Capital controls reinforce the shallowness of China’s financial markets which hinders the RMB internationalization process. More fundamentally, the lack of independence of regulatory bodies and the state’s sway over financial market participants draws a line in the sand for RMB internationalization.
This is the second in a series of articles on RMB internationalization. The first article discusses the RMB’s growing global role and the wins notched up so far. This article discusses the exchange rate and capital controls and the constraints to full RMB internationalization.
The Controls
Exchange rate and capital controls are central to China’s management of global RMB sentiment.
The Peoples Bank of China (PBoC) maintains control over the RMB exchange rate by announcing the ‘RMB central parity’ each day around which the currency can fluctuate subject to a +/-2% band. The exchange rate reform of August 2015 was supposed to make the calculations of the central parity more market determined by considering the previous day’s closing value as an input.
Since then, the number of variables that the PBoC uses to calculate the central parity has expanded to suit the PBoC’s need to steer the RMB’s value. Today the central parity is determined by a clutch of factors. The RMB’s relative value versus a basket of thirteen currencies was added as another determining variable in December 2015 and the number of currencies was increased to twenty four in January 2017. When depreciation pressures mounted in May 2017 and August 2018, rather than use market data to determine the CNY central parity, PBoC introduced a subjective variable like the countercyclical factor (CCF) in its calculations. The constituents of the CCF are unknown and its use has been justified by the need to counter speculative and herd behaviour in the market.
Besides exchange rate controls, China also has an array of schemes to regulate the size and extent of portfolio flows entering and exiting the country.
Inbound flows are regulated by quota based schemes for institutional investors like the Qualified Financial Institutional Investor (QFII) and its RMB counterpart, called RQFII. Two-way flow schemes include the Shanghai-Hong Kong stock connect, the Shenzhen-Hong Kong stock connect and the bond connect. Regulations on outbound retail flows have been stricter and authorities have sporadically suspended the Qualified Domestic Institutional Investor (QDII) scheme, the only scheme for retail investors to invest abroad.
Constraints to Internationalization
As a result of these controls, foreign holding of Chinese bonds and stocks is still in the low single digits, a very shallow level relative to its economic heft.
The longstanding bottleneck towards full RMB internationalization is the shallow and unsophisticated nature of China’s financial markets that cannot withstand the large volumes and volatility associated with international financial flows. This lack of depth can cause sudden spikes or crashes in asset prices as big money moves in or out of the country. Moreover, Chinese brokerages are far behind international standards in terms of their technological capabilities – several of them still trade manually. Quant funds have been asked to submit their orders to each broker manually since the stock market crash of 2015.
To achieve fuller RMB internationalization, China needs to open up its capital account and allow global flows into and (especially) out of the country or in economic parlance, let the RMB be ‘convertible on capital account’. However, the pilot project on RMB convertibility in the Shanghai Free Trade Zone (FTZ) was put on hold after the August 2015 depreciation, barely six months after its launch as capital controls were imposed to stop money from leaving the country.
A more fundamental problem is the lack of independence of the PBoC and other regulatory bodies. Financial market participants are often used to fund bailouts and steer the domestic credit cycle. A set of local brokerages, mutual funds, insurance firms and other local entities (dubbed the ‘National Team’) were asked to support the equity market during the stock market crashes in June 2015 and October 2018. In February 2019 the government issued a policy directive explicitly asking the PBoC to cut the required reserve ratio to boost bank lending and the banking regulator to be more tolerant of non-performing loans.
In Perspective
Looking at historical precedents for internationalized currencies shows that the RMB’s position is unique. In contrast to the US Dollar, Deutsche Mark and the Japanese Yen whose internationalization was driven by market forces, RMB internationalization is state led. So the extent of RMB internationalization will always be subject to the government’s relative priorities between furthering RMB internationalization and manipulating financial market participants to fix other problems in the economy. Coupled with the subordinate status of financial regulators to the government, it puts a line in the sand for RMB internationalization.
The next article in this series discusses the future course of RMB internationalization.
Macrologue 