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China’s City of London blessing is part of a bigger design

20th June, 2014

During Chinese Premier Li Keqiang’s visit to the UK this week, it was announced that China Construction Bank, the country’s second largest bank, had been approved by the People’s Bank of China (PBC) as a clearing agent in London to settle renminbi (RMB) foreign exchange trading. This is a win-win arrangement for London and China, but not as profound as the rush to judgement that this is another nail in the coffin of the US dollar in the global financial system.

From the City of London’s point of view, the announcement was unequivocally good news. London will now join Hong Kong and Singapore as the principal hubs for RMB trading and the settlement of commercial transactions. It gives London a strong edge over New York and European financial centres. Until now, RMB trading in London has been running at a mere $25 billion a day. While that is about 50% bigger than in 2012, it pales in comparison to global foreign exchange trading turnover of $3.9 trillion a day, and London’s of over $2 trillion a day. Nevertheless, as London becomes the Western centre, par excellence, for RMB trading and clearing, the City’s opportunities will flourish. The nearly $13 billion quota allocated to financial institutions in London last year to invest RMB held offshore in China’s capital markets will most probably be increased before long. Direct trading (that is, avoiding the US dollar as a third currency) between sterling and the RMB is likely to extend to other currencies and the RMB. Chinese companies doing business in Europe, Africa or the US will be drawn to route their transactions through, or locate in London, regardless of where the business might be geographically……

China has an altogether different agenda, which is to internationalise the use of the RMB, propel it to the core of the international financial system, and eventually perhaps to displace the US dollar or at least rival it, much as the Euro does today. This sequencing, however, is neither linear, nor even likely. For the time being, the first part, though, is important, particularly since China was for the most part  ‘closed’ financially just five years ago.

Consider how China has been gradually changing its own engagement in global finance. From 2005 onwards, the RMB exchange rate system has become slowly, but steadily, more flexible. As of 2014, it is now allowed to fluctuate within 2% above and below a central rate, and Governor Zhou of the PBC has pledged that over time the central bank will withdraw from regular intervention. Since 2009, the RMB has been used more and more for settling trade, and it now accounts for about 11% of Chinese exports and imports combined. Rules have been eased for RMB financing of investment overseas. Several central banks, including those of Malaysia, Nigeria, Chile and Brazil, hold RMB in their foreign exchange reserves, and about 24 countries now have bilateral currency swap arrangements with China, worth close to RMB 2 trillion. In 2013, the State Council approved the establishment of the Shanghai Free Trade Zone. Over time, RMB held in the legally separate and much less regulated offshore RMB markets in Hong Kong and Singapore have been allowed to finance some domestic banking transactions and foreign investments. RMB deposits and certificates of deposit in Hong Kong have grown fourfold since 2010 to stand at over RMB 1 trillion, and offshore RMB bonds issued have grown from RMB 100 billion in 2010 to almost RMB 500 billion.

Even if the levels of RMB activity still look quite tame by the standards of global finance, the growth rates have been spectacular and cause international financiers to salivate at the prospects as they extrapolate trends to the end of the decade and beyond. There is also little doubt that China’s intention to have the RMB used more widely in global trade and finance serves both domestic economic and financial goals, as well as foreign policy objectives. The RMB will doubtless finance a higher share of world trade and investment over time, and regulations governing the flows of RMB to and from China will be eased in line with the Chinese Communist Party’s comfort levels of control.

This last point is key, though, and underlines why the expectations of the RMB becoming a global reserve currency, or a replacement for the US dollar are exaggerated or poorly informed. To achieve this kind of status, China has to do one of two things, designed to let foreigners accumulate RMB, that is, claims on China. Both are highly improbable. One is to run balance of payments deficits in perpetuity, the other is to open up capital account transactions, allowing citizens and local companies free access to foreign currencies and assets. The risk of capital flight is just too great. There are other requirements, which are more or less out of reach.

Allowing market forces to determine the value of the RMB is a process that has started, but it is still questionable as to whether China would float the RMB completely. Allowing market forces to determine interest rates is a stated goal, but may prove difficult or reversible in the next few years as China comes to terms with slower growth, a property downturn, and rising bad debts in the financial system and the economy. Developing more liquid, more diverse and internationally trusted bond and capital markets is likely to demand changes in governance and transparency that go beyond the political pale.

Ultimately, however, it is mistaken to believe that the Chinese authorities have it within their power to establish the RMB as a global reserve currency, even if they could. They can certainly allow it to be more widely used, and it is or will be the dominant currency in Asia without any doubt. But reserve currencies have historically been far and few between, and come of age as markets, agents and participants demand something for the purposes of commerce, trading, storage, and a unit of account that, crucially, they trust. Don’t expect the Communist Party to change its judicial, legal, and governance systems and institutions in a hurry, if at all. My guess is that 25 years from now, the RMB may account for about the same proportion of global reserves as the Japanese Yen, or roughly 7-8%, and that the US dollar will dominate global finance for a very long time to come.