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ZHOU Ziheng:Political Path for the Internationalization of Chinese Renminbi

ZHOU Ziheng is a research analyst of the CASS Institute of Finance. His research forces on the history of finance, currency, financial stability, regulatory economics and jurisprudence.


Last year's two rounds of consecutive fall (in spring and winter) of the Renminbi (RMB) exchange rate have sent out strong halting signals. As economic momentum for RMB appreciation becomes inadequate, sustaining RMB appreciation will have to be done by switching to political high gear. 2012 is election year around the globe and also a volatile time for the big international currencies to try out-perform and oust each other. In this complex situation, the internalization of the RMB must rely not only on economic means but also on political means. We can say, in a way, that the internationalization of the RMB has now entered the circuit of international currency politics.
Manipulator or Manipulated?
Following the US Congress's decision of not listing China as a "currency manipulator" last year, the RMB's exchange rate against the US Dollar rose to a historic high of 6.31:1. So, is China a currency manipulator, or is China "being manipulated"?
       In 2011 the Shanghai Foreign Exchange Trading Center (which controls the RMB exchange rate) recorded a 3-day consecutive fall of the RMB exchange rate in April, and a 10-day consecutive fall in winter. This demonstrates that when the People's Bank of China (PBOC, China's central bank and the largest buyer and highest bidder of US dollars) stopped purchasing the Dollar for just a single trading day, the local currency immediately dipped. This further demonstrates that the RMB exchange rate level at the time was the result of the central bank's buying-in - i.e., intervention and manipulation.
       Using its unlimited capability to generate local currency, the People's Bank of China can purchase US currency without restriction, thereby creating a continuously-climbing RMB to US Dollar exchange ratio. This kind of exchange rate control mechanism is RMB appreciation manipulation through and through.
       On the US side, they will not call it currency manipulation as long as the RMB exchange rate goes up, but will definitely call it currency manipulation if the RMB exchange rate goes down. Not only that. If RMB appreciation slows or halts or slackens, they will quickly reiterate their government's grave concern and their private sectors' sharp queries, and their media will trumpet their so-called public opinion, and some politicians will even propose legislation as a threat.
       Now we can see how simple the question is. Manipulation in whatever way is not important. What is important is: it must result in the RMB's one-way appreciation. According to this logic, the RMB is "being appreciated", and so China is absolutely not the so-called "currency manipulator", but a country whose currency is "manipulated" through and through. Who is actually manipulating the RMB exchange rate? Whether the blame is put on the US or whether it is put on China, the result is confusion. We can only say that this is an outcome of the US-China currency war.
       Thirty years ago, China was "starving for foreign exchange". Thirty years later, China has too much foreign exchange. From both the trading angle and the currency angle, China's central bank has bought in really enough of US dollars.
       From the angle of the Shanghai Foreign Exchange Trading Center, the matter is straightforward: Local currency continuously appreciates, causing influx of US dollars; Dollar-selling in domestic market increases; the central bank snaps it up, and that naturally causes excessive local currency supply volume. Leveraging local currency appreciation is bad strategy, much like drinking poison to quench thirst. It can reduce the current period's local currency supply volume, but can also excessively expand the next period's local currency supply volume. Local currency depreciation is the only way to make Dollar-buying in the domestic market increase and make hot money exit the market. Only when the central bank buys US dollars cautiously or even sells US dollars can large volumes of local currency be returned to the banks. This is economic accounting and relatively simple, whereas political accounting is quite complicated. If the two accounts are mixed together, the result is confusion.
Reasons for "politically-driven appreciation"?
Projections of local currency appreciation were shattered by the two rounds of consecutive fall last year. That the central bank should still be hiking the price of the local currency even now shows it is packaging "politically-driven appreciation". It has five reasons for doing so:
1,  Stabilize the local currency: If the central bank stops purchasing the Dollar, expectations of local currency depreciation will surface, triggering a foreign exchange buying spree and destabilizing the local currency. Therefore the central bank would rather protect the local currency through appreciation.
2,  Protect China's international image: There is an imminent potential for the global currency system to collapse, leading to the crippling of the Euro and the paralyzing of the Dollar, and RMB depreciation will be seen as the shattering force that brings about this chaos. To avoid angering other countries, it is better for China to do the more popular thing - let the RMB appreciate.
3,  Export local currency: China must ensure the RMB's appreciation ability before it can step by step make the RMB convertible with other currencies, and hence enable external pressures to be, if only partially, externally diverted. RMB appreciation will encourage some countries, such as the Sudan, to agree to trading with China using each country's local currency instead of going through the Dollar. 
