Piecing together China's economic reform jigsaw
Candy Ho examines how renminbi internationalisation fits into the bigger picture of China's ongoing financial and economic reforms, whose effects will eventually be felt around the globe
Despite the current economic headwinds, Chinese authorities are continuing to accelerate the pace of financial reform. The recent introduction of a raft of liberalisation measures will both facilitate the currency's integration into the global economy and set the stage for long-term domestic growth.
Internationalisation of the renminbi has stolen many of the headlines, but it is only one piece in a much larger and infinitely more intricate jigsaw of economic reforms.
The largely state-controlled "socialist market economy" served China well through its first stage of industrialisation when the comparative advantage of cheap labour made investment decisions relatively simple. However, success has bred complexity.
There is much debate over whether China has passed the so-called "Lewis turning point" when a labour surplus becomes a labour shortage, but what is clear is that labour is becoming more expensive; the marginal utility of infrastructure investment is declining; and that future growth will have to come from more elusive sources of increased productivity, a grail governments have historically proved ill-equipped to find.
The new administration of President Xi Jinping and Premier Li Keqiang should be applauded for grasping the problem and recognising that introducing a greater element of market discipline into the economy - and the financial sector in particular - will be key to promoting long-term growth, even if it does come at the cost of a short-term slowdown.
"Reform is about cutting government power," Li said earlier this year. "It is a self-imposed revolution that will require real sacrifice, and it will be painful."
The June liquidity shortage, which briefly saw overnight inter-bank rates spike above 25 per cent, and the more recent symbolic abolition of the lower boundary on the lending rate, were both clear signals that banks need to tighten up their risk management: the days when the domestic financial sector could take for granted the implicit guarantee of the state are numbered.
At the cutting edge of the broader reform programme is the internationalisation of the renminbi, a three-stage process of establishing it first as a global trade settlement currency, then as a global investment currency, and ultimately as a global reserve currency.
It sounds in principle a relatively simple process - the renminbi becoming less idiosyncratic and more like any other global currency - but in practice the ramifications will spread to every corner of the Chinese economy, and eventually the world.
The potential of the renminbi to reshape the global economy is already evident. The Chinese authorities started to free it up for trade settlement in earnest just four years ago, but last year it already accounted for some US$422 billion in trade settlement, or 12 per cent of China's overall trade, and we expect that to rise to 30 per cent by 2015, which would make it the world's third-largest settlement currency after the euro and the US dollar.
The renminbi's role as an investment currency is also growing, but has been capped by limited access to mainland capital markets and a lack of depth offshore. The People's Bank of China has expanded its Qualified Foreign Institutional Investor scheme and its yuan-denominated sister scheme, which give international investors a quota for access to domestic markets. But the renminbi will not realise its full global potential until many of the current capital controls have been removed.
Premier Li has called for a timetable for full convertibility under the capital account, but it will be a long and delicate undertaking.
Just how deep and complex the problem is can be shown by following a single reform thread.
China has historically kept deposit rates artificially low and liberalisation of the capital account risks triggering substantial capital flight unless domestic deposit rates are allowed to rise, particularly if - as seems likely - international rates start to rise because of a gradual tightening of monetary policies in the West.
But if interest rates rise, domestic borrowers already squeezed by the economic slowdown will be put under further pressure and banks will lose their current commodious net interest margin, a margin that is frequently used to fund government investment priorities.
Part of the process of both domestic financial reform and renminbi internationalisation will be building the kind of shock absorbers that most major currencies take for granted: market input into both the price and allocation of capital, large pools of readily accessible liquidity, and transparent regulation.
These things take time: some European currencies took nearly two decades to reach full convertibility.
China's major banks can either be extensions of government policy or independent commercial entities: it would be unfair and unreasonable to expect them to be both.
These things are happening, but they cannot be rushed, and external pressure to accelerate the pace of change would be counterproductive. The prize is too great to risk.
The overarching narrative of the internationalisation of the renminbi and China's domestic financial reforms is one of China's growing integration with the global economy, and the greater the degree of integration, the wider the benefits of its extraordinary growth story will be felt.
And what sort of fiscal discipline would emerge in a world where investors unhappy with the policies of the US Federal Reserve or the European Central Bank could vote with their feet and put their assets into renminbi?
