In the first of three articles on China’s financial market opportunities, Julien Calavia, Analyst, Hedge Funds, discusses China’s attempts to make the renminbi a truly international currency and the potential opportunities for hedge fund investors.
For most of this year, financial headlines coming out of China have been dominated by the performance of the country’s stock markets. However, in our opinion, those headlines represent the tip of the iceberg. The first development worth looking at – and the recent cause of much market disruption – relates to attempts to internationalise the renminbi.
The arrival of Xi Jinping as China’s president and the subsequent roadmap that was drawn during the ‘Third Plenum’ have just started to yield a number of pro-market reforms. This should result in an entirely new economic framework for the country with an ultimate goal of transitioning to a market-based approach of allocating capital resources.
To achieve the aim of making the renminbi a truly international currency on a par with the US dollar, China is progressively moving towards opening its capital account and liberalising its interest rates – essentially, allowing its rates to be determined by market forces. At the 2014 National People’s Congress, Chinese Premier Li Keqiang stated, “China will accelerate renminbi convertibility under capital account.” By this year, he was proclaiming, “China will achieve renminbi convertibility under capital account.”
Meanwhile, Chinese officials have been sending very strong signals regarding their wish to raise the Chinese currency’s profile on the international stage. Mr Li formally asked the International Monetary Fund (IMF) earlier this year to include the renminbi in the Special Drawing Rights (SDR) basket. This is the international reserve asset of the IMF made of a mix of US dollars, euros, sterling and Japanese yen. Membership of this SDR basket is largely symbolic and neither necessary nor sufficient for the renminbi’s acceptance as a global reserve currency. But it is seen as a vital stepping stone on the way to China’s currency aims.
One of the main conditions to join the SDR basket is for the currency to be “freely usable”. This is further defined by “widely used” and “widely traded” though this does not necessarily mean it has to be freely floating or fully convertible, according to the IMF1. The IMF will complete a technical assessment on whether to include the renminbi in the SDR by the end of the year.
China’s financial reforms are expected to continue at a steady pace until the political leaders achieve their goal of genuine renminbi internationalisation.
Even if the decision goes against China, this shouldn’t trigger a U-turn in terms of the reform agenda. The renminbi is already the second-most widely used currency for trade finance – 25% of China’s trade is conducted in the currency – and it is the fourth-most used global payment currency2
Meanwhile, the recent creation of the Asia Infrastructure Investment Bank and the opening of new swap lines between the People’s Bank of China (PBoC) and major central banks will likely further strengthen the position of the renminbi in the international financial system.
The PBoC move that shocked many in August involved several changes in the fixing level of the currency against the dollar, resulting in a notable depreciation. The PBoC will also factor in the market closing rate when setting the fixing rate of the following day, adding an element of market pricing. As a result, the renminbi is edging closer to a fully-floating market-determined system.
While the reason behind this move may be a desire to boost trade thanks to currency depreciation, it is also supportive of the currency’s inclusion in the SDR basket. Chinese authorities have also recently announced the extension of the onshore renminbi trading hours to 23:30 Beijing time (15:30 GMT) in order to ease IMF’s concerns on renminbi liquidity during London trading hours. The foreign exchange value of SDR basket currencies is calculated at noon, London-time by the IMF.
The capital account opening will be a key element for hedge funds to capture direct opportunities. This will result in a more freely accessible onshore equity market and the onshore bond and derivatives markets will become available to foreign investors for the first time.
Moving closer to a fully-floating exchange rate mechanism would increase currency trading opportunities as price moves wouldn’t be constrained within the current +/- 2% band. Price trends would become more supply & demand driven as opposed to engineered by the Chinese authorities.
If China is successful in its aims, we anticipate this endeavour could result in some attractive new macro trading opportunities for hedge funds.
Article 2: Welcome to China’s financial markets