4,  Strengthen China's macro-economic control: RMB appreciation is helpful to China's regulatory authority in implementing foreign exchange control measures such as containing external economical factors through leveraging of foreign debt and equity holdings, influencing the local currency's domestic supply, and strengthening the government's economic authority. On the other hand, RMB depreciation will cause different sectors to compete with the government to acquire foreign exchange, making the government's foreign exchange reserve shrink instead of grow, and weakening the economic-control capabilities of the regulatory authority.
5,  RMB appreciation can enable China to buy more US treasury bonds and improve goodwill between the two countries.
       2012 is election year around the world and also the critical year for rebuilding the global currency system. Resolving currency issues through political means is the inevitable global trend. In the process of the RMB's internationalization, the economic approach has been taking the lead, but ultimately we have to "talk politics".
       Europe, the United States and China are now the "big triangle" in the world order. In this triangular relationship, Europe and the US are competitors on the currencies issue but integrated partners on the security issue. China and the US are competitors on the security issue but integrated partners on the currencies issue. In other words, Europe's security interests and China's currency interests are subject to the US's constraint. However, there is no troublesome argument between China and Europe over security interests and currency interests.
      In October last year Mongolia applied to join the Organization for Security and Cooperation in Europe. Brussels, giving lame reasons, played the security card against China and, bypassing Washington, pressed China to mitigate Europe's financial woes. Responding to this, China declared at the G-20 summit that it believed European countries had the capability to help themselves, and China wanted the RMB and the Euro to each take its own course without inter-mixing.
       In this big currency triangle, the Euro is too isolated while the RMB is tied too closely to the Dollar. For the RMB, the guideline "the Dollar comes first" will remain unchanged in the election year.
Do not end up like the Japanese yen
In East Asia, the US, Japan and China form a smaller triangle. On the security issue, Japan and the US are close allies against China. On the currencies issue, the Japanese yen, although an independent currency, is, like the RMB, greatly pressured to appreciate against the Dollar. In this small currencies triangle, it is inevitable that China and Japan will come closer together and adjust their currency policies against the Dollar. 
       Last Christmas, the Japanese Prime Minister visited China and signed a deal to buy $10 billion's worth of Chinese government bonds. This gesture of "national debt diplomacy" on the part of Japan should be seen as a positive move that draws the currencies of the two countries closer to each other. Last February, China replaced Japan as the first biggest economy in East Asia and the second biggest economy in the world, and the two currencies have yet to adapt to this change. From March onwards, with Japan caught in the nuclear outbreak crisis and the US pulling back its strategic front, the South China Sea dispute came to center-stage while the China-Japan security situation gradually stabilized. In December, the Japanese government did its best to hold back the yen's appreciation and injected 40 trillion yen for anti-appreciation. Almost at the same time, the RMB exchange rate nose-dived for 10 straight days. China and Japan must coordinate their moves in the currencies market whilst avoiding seriously jeopardizing the Dollar.
       At present, Japan is eagerly developing its defense industry to boost its sluggish economy. Showing goodwill to China by purchasing a small amount of Chinese government bonds, Japan is trying hard to create new political and economic space for itself. Of course, Japan can also constrain China through its holdings of Chinese government bonds or even through its US alliance. This means that China should and must listen more to Japan's opinions and also work together with Japan to coordinate mutual stands on the currencies issue. On this point, the People's Bank of China has expressed welcome to Japanese corporations' issuance of RMB-denominated bonds in China. In other words, China is not content with just inter-government collaboration and advocates bilateral cooperation to be extended to the corporate level or the market level.
       While enduring the metamorphosis of the global currency system, the RMB must remember its constraints and make more friends and fewer enemies. It should forge its way forward pragmatically and avoid political obstacles until it acquires the full stature of a sovereign currency.       At the moment, the RMB is depreciating domestically and appreciating internationally. There are opinions which say that prices of goods in China have overall exceeded prices in the US. If we only "talk politics" and allow the RMB to "be appreciated" endlessly, RMB internationalization may bump into obstacles. Then, even if it can manage to exit the political circuit, it will still be unable to escape the "crippled" fate of the Japanese yen.
