The long-term and sustainable goal of achieving full yuan convertibility is now a very realistic proposition. Last year, China’s currency took its most conspicuous steps toward internationalization. While these liberalization moves were a quantifiable success, moves are happening at staged and considered process. As a result, the subject of when full convertibility will be achieved has become a hotly debated issue, leaving many speculating whether China will accelerate its yuan convertibility project.
Specifically, the debate whether the yuan could achieve full convertibility within five years has gained a voice. Indeed, there has been an enormous surge of activity since mid-2009 that provides support for this estimation. In particular, after some teething problems, the resounding interest in and subsequent success of the yuan trade settlement scheme is considered by some as indicative of a faster-than-expected path to full convertibility. Similarly, the nascent offshore yuan bond market, which doubled its issuance amount to 36 billion yuan (US$5.5 billion) last year from the year earlier, is used as evidence that convertibility will occur sooner than previously anticipated.
If any major economy could achieve full convertibility within five years, it would likely be China. However, while the two aforementioned examples — in addition to several other clear cases of internationalization-supporting measures — are creating enhanced yuan liquidity, especially in Hong Kong, full convertibility is still some way off. Fulfillment of short-term gains is clearly not the end game of this process. From where we stand, there are too many factors that will rightly keep the yuan convertibility process on a staged path for the foreseeable future.
Very few economies have the international clout to achieve currency convertibility. To achieve such a lofty goal, the process will not be rushed, resting on the completion of several pivotal steps that create a trade currency, an investment currency and finally, a reserve currency. For China, the stakes are too high and policymakers will be in no rush to achieve the inevitable.
Let’s examine what needs to happen before the yuan can be considered convertible. Firstly, any estimations of a yuan convertibility timeline must first consider its usage in trade. Currently, trade stands as the largest offshore sector for yuan globally, which paints a telling picture of the progress of internationalization.
The volumes speak for themselves. As of early this year, approximately 3 percent of global trade is settled in yuan, largely a result of the highly successful launch of the RMB (yuan) Trade Settlement Scheme. Of this 3 percent, the fact that approximately 75 percent of yuan trade settlement occurs in Hong Kong indicates that there is still plenty of room to move and its impact on the global stage is minimal.
Examining these numbers, the yuan will have to accelerate substantially as a global trade currency to hit critical mass — and this will happen in the coming years. HSBC estimates that the yuan will transform into a global trade currency between 2013 and 2015, as increasing numbers of traders with both relationships with China and medium-term appreciation views utilize the currency. The successful completion of this goal is a foregone conclusion, but represents only one element of achieving full convertibility.
To fulfill its long-term goal of becoming a fully convertible currency, the yuan must also take significant steps toward establishing itself as a global investment currency. In the middle of last year, policymakers began this process by encouraging the offshore yuan bond market in Hong Kong and other yuan-denominated investment products. Yuan initial public offerings (IPOs) have launched in Hong Kong in the second quarter of this year.
However, to genuinely hit the goal of global investment currency status, substantial volumes of yuan-denominated foreign direct investment (FDI) are required. Hong Kong stands as the largest provider of FDI into China, which plays to the territory’s strength and a deep financial services sector.
Further yuan bond issuances will fill some of the gap. According to the Hong Kong Monetary Authority, FDI into China financed directly by yuan bond issuance represented 1.5 percent of total FDI. If 10 percent of China’s total FDI was financed by yuan bonds booked in Hong Kong, the total number would stand at around US$10 billion. While HSBC forecasts that yuan bond issuance in Hong Kong will grow by 50 percent this year, its contribution to overall FDI will be relatively minor.
Overseas Direct Investment (ODI) is another area that would require rapid expansion for the yuan to be fully convertible within five years. The process of liberalizing ODI has clearly occurred in recent times. Hong Kong has easily emerged as the primary recipient economy of yuan ODI, with approximately 60 percent of the sum total either going directly to or channeled through the territory.
While Hong Kong does have a unique role in facilitating yuan investment through its position as a global financial center, for the currency to move toward convertibility, the destinations of ODI must expand exponentially and rapidly. At present, only a handful of enterprises can engage in this activity, indicating that the scope for yuan ODI is limited.
For last year, it is estimated that yuan ODI accounted for approximately 1.1 percent of China’s GDP or US$57 billion. This percentage is low when compared to other economic peers in Japan (1.5 percent) and in particular, the US economy, where ODI accounts for approximately 1.8 percent of GDP. If China were to have the same ODI as a percentage of GDP as the US, it would inject an additional US$33 billion of yuan liquidity into the global economy, which is significant.
A pilot program launched by the People’s Bank of China (PBOC) in January whereby Chinese enterprises can settle higher volumes of ODI in yuan is a step toward bolstering the percentage of offshore investments relative to GDP. All indications indicate that this pilot scheme could potentially expand in stages, similar to the pilot RMB Trade Settlement scheme of the past two years. In other words, to reach the point achieved in the US, home of the only true benchmark convertible currency, will take close to full liberalization of ODI and obviously, time.
Inherent issues in China’s financial sector will also need addressing before the yuan becomes a global reserve currency. It is well recognized by virtually all participants that banking industry reform is required to move the process of convertibility along more rapidly. Given the sheer size of the sector, liberalization of the entire banking industry will require an enormous investment, both time and money, by Chinese regulators.
Yuan deposit rates is one area that needs to be considered. While yuan deposit rates in China are stringently controlled by the PBOC, policymakers will eventually have to let rates be determined by the market. This shift must occur for yuan convertibility to be achieved, but policymakers have appeared to be in no rush to take this hugely significant step.
Any timelines of full convertibility must also take into account political events slated to occur two years from now. In 2013, China is poised to change its leadership in its most significant overhaul in 10 years. While the long-term course of yuan internationalization will not be altered as a result of new leadership, there may be knock-on effects.
Foremost, the new leadership is unlikely to make any major and radical concessions in its early stages of governance. Rather, it is widely anticipated that the new leadership will continue the charted course of further expanding the reach of the yuan as a trade and investment currency before instituting any reform that would speed up full convertibility.
While it is not completely impossible that the yuan will be fully convertible within five years, it is improbable that policymakers will push this delicate cycle to the extreme. The fact of the matter is yuan convertibility is a long-term goal that policymakers in China recognize will complete their arrival as a global economic power. In other words, the process is a marathon, not a sprint, a sentiment consistently upheld by policymakers.
It is clear that in between where the yuan currently stands and the position it is destined to hold internationally, many pivotal stages must still crossed. If the process requires haste, then we are confident that the relevant authorities will respond with appropriate measures. However, given the long-term result, we can’t see any reason why the path to full convertibility will be greatly accelerated in any significant way.
Thomas Poon is head of business planning and strategy at HSBC, Hong Kong.
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