Behind the start of renminbi trading in London is a Chinese leadership that wants a bigger role in the world economy
Economic View: From an investment perspective supporting the peg was a dreadful policy - you just lost money
Thursday 19 June 2014
There is the British version of the story about London becoming the clearing hub for Chinese currency trading, with the appointment yesterday of China Construction Bank as the renminbi clearer. This follows on an agreement in March with the People's Bank of China that London should take on this role.
Mark Carney said the appointment was an "important milestone", because the Chinese bank would "play a valuable role in facilitating greater use of the renminbi for trade, investment and other economic activities in the UK".
It is indeed a milestone, though the process is a natural one. London is the largest foreign exchange market in the world and already does two-thirds of trading in renminbi outside China and Hong Kong. It is important, from our perspective, to have this business, so the news is most welcome.
There is also, however, a Chinese version of the story, which is also welcome but in a rather different way. It runs like this:
China is heading down a path to becoming a "normal" market economy that it has been treading for the past 35 years. It has been a long and immensely complicated transition and one that the country has managed pretty well. It has certainly done vastly better than the former Soviet Union. This process did, however, slow down following the financial crisis, and in some aspects went into reverse. It is now picking up again and liberalisation of the use of its currency is one aspect of that.
It seems ridiculous, from the Chinese point of view, that global trade takes place largely in dollars. Commodities are denominated in dollars – including oil, where China has now become the biggest importer. This rankles, but for the renminbi to take on a greater global role, it has to be fully and freely convertible and be held by foreigners in accounts outside China. In short, China loses a large degree of control over its currency. The rest of us are used to this: we know we cannot control our exchange rates. But ensuring a competitive renminbi has been a key element of Chinese economic policy.
You can see the way this policy has evolved in the top graph. The currency was pegged to the dollar until the middle of 2005. As the dollar depreciated against other currencies between 2002 and 2005, the effect was for the trade-weighted value of the renminbi to fall too.
The peg was then eased, before being re-pegged in 2008. Since then China has permitted a further gradual appreciation, although this has been reversed a little in recent months and there is a general perception outside China that the currency is still somewhat overvalued. The People's Bank of China appears to disagree, feeling that the present exchange rate is about right.
Pegging the currency came at a cost. On the bottom graph you can see the extent to which the People's Bank of China intervened in the markets, offsetting the considerable current account surpluses run up by its exporters by buying foreign currency-denominated assets, mostly US Treasury securities.
From an investment perspective this was a dreadful policy: you just lost money as the dollar fell against the renminbi. But this was deemed a necessary price to pay to maintain the competitiveness. Senior Chinese officials were especially concerned that the country did not make the same mistake as Japan, which they believed had allowed an excessive rise in the yen and accordingly encouraged the hollowing out of Japanese manufacturing industry.
At any rate priorities now seem to have shifted, in that getting the renminbi to supplant the dollar has risen as an objective, and holding it down has declined. So looking ahead, the gradual relaxation of controls will continue and the currency will increasingly be allowed to find its own level.
This shift of policy on the renminbi is the external counterpart of a parallel shift in domestic monetary and regulatory policy. China managed to avoid the slump that struck the West, but at the cost of increasing the direction of investment, lashing out loans from the state-controlled banks, and borrowing to build large infrastructure projects. Some of this investment was wasted, leaving a legacy of loans that will never be repaid.
Over the past 18 months, since the new leadership was installed, reform has begun again. Diana Choyleva, China-watcher at Lombard Street Research, thinks foreign observers have not given enough credit to the new leadership for the steps it has taken. In a recent note she comments: "The evidence suggests to me that watershed change is under way… China has not only embarked on the right reform path, against powerful vested interests, but has so far accepted the economic pain this brings."
This pain includes a slowdown of growth to an estimated 6 per cent for the past two years, half the level of previous years. Measures so far include allowing higher interest rates on savers' deposits, a partial clean-up of bank balance sheets, and a widening of the bands that the renminbi can trade at on the exchanges.
But there may be some major commercial or bank failure ahead; indeed it seems many Asian investors now expect this. Some people argue that China needs this to show that failing institutions will indeed be allowed to fail. But this pitches the government against much of the country's financial establishment and, as we know to our cost, picking up the pieces after a financial failure is a difficult and costly process.
We'll see. I think the big point here is that the country has to make market reforms and doing so means acknowledging past mistakes. Not to do so would be to follow the Japanese path, one that China does not want to go down. The challenge is to continue to reform gradually, but to keep moving. China needs these market reforms to become a more equitable society – less cronyism, more support for the ambitious middle class. What is happening here in London to renminbi trading is a small part of these reforms, but a notable one.
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