Strong signals of "RMB softening"
In recent years, a number of factors have become prominent -- shrinking of China's trade surplus; exit of hot money from China; lessening of foreign investment in China; and the central bank's attempts to abandon "unlimited buying of foreign exchange" etc. These are factors determining the softening of the foreign exchange market. Saying goodbye to unilateral-appreciation, the RMB will enter the depreciation passageway. However, with the managed float regime unchanged, this will still be a tentative kind of depreciation, and, as far as we can see, will go through the following three stages: 
       Stage One: In this stage, the central bank ceases to buy uncapped amounts of foreign exchange, and this leads to insufficient buy orders in the market.
       Early this year, the foreign exchange administration authority announced that businesses will be allowed to selectively retain their overseas foreign currency earnings off-shore without repatriation back to China for settlement. This signifies the ending of the mandatory foreign exchange settlement regime, permitting businesses to hold large amounts of foreign currency offshore. Prior to that, the government has already announced permission for residents in China to buy foreign currencies up to an annual total of $50,000 per person, showing the breakaway from the old practice in which the central bank was the major foreign exchange holder. The central bank no longer buys foreign exchange without ceiling, and is systematically transferring on-shore or off-shore holdings of foreign exchange into the hands of businesses and residents. In mid-April last year, the central bank tentatively abandoned its real-time intervention in the foreign exchange market and widened the trading band of the RMB, thus sending out a strong signal about the softening of the RMB.
       Maintaining the managed float regime requires repeated hiking of the RMB exchange rate. This winter, however, when domestic and international economic-political environment allowed the central bank to further give up real-time intervention in currency trading, the RMB exchange rate tumbled for 8 days in a row. RMB depreciation is thus formally hailed in. Although the mid price of the exchange rate published by the central bank did not slide down continuously, market reaction clearly reflected the depreciation. This was basically the result of inadequate buy orders, which in turn was caused by the central bank's exiting from active trading.
       If there is insufficient buying but massive selling, the exchange rate may fall rapidly. In that scenario, the launching of Stage One will fail. Therefore, selling volume must also be tightened to facilitate the market's transition.
       Stage Two: In this stage, commercial banks increase their buildup of foreign exchange, leading to insufficient sell orders.
       In international practice, the foreign currency holdings of commercial banks are counted into their country's foreign reserve. China does not observe this practice. Under the mandatory foreign exchange settlement regime, commercial banks only hold limited amounts of foreign exchange. The Chinese system dictates that foreign exchange is government-owned and held by the central bank. The foreign exchange deposits separately held by the central bank and commercial banks are also used for different purposes. As the holding and usage of foreign exchange by businesses and private sectors are regulated by the foreign exchange administration authority, such total amounts could not be large. In recent years, following an increase in foreign exchange supply sources, the foreign exchange administration authority has adopted a new policy, allowing the private sectors to keep more foreign exchange and letting commercial banks and corporations use foreign exchange more flexibly. Owing to a continuous high RMB exchange rate, sufficient foreign currency supply, and unwillingness of different sectors to buy and hold foreign exchange, the central bank is forced to systematically buy foreign exchange in large amounts at high prices, leading to large-scale funds outstanding for foreign exchange.
       At the same time as the central bank abandons uncapped purchasing of foreign currencies (i.e. reducing the largest buy order), inadequate buy orders in the market will also suppress large volume selling of foreign exchange. Commercial banks will then start to increase their foreign exchange holdings, causing insufficient selling of foreign exchange and intensifying the expectations for RMB depreciation. Increased foreign exchange buying and holding by commercial banks signifies that the allocation of foreign exchange between the central bank and the commercial banks will be re-defined. Because business and private sectors basically deposit their foreign exchange into commercial banks, the commercial banks are acquiring foreign exchange holdings from direct domestic sources. Owing to factors such as narrowing trade surplus, outflow of hot money, decrease in the influx of cross-border foreign currencies and capitals into China, and rising domestic inflation, business and private sectors are more willing to increase their foreign exchange holdings, while commercial banks are even further motivated to build up their foreign exchange positions. This situation may cause the possibility of long-term lack of sell orders for foreign exchange in the domestic market.
       In the current foreign exchange market, inflow of foreign exchange is declining, outbound flow is on the rise, increase of foreign exchange is slow, purchase of foreign exchange by the central bank is decreasing, commercial banks are unwilling to sell foreign exchange, and the RMB exchange rate is falling. We are just at the beginning of Stage Two, when buying and selling are both insufficient and people are watching and not acting. At this stage, RMB depreciation is already fully expected.
