Events show there are ways to strengthen the renminbi's market basis for being internationalized

The renminbi appreciation that was consistent for a decade has come to an end. The offshore market feels pessimistic about the renminbi's exchange rate, even after the International Monetary Fund recently announced to include the renminbi into the special drawing right basket. But how does the expectation of the renminbi depreciation affect the currency's internationalization?

When there's an expectation of renminbi appreciation, the logic of renminbi internationalization is easy to understand.

Encouraged by the expectation of appreciation, the offshore market renminbi business has developed very well for about six years. Hong Kong, London, Singapore and Taiwan all set up offshore renminbi markets.

The expectation of depreciation of the renminbi is not totally new. Between the time China started renminbi internationalization until the central parity rate reform in August, the currency met with expectations of relatively long periods of depreciation twice. The first was during the European crisis from September 2011 to July 2012, when there was a great need to avoid cross-border capital risks. The renminbi exchange rate frequently reached the daily amplitude's upper limit.

The second time was December 2014 to March 2015, when the renminbi exchange rate also frequently reached the upper limit, due to capital outflow caused by people's concerns about China's economic situation. At that time, the renminbi internationalization business growth greatly slowed, or even stagnated.

Given the expectation of the renminbi depreciation, the willingness to use renminbi in exports and imports drops sharply.

Although the renminbi's share of cross-border trade settlement has been increasing, using renminbi settlement doesn't mean the parties will use the renminbi to do the calculation. When the renminbi changes from appreciation to depreciation, many domestic importers that used renminbi settlement are required by foreign companies to pay in US dollars, while domestic exporters would be asked to pay in renminbi.

Meanwhile, when offshore market renminbi is cheaper, many domestic exporters are prone to use US dollar settlement in the offshore market, and then back-flow renminbi to the Chinese mainland. From the August data we can see that domestic banks' foreign income, which is made on behalf of clients, reached 731.1 billion yuan ($114.4 billion; 107.7 billion euros) and saw a year-on-year increase of 158 percent. Their foreign expenditures were 490.7 billion yuan, which saw a year-on-year increase of 24 percent. That showed the renminbi changed from flowing out of China to flowing into China. Second, the expectation of the renminbi depreciation means decreasing demand for dim sum bonds.

In the international monetary system, the renminbi is still a risky currency. In money arbitrage strategy, investors are prone to using Japanese yen and US dollars as financing currencies, and Australian dollars or emerging markets' currencies as investing currencies.

In 2013, the Chinese currency's market liquidity was very tight, and many companies tended to issue dim sum bonds for financing in offshore markets. At that time, there was an expectation of renminbi appreciation, and the domestic interest rate was relatively high, so there was a great passion for issuing bonds.

Now that the expectation has been changed to depreciation, and the domestic short-term interest rate is also at a low level, differences between the onshore and offshore renminbi exchange rates are narrowing, so companies in the Chinese mainland also are less enthusiastic about issuing bonds in Hong Kong. By Sept 23, in the third quarter, Hong Kong had issued only 14.2 billion yuan in dim sum bonds, a year-on-year decrease of 64 percent. If the renminbi depreciation expectation is not changed, then the dim sum bonds market will continue shrinking.

Last, a renminbi depreciation expectation reduces the ability of offshore renminbi to flow. When the market expects that the renminbi will depreciate, residents' willingness to hold renminbi deposits also decline.

The above data and analysis show that renminbi depreciation expectations would have a huge impact on the renminbi offshore business.

But we need to distinguish two concepts here: depreciation and depreciation expectation. If the renminbi depreciated one time, it wouldn't affect its international business performance much.

Because investors take a certain amount of time to make decisions, renminbi depreciation doesn't mean it will continue to depreciate in the future. But if the depreciation expectation occurs, it is totally different, and investors will ask for higher interest rates.

For example, assume that one day the China purchasing managers index is lower than expected, and the market thinks the renminbi exchange rate should depreciate 8 percent. If, on that day, the renminbi depreciated 8 percent, then investors had their expectations fulfilled. The next day, they would reevaluate the renminbi exchange rate, but it wouldn't influence their decisions on lending. However, if, that on the next day, the renminbi depreciated only by 5 percent, then investors would tend to think the depreciation has not been fully realized, so when they bought a renminbi asset, they would ask for an extra 3 percent.

This kind of thinking by investors will continue until the People's Bank of China calms market expectations or there is some good news. And the period of time before that occurs is the time that depreciation expectations are persistent.

There are many ways to eliminate the renminbi exchange rate depreciation expectation, and one way is through central bank invention in cracking down on arbitrage forces. This is effective, but it delays market clearing, which is when supply and demand are in balance.

A more effective way is to increase exchange rate elasticity, to let the market find the proper prices; in this case there would be consistent exchange rate expectation.

As a result of the international influence of the Aug 11 exchange rate reform, we can see that the renminbi already has the basic qualities for internationalization.

After the Aug 11 reform, when the renminbi depreciated against the US dollar, many emerging countries' currencies no longer simply followed the dollar but also depreciated, following the renminbi. This shows China's influence as the world's largest trade country and manufacturing power. Actually, many emerging market countries already were following the renminbi because their economic and trade relationships are closer with China. Some countries also have listed renminbi in their state foreign exchange reserves such as Malaysia, South Korea, Russia and Nigeria.

From this reform, we also see that while there is no basis for consistent depreciation of the renminbi, the offshore market performs better than the onshore market when they are hit by a significant event, because the offshore market's foreign exchange trade is more active and lacks regulation.

All in all, the renminbi possesses a basis for being an international currency. However, because its foreign exchange market's depth and range haven't reached the requirements of an international currency, in the financial area, the renminbi internationalization business is always led by short-term hedgers. The reasons that its foreign exchange lacks depth are that the onshore renminbi exchange rate lacks elasticity, market players have an inadequate awareness of avoiding exchange rate risks, and the demand for foreign exchange market products is inadequate, so the foreign exchange market lacks a driving force for innovation.

Currently, apart from continuing to push forward exchange rate reform, we need to strengthen exchange rate elasticity step by step, cultivate domestic foreign exchange markets of various levels, promote the development of foreign exchange market derivatives, and strengthen market players' ability to manage foreign exchange risks, so as to lay the market foundation for the steady development of renminbi internationalization.

The author is deputy director of the Research Center for International Finance of the Institute of World Economics and Politics Research at the Chinese Academy of Social Sciences. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 12/11/2015 page12)