The Renminbi's Rise to Reserve Currency
In general, internationalization culminates in the status of reserve currency—a currency held in significant amounts by central banks and others as part of their foreign exchange reserves. To the outside world, the Chinese effort to internationalize its currency is meaningful mainly because it is associated with financial market reform, which will lead to a gradual opening to foreign investors.
Becoming a reserve currency is a multistage process, in which it progresses from the trading to investment stage before it is accepted by central banks. China has transitioned the RMB to a trading currency by expanding its role in international payments, mainly through bilateral agreements. To become an investment currency, it was necessary to broaden access to financial products outside China. This process started out in the Asian financial hubs of Singapore and Hong Kong, but the current trend seems to be creating joint projects with European Union governments.
The Battle Offshore
China is the second-largest economy in the world, and since it began the push for internationalization, it has been courted by governments who seek to be part of China’s financial opening. Politics and social issues have taken a back seat in their discussions.
Naturally, China’s main trade partners are in its vicinity, and it is not surprising that the RMB, both as a trading and investment currency, is most present in the Asian region, with Hong Kong and Singapore the largest clearinghouses outside China. Nevertheless, European governments seem eager to compete for a role in the offshore RMB market and close involvement in the RMB's development.
The United Kingdom has long been the frontrunner in Europe when it comes to financial ties with China. It was the first nation to obtain a quota for financial institutions to invest in China's domestic securities and it struck a bilateral swap agreement between the pound and the RMB. As the center of foreign exchange trading, accounting for 41 percent of global trade and 51 percent of RMB FX transactions by value (outside China and Hong Kong), London seemed likely to become Europe's offshore trading center and connect its exchanges tidily with China.
On the other side, Germany and its financial hub, Frankfurt, are profiting from the large capital flows between the two countries. Germany is China’s biggest trade partner in Europe and, according to the Society for Worldwide Interbank Financial Telecommunication (SWIFT), is among the top five countries participating in RMB letters of credit. While some exchanges already provided RMB denominated products, the race to establish an offshore trading hub has intensified this year. With its October 29 announcement of a joint venture with two Chinese exchanges, Germany’s Deutsche Boerse AG seems to have taken the pole position for now, beating the London Exchange to becoming the first RMB denominated trading platform outside China. The joint venture—China Europe International Exchange (CEINEX)—is a strategic coup for Germany's exchange and an important step for RMB internationalization because it enables Asian investors to directly access European capital markets.
This expansion of direct investment opportunities for foreigners through quotas for RMB investment in China and foreign currency investment alike, together with the October 29 deal, has propelled the RMB to the status of a nascent investment currency in just two short years.
RMB as a Reserve Currency: A Work in Progress
When it comes to the establishment of the RMB as an investment currency the new European and Chinese focus on tighter financial interlinkages does point to the imminent growth of the RMB. In fact, European governments are making inroads in the offshore RMB market and pushing for an even bigger role in China’s financial opening. While many investors rightfully think Hong Kong and Singapore when they hear “RMB offshore market,” they should consider adding Frankfurt and London to the list in the near future.
The internationalization of the RMB and China’s financial opening, however, are still a long way from their full potential based on the scale and power of the Chinese market. For the RMB to become fully accepted as a reserve currency, the government will have to further reform its domestic financial markets, a process that might be slowed by recent capital outflows. This process will in addition depend on the continued desire of developed countries to be part of the RMB manifestation as an investment currency and gradual capital account liberalization.
Given recent comments by the IMF, it seems likely that the RMB will be included in the special drawing rights basket at the global funding agency’s meeting next week. While a mostly symbolic move, this inclusion is a milestone of sorts, considering the longstanding concerns of developing countries about their sparse representation at the IMF. For China itself, the new status may act as a steppingstone that will, hopefully, spur financial market reform and send a global signal of its commitment to a strong and stable renminbi.