In the multidimensional geo-economic contest in which China and the U.S. are currently engaged, the future roles of their respective currencies have become a key focus of speculation. Concerns over debasement of the dollar have driven a surge in interest in cryptocurrencies. Meanwhile, the People’s Bank of China (PBOC) has been making steady advances in the roll-out of its own central bank digital currency (CBDC), dubbed the Digital Currency Electronic Payment (DC/EP).
It is conjectured that the Chinese CBDC will eventually eliminate China’s dependence on the dollar and dollar payment systems and propel the renminbi, also called the yuan, to usurp the dollar as the leading global reserve currency. However, the DC/EP alone is far from sufficient to truly internationalize the renminbi.
The Chinese CBDC could bring about a wide range of benefits, including raising financial inclusion, lowering the cost of payments across the economy, improved ability to monitor inflation and transmit monetary policy, as well as greater capacity to combat tax evasion, money laundering and other financial crime.
While the initial focus of the DC/EP is on domestic retail payments, the efficiencies offered could lead to increased use of the renminbi for invoicing and settling international trade. Nevertheless, trade accounts for a mere 10% of global cross-border capital flows; financial flows account for around 90%. Trade counterparties are unlikely to increase their acceptance of renminbi unless there are sufficient suitable renminbi-denominated investments for them to deploy the proceeds to. For the renminbi to match the dollar’s global status, therefore, it is necessary to massively expand the Chinese currency’s role in international capital raising and investment.
Policymakers began making gradual steps toward capital markets internationalization in 2002 with the Qualified Foreign Institutional Investor (QFII) program, which allowed foreign investors to access the Chinese mainland’s stock markets. This was followed by a series of further initiatives, notably the establishment of the ‘dim sum’ market for offshore renminbi bonds, and the Stock and Bond Connect programs via Hong Kong. Major international index providers have begun including Chinese stocks and bonds in their benchmark indices, and the International Monetary Fund (IMF) has included the renminbi in the basket of currencies backing its Special Drawing Rights (SDRs). However, foreign investment in China’s capital markets remains very low compared with the U.S.
As of September 2021, international investors’ share of China’s onshore stock and bond markets was a mere 4.1% and 3.1%, respectively. By comparison, international investors held more than a quarter of all U.S. domestic securities outstanding — and this doesn’t even take into account investments in the offshore dollar securities markets. Several key factors continue to inhibit greater international investment in Chinese domestic securities.
First, there is continued skepticism about the level of property right protections offered by the Chinese legal and regulatory system. Without greater judicial independence, investors remain concerned about the risk of arbitrary government and regulatory actions. The reaction to the government’s crackdown on the for-profit education sector in July 2021 illustrates this point. However morally justified, the lack of public debate and due process spooked investors, triggering a broad sell-off in Chinese stocks.
Second, the renminbi-denominated derivatives markets remain underdeveloped. The lack of adequate tools for international investors to hedge renminbi interest rate, credit and other risks restricts further expansion in their Chinese securities holdings. Further developing renminbi derivatives markets would also enhance demand for Chinese government bonds as collateral to meet clearing house margin requirements.
Third, related to the two foregoing factors, there are still few avenues for investors to raise short-term liquidity from their Chinese securities holdings in the offshore market. This makes holdings in Chinese securities relatively capital inefficient versus alternatives. As a consequence, international investors will either demand a substantial premium to hold them or shun them altogether.
Fourth, heightened geopolitical tensions have added to the risks of investing in Chinese securities. In response to perceived security threats, the U.S. has recently imposed sanctions to restrict investment in Chinese companies in certain sectors. As these tensions persist, further measures may be introduced to limit investment in Chinese securities.
Nevertheless, there is a clear path toward renminbi internationalization: expanding outbound investment by Chinese investors.
As of October 2021, Chinese domestic bank deposits stood at $35.9 trillion, far outstripping the size of the country’s stock and bond markets. These represent the largest ‘untapped’ capital pool in the world. Since China’s domestic capital markets are not yet large enough to absorb such a large pool of savings (without generating dangerous asset price bubbles), expanding Chinese outbound portfolio investment could serve a number of strategic purposes.
First, given China’s rapidly aging demographic profile, there is an urgent need for Chinese citizens’ retirement savings to be invested in higher-yielding assets in order to alleviate the inevitable social welfare burden on national finances.
Second, in contrast to foreign direct investment by Chinese corporations and public entities, the purchase of a few shares or bonds by Chinese retail investors raises no sensitivities over Chinese control, technology transfer or government interference, which have plagued the Belt and Road Initiative.
Third, since Chinese investors are natural buyers of renminbi-denominated investments, this would attract substantial renminbi issuance by international issuers, thereby massively increasing the pool of renminbi-denominated securities in international markets.
Of course, new international financial infrastructure would need to be developed to support transparency, prevent tax evasion, and protect China’s national financial security. Significantly, all Chinese outbound capital markets investment beyond Hong Kong today is heavily reliant on a depository and custodian network that is highly susceptible to U.S. influence.
Mainland policymakers should consider developing Hong Kong as a custody center for the safekeeping of Chinese investors’ international securities holdings, further extending the territory’s role as a bridge between Chinese and international markets.
James Fok, a former senior executive at Hong Kong Exchanges and Clearing, is author of the upcoming book, Financial Cold War.
Contact editor Heather Mowbray (heathermowbray@caixin.com)
The views and opinions expressed in this opinion section are those of the authors and do not necessarily reflect the editorial positions of Caixin Media.
If you would like to write an opinion for Caixin Global, please send your ideas or finished opinions to our email: opinionen@caixin.com
Get our weekly free Must-Read newsletter.
