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Dominic’s Take: 2016 U.S.-China Outlook

What the Rise of the Renminbi Means

By Daniel Allen

Renminbi inclusion in the Special Drawing Rights

As the renminbi rises on the world stage, what’s next for business and the global economy?

When the International Monetary Fund decided to promote the renminbi to their basket of Special Drawing Rights currencies at the end of November, it marked a milestone in Beijing's drive to make Chinese money a truly global commodity. This drive has already taken the RMB on a remarkable journey.

It was in the aftermath of the 2007-8 global financial crisis that the Chinese government, eager to escape the so-called "dollar trap," decided that internationalization of the RMB was the best way to lower its dependence on the greenback.

"Beijing realized that to maintain growth, Chinese consumers needed to pick up the slack from the fall in global demand," says Adrian Gostick, managing director, Financial & Risk, at Thomson Reuters China.

"It also realized the need to reduce its huge holdings of foreign government debt (and therefore foreign exchange risk) that it had built up by running persistent trade surpluses. Interest rate liberalization and RMB internationalization were seen as ways to achieve these goals."

Today, thanks to Beijing's deliberate and ongoing policy measures, the Chinese currency's statistics demonstrate its meteoric rise.

The RMB is now the world's second-most-used currency for global trade finance. According to global transaction services organization SWIFT, the RMB overtook the Japanese yen to become the world's fourth-most-used payment currency in August 2015 (up from 12th in August 2012). And, according to HSBC, cross-border trade settlement in RMB will soar to more than 50 percent of China's total trade by 2020, up from just 1 percent in 2010.

International implications

The RMB will be officially included in the Special Drawing Rights basket on October 1, 2016, with a weighting above that of the Japanese yen and the British pound. While this move makes the Chinese currency, by definition, a "reserve asset," what effect this inclusion will have on capital flows is far less definite.

Before central banks will consider a currency to be a reserve asset, they need confidence in its salability. This, in turn, requires deep and liquid markets. While some interpret the IMF's award of SDR status as an endorsement of the RMB and China's markets, well-informed financial institutions will form their own judgments. Indeed, ongoing concerns over the Chinese economy and financial market valuations recommend a cautious approach to the acquisition of RMB-denominated assets.

"SDR inclusion does not make the RMB a de facto reserve currency," says David Blair, managing director of Singapore-based Acarate Consulting and the former vice president of treasury at Chinese telecom giant Huawei. "For now, at least, SDR status is mainly a morale booster."

Given that most foreign financial institutions are underinvested in RMB assets, however, most analysts believe that the IMF's decision will have a more pronounced effect on capital flows over the longer term.

According to research by asset management firm AllianceBernstein L.P., SDR inclusion "could lead to inflows of up to $3 trillion over the next few years." Financial services firm Morgan Stanley expects inflows to exceed $2 trillion over 10 years, while Standard Chartered PLC and AXA Investment Managers collectively predict the transfer of at least $1 trillion of global reserves into Chinese assets over time.

Hedging bets

To date, RMB internationalization has primarily been facilitated by RMB-denominated bond issuance, RMB-denominated foreign direct investment, cross-border trade settlement and currency swaps. Beijing has worked hard to increase global RMB liquidity, with 32 countries having bilateral currency swap agreements in place as of June 2015. Since 2007, China has also established 13 offshore RMB clearing centers.

What this means is that an ever-growing number of people have the capability and desire to do business in RMB. According to SWIFT, a typical month now sees around 160 of the world's countries carry out transactions in the Chinese currency. According to HSBC, more than 10,000 financial institutions were conducting commerce in RMB as of March 2014, compared with just 900 in June 2011.

If they are not using RMB already, companies with exposure to the Chinese market should certainly consider making it part of their cash management strategy. Use of RMB can increase leverage on prices with Chinese customers and suppliers, improve the effectiveness of corporate investments and help to strengthen business partnerships.

Of course, there's a flip side to every coin. A recent uptick in the volatility of the RMB has seen a growing number of China-exposed companies looking to mitigate risk. As the Chinese currency continues to free itself from state control, this will become increasingly imperative, especially for small and medium size enterprises, which typically have a bigger need to protect their operations from the dangers of currency fluctuation.

"Every investor that is interested in international markets should consider the same three risks," says Nick Li, a foreign exchange analyst with East West Bank. "Transaction costs, liquidity risks and currency risks. The latter can be mitigated by hedging currency exposure."

Following the recent liberalization of trade flows by Beijing, many international companies have moved their RMB exposure offshore by buying from and selling to China in Chinese currency. Their offshore RMB risk can then be hedged according to global best practice, which typically means using forward contracts.

"There are some natural hedging strategies, such as matching sales and procurement currencies and borrowing in RMB, to offset RMB sales or the reverse," says Blair of Acarate Consulting. "But, in general, hedging with forwards offshore is cheaper and more convenient."

Future focus

The inclusion of the RMB in the Special Drawing Rights basket is a victory for Chinese politicians who want to see the country's economy liberalized further. Yet the speed at which this liberalization process will continue, and the point where it will stop, are unclear. While there have been murmurs recently that Beijing will allow full RMB convertibility by 2020, the Chinese government is not one to readily release control.

"Permitting freer flows of money into and out of China will create greater volatility and will test China’s resolve to allow interest and exchange rates to become more market driven," says Thomson Reuters’ Gostick.

On the support side, the RMB's rise means financial institutions will need to keep investing in RMB-related products and services.

"The Chinese currency needs to be supported by a broader connectedness," says Daphne Huang, SWIFT's China chief representative. "We're already seeing banks adopt services like business intelligence, messaging conversion and networks for developing their global RMB utility."

The chances of the RMB supplanting the U.S. dollar as the global reserve currency in the foreseeable future are slim to none. Still, the RMB's rise means that ever more companies will encounter the Chinese currency as they go about their business. They will need to understand what it is, and how they can employ it prudently to benefit their operations.

In this respect, the West still has a ways to go.

"As geographical distance from China increases, so the comprehension and use of RMB in trade generally decreases," says Gostick. "We are seeing companies in Asia leading the way with a large volume of trade being settled in RMB, followed by Europe. The U.S. lags behind, not only in understanding and usage, but in its resolve to embrace the world's changing currency landscape."

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