They want to know that these reserves will continue to hold value and will be useful assets in stabilizing their own currencies in volatile markets.  It’s very important for reserves to be denominated in liquid currencies so central banks can transact in bonds quickly and their actions will have a large effect on the overall Forex market.

Therefore use of the RMB as a settlement currency and having offshore clearing centers are vital to ensure a liquid and stable market.  Unfortunately for the RMB, the offshore Dim Sum market is shrinking in size, which will put further pressure on all yuan-denominated bonds including government debt.  In addition, China’s government bonds lack the liquidity and depth to support large-scale central bank investment.  See my previous article for more information on how China’s Dim Sum and Panda bonds differ and why one might be shrinking as the other grows:

Edwar Prasad questions if the RMB can become a global reserve currency without significant political reform.  He points out that usually central banks invest in countries that are democratic and transparent, with a right to free expression and an unfettered media.  Prasad also points out how most of these countries have a history of central bank independence, which is not really the case for China; the PBoC (central bank) doesn’t make decisions without direction from the CBC (main government agency).  This lack of central bank independence could put downward pressure on yuan, as the government could depress the currency and interest rates to service debt and finance popular political projects.  In addition, foreign central banks may not trust China’s current political environment of corruption.

The biggest obstacle to becoming a reserve currency is China’s closed capital account.  It’s amazing that the RMB has managed to get ANY reserve allocations with a closed capital account,  since the closed capital account obviously decreases liquidity and fragments the bond market into separate Dim Sum and Panda markets.

Starting in 2017, the European Central Bank said it is holding $500 million in Yuan reserves.  This is a huge move forward for the Renminbi, but a relatively modest position for the size of the ECB’s reserves.

Equity Market Liberalization

As we discussed in a previous article on why China’s equity markets are unique, there are multiple types of shares for equities.  China has recently made attempts to liberalize this with the Qualified Institutional Investor (QEII) program which allows screened foreign institutional investors access to Mainland A-shares.  Also the Shanghai-Hong Kong Stock Connect program allows Hong Kong’s investors to access Shanghai A-shares.

These steps taken by China to liberalize its equity markets are important baby steps towards internationalization of the Renminbi.  However, to get foreigners to accept trade settlement in RMB, there has to be a significant liquid market for them to invest in RMB denominated assets.  As Prasad notes, it’s unlikely these steps are enough without opening the capital account.

SDR Inclusion

The International Monetary Fund (IMF) currently exists to help countries manage their balance of payments.  (Originally it was created to manage the gold standard;  some job they did at preserving that!)  One of the tools of the IMF is the SDR which stands for Special Drawing Rights.  These are claims to a basket of reserve currencies held at the IMF.   It’s like a currency for currencies.

The SDR has a low amount of use and essentially symbolic.  Since the SDR is only held by central banks, it’s not useful to help them manage their exchange rate.  All the central banks can do is exchange the SDR for currencies that the normal market accepts. 

While in theory bentral banks can trade SDRs with each other (this was certainly the IMF’s intention), in practice the liquidity for this is essentially nonexistent.

Initially, the IMF tried to force Beijing to institute political reforms and open up the capital account as a precondition for being included in the SDR.  However, through political pressure, China managed to be included without much liberalization or reform.  So basically China was included in a fake/symbolic political currency with fake/symbolic political reform.  According to the IMF, the SDR basket is currently as follows:

International Aid Agencies

I discussed in a previous article how the World Bank works and how international agencies are set up to trap the Third World in perpetual debt to enslave them.  China was angry that the United States wouldn’t give them a larger say/vote in the World Bank.  It is especially infuriating them that their arch-rival Japan has more votes.

So China formed the competing Asian Infrastructure Bank with $100 billion in pledged funding coming from a variety of nations.  At first, the United States effectively organized a boycott of this with the world’s major Western industrial nations.  However, Great Britain was the first to crack, likely over the promise of turning London into an offshore RMB clearing center.  Also who better to get in on financial imperialism than the British?!

The author Prasad didn’t discuss this because he works for the IMF, but I’d like to suggest that one effect of the World Bank is that it artificially props up the US Dollar as most loans are done in USD, Euro, and Yen.

Positives

Overall Eswar Prasad thinks the China has made great progress towards internationalization of the Renminbi.  He notes:

o  Increased Cross-border trade settlement

o  Increased offshore clearing centers

o  China Cross Border International Payment System (CIPS)

o  Formation of the Asian Infrastructure Bank

o  Trend of diversification

o  Swap Lines setup

o  IMF SDR inclusion

o  RQFII program for A-shares vs B-shares

o  Shanghai-Hong Kong Stock Connect program

o  Mutual fund connect 2015

Negatives

However, Prasad sees many obstacles for China to become an international reserve currency.  Some of his reasons include:

o  Closed/Regulated Capital Account

o  Lack of political reform and trust

o  Less liquid and robust government bond market

o  Requires a political process that respects rule of law and property rights

o  Exchange rate isn’t market determined

o  Capital Flight from trade misinvoicing

While Prasad does see amazing potential in the Renminbi to become internationalized, he thinks China will need to address these issues first.