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19 November 2014

The Rise of the RMB; Are We Prepared?

For those who have been around for a while, the day when the pricing of London Metal Exchange (LME) contracts switched from UK sterling to US dollar is perhaps still fresh in their memories. From the beginning of its existence in 1877, the flagship copper contract on the LME had been denominated in sterling. In 1993, the sterling crisis formally ended sterling’s role and all the contracts on the LME became denominated in US dollars. Fast forward twenty years, we may now be on the verge of seeing another important landmark shift in the currency of LME contracts. This time, the most likely contender is going to be RMB or Chinese ‘yuan’.

Getting to know the Yuan

As a country, China is no stranger to us. However, the same cannot be said about its currency, RMB, which stands for renminbi and literally means ‘people’s currency’. It is equivalent to ‘sterling’ in Britain.  But in everyday expenditure, a unit of Chinese currency is called ‘yuan’, (symbolised as ¥), just as we say British ‘pound’. For example, one would say 10 pounds but not 10 sterling. Likewise, one would say 10 yuan but not 10 RMB.

 While it took the US dollar around five decades to replace sterling as a global reserve currency, what chance has RMB got in replacing the US dollar when China only started modernising its economy in the 1980s, one may ask? When did China start moving towards internationalising its currency? 

Setting the direction

The answer is in the last financial crisis which hit the world in 2008. The result is that in 2009, China, and perhaps together with other countries as well, became keenly aware of the risk of depending on a single currency, the US dollar, as a safe haven. China’s determination was made then to set out on an ambitious journey of internationalising its currency, the RMB. Once China’s mind was made up, it adopted a three-stage approach to achieve this goal; first, expanding the RMB’s role in foreign trade settlements, second, increasing its use in cross-border investment, and finally establishing it as a reserve currency.

Five years down the line, steady progress has been made in all these directions. First of all, by June 2014, RMB has become the 7th most used payment currency in business transactions, according to SWIFT (The Society for Worldwide Interbank Financial Telecommunication), up from a ranking of 35, less than four years ago. RMB is now the second most important currency (with an 8.7% share) in trade finance – ahead of the euro (although still far behind the US dollar with an 81.1% share). It has now made a start as a reserve currency as well. The British Government issued a RMB denominated bond in September this year, which makes RMB a de facto reserve currency in Britain, the first by a Western country.

One may argue that for China to flex its muscle in trade settlement is not that difficult; after all, China is the world’s top exporter and the second largest importer, with total exports and imports reaching USD4.2trn in 2013, representing around 12% of world trade.  One may also say that there is a political dimension on the side of the UK government by  making RMB part of its portfolio of reserve currency.  What about cross-border investment? How can a country with strong restrictions on its capital account achieve the goal of internationalisation of its currency? What is the use of RMB if it cannot be invested back into China?

The next steps

The recent developments on the stock market may provide us with some answers.  In 2011, China introduced a scheme called RQFII (RMB Qualified Foreign Institutional Investors) under which the investors are allowed to use offshore RMB to invest in China’s bond and equity market. In less than 3 years, total investment of RMB 640 billion has been made under the scheme. In April 2014, China started preparing for the ‘Shanghai-Hong Kong Stock Connect’ programme, which is aimed at enabling Hong Kong and overseas investors to invest in A-shares listed in Shanghai through Hong Kong, and mainland China investors to invest in Hong Kong shares through Shanghai. The programme was launched a few days ago, on 17th November. Although the jury is out on its potential success, there is no denying that the concept itself is proof that progress is being made in the right direction. 

Shanghai-Hong Kong Stock Connect will be a milestone in the opening up of China’s capital markets, because it allows foreign investors to trade stocks in and out of China in real time. If it is successful, the model will no doubt be replicated over and over again all over the world. Indeed the LME has taken notice of this trend, as indicated by HKEx Chief Executive Charles Li during the LME dinner week in October this year. The first move in this direction on the metals front is the imminent launch of aluminium and copper mini metals contracts denominated in RMB to attract Chinese investors. LME Clear is also planning to take RMB as collateral. 

So far, China is going in the right direction in pushing towards the internationalisation of RMB. As this drive gathers momentum, its impact on the investment world will be phenomenal. China has the largest amount of national savings - larger than those of the US and Japan combined. These savings are likely to seek overseas opportunities as soon as allowed. As more legally sanctioned routes open up, more capital would undoubtedly flow out, and more quickly. 

Watch the money flow...

To be forewarned is to be forearmed. The conversion of China’s household savings into investments worldwide will be the biggest driving force of the financial industry in the foreseeable future.  

This article was written by Mei Xin Wang; all opinions expressed are strictly her own.

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