       Such a situation will certainly be reflected in the structural changes in foreign exchange holdings. The central bank has ceased to proactively increase its holdings but is absolutely unwilling to decrease them. The commercial banks are increasing their holdings passively by appropriate amounts, and their willingness to increase holdings will be adjusted according to stimulation coming from the business sectors. Private residents are cautiously watching the situation, and the broad environment is warming up to buying more foreign exchange. It can be said, therefore, that in the domestic foreign exchange market a dramatic change in the structure of foreign exchange holdings is brewing. However, it will first be a quantitative change. As increase slows down, strengthening expectations of RMB depreciation, the foreign exchange reserve volume will be impacted. By then, the central bank will have to opt between not selling foreign exchange, thereby letting the RMB exchange rate balloon, and selling foreign exchange, thereby expanding foreign exchange supply and stabilizing the RMB exchange rate.
       This is the situation in which the RMB depreciation is caught as the central bank and the commercial banks probe and test other. The trend of the exchange rate will depend on two factors: first, the central bank's reaction to international pressure exerted by the US demanding currency appreciation, and second, whether private sectors will increase their foreign exchange holdings. The short-term lowering of the RMB exchange rate will boost the domestic purchasing of foreign exchange by buyers other than the central bank, thus reducing the international pressure on the central bank. In fact, external pressure clamoring for RMB appreciation have visibly deflated. With the US saying how pessimistic it is on China and the Euro badly in need of help, this is now a good time for the RMB to go soft.
       Stage Three: In the third stage, full-blown expectations of RMB depreciation have been formed. Businesses and private sectors massively buy in foreign exchange, very likely generating black market supplies.
       When the RMB exchange rate has remained soft for a long time, businesses and private sectors will certainly begin to buy more foreign exchange assets or even sell local currency to do so. At present, because expectations for RMB exchange rate appreciation has not yet totally vanished, and also because of the distinct difference in interest returns between foreign currency assets and local currency assets (local currency asset yields are clearly higher), the private sectors will lag behind commercial banks and businesses in additionally acquiring foreign exchange assets. However, when the private sectors have developed strong desire to acquire foreign exchange, that trend will be irreversible. Judging from the central bank's avowed policy of "keeping foreign exchange in the private sectors", the government will not forcibly bar the private sectors from holding foreign exchange, nor compete with the private sectors in foreign exchange acquisition. However, when the private sectors expect long-term depreciation of the local currency, they will go on a foreign exchange buying spree. With the current annual purchase capped at $50,000 per person, massive acquisition of foreign exchange will quickly use up the foreign exchange positions of the commercial banks. At such times, black markets will enter the stage.
Beware of black markets as RMB tentatively depreciates
If commercial banks, to avoid foreign exchange liquidity risks, restrict account holders to purchase foreign exchange, market panic and subsequent big cash withdrawals will occur. Following that, if the regulatory authority goes against public sentiments and limits the channels for buying and using foreign exchange and withdrawing cash, a foreign exchange black market will be generated.
       In recent years, the series of reforms in the commercial banks' foreign exchange payment and settlement system has achieved remarkable results. From the technical point of view, electronic processing of large volumes of foreign exchange and their payment and settlement in RMB had the effect of reducing the foreign exchange positions of the commercial banks. However, when the RMB exchange rate exhibits significant or prolonged softening or dropping, bank account holders' desire to hold real sums of foreign exchange will rise quickly, possibly causing big cash withdrawals. Once a black market appears, part or most of the cost of the foreign exchange reform will be transferred to the private sectors, deeply shaking the public's confidence in the local currency, with disastrous consequences.
Black markets are induced by two incentives: First, demand for buying foreign exchange is huge. Second, control measures are poor. The problem is, when a significant demand for foreign exchange emerges, it will be difficult to suppress a buying spree unless some control measures are restored, but implementation of control measures will quickly generate black markets. Once black markets are formed, arbitrage between the official mid price and the black market price of foreign exchange will drive holes into the existing foreign exchange trading system. As the goal of having an exchange rate is to maintain the stability of the local currency, the exchange rate must be neither too high nor too low. The RMB, trying to go soft after its previous sharp rise, must stick to its bottom line and avoid any black market interference.
       On the whole, the central bank's foreign currency assets are quite sufficient for satisfying domestic demand and suppressing black market trading. However, after spending huge volumes of foreign exchange reserve on hedging black market trading, the foreign exchange system will be badly hurt and the managed float regime will hardly be able to survive. In the next stage, what can the local currency rely on to maintain its stability?
       Although this new foreign exchange reform is a tentative, phased-out reform, it is nevertheless irreversible. Still based on the Dollar, the RMB will have a hard time ahead.
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