By Jens Petersen
China’s foreign exchange policy and capital controls have been highly controversial over the last decade. Whether the discussion centers on the apparent undervaluation of the Renminbi (RMB) or the stringent control of currency flowing in and out of China, it seems quite certain that these issues will continue to receive considerable attention in the foreseeable future.
Amidst the controversy and accusations, what is often overlooked or ignored are the great efforts already made to internationalize the RMB. China has gradually increased the convertibility of its currency over the last decade as it pledged it would do upon joining the World Trade Organization in 2001. In fact, it is true at this very moment that companies can engage in limited trade, hedging and even cross border trade settlement in RMB!
The Status Quo: Currency Controls
Very few people will be surprised to learn that China keeps a firm grip on currency flows in and out of the country. However, the severity is highly dependent on whether the currency flows are associated with a current account or a capital account.
A current account in China includes categories such as the sale of goods, provision of services, interest payments, and repatriation of dividends. For domestic Chinese companies, foreign currency received by such means may be retained or sold to financial institutions permitted to engage in foreign currency conversion; whereas, on the other hand, foreign companies receiving profits in RMB may convert them into foreign exchange through a process by which certification is obtained from the State Administration of Foreign Exchange (SAFE).
Foreign exchange restrictions on the capital account items, however, are far stricter. In broad terms, any transaction whose purpose is to create or transfer capital will be regarded as a capital account item. Examples of such items include foreign direct investment (FDI), outbound direct investment (ODI), cross-border or cross-currency loans, capital markets investments, and derivative transactions.
Foreign companies interested in FDI must obtain approval through SAFE and other Chinese government authorities and may thereafter inject capital into their China-based entities and operations. Chinese investors interested in ODI must obtain approval from the National Development and Reform Commission (NDRC) and Ministry of Commerce, among other agencies, and are then permitted to invest abroad.
International capital markets investors may invest in domestic Chinese capital markets only through Qualified Foreign Institutional Investors (QFII). Domestic Chinese are permitted to invest in global capital markets only by means of Qualified Domestic Institutional Investor (QDII).
These restrictions present some serious obstacles to capital markets participants and corporate investors. On the one hand, it may be rather difficult for foreigners to gain exposure to Chinese capital markets, and, on the other hand, global companies may face intriguing challenges when seeking to hedge their exposure to the RMB. While such challenges can only be truly overcome when there is a freely convertible RMB, the Chinese government has already initiated measures that in part may solve the problem.
Hong Kong as Proving Ground
Because of its position as a global financial center and strong legal framework, Hong Kong has time and again served as a laboratory for China’s newest financial and currency policies. This was the case in 2003 when the Chinese government sought to develop an offshore RMB-market as part of the currency’s internationalization process.
RMB transactions began in 2004 with an arrangement that allowed Hong Kong banks to develop an offshore deposit market for RMB. In 2007 the Chinese government took another major step in liberating its capital accounts when it allowed companies to issue RMB denominated debt in Hong Kong – the so-called “Dim Sum Bonds”.
Although Hong Kong’s offshore market allowed both non-Chinese individuals and companies to own RMB, the Chinese currency still had a long way to go before it could claim to be truly convertible. A very strenuous approval process was required to transfer the offshore RMB back into Mainland China. In fact, because of these stringent capital controls, the Chinese government had effectively fostered and developed two parallel markets for the RMB, the onshore RMB market and the offshore RMB market.
Another milestone was reached in 2009, when a pilot program allowed cross-border trade to be settled in RMB. Initially, this program only included the Chinese cities of Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan, the territories of Hong Kong and Macau, and the ASEAN countries. The program was gradually expanded, and in 2012 all Chinese provinces were permitted to conduct international, cross-border trade as long as the Chinese participant had obtained an import-export qualification in its business license.
The pilot program for the cross-border settlement of RMB complemented the bilateral currency swaps that China had signed with selected partner countries after December 2008. Essentially, these swap agreements allowed foreign governments to offer local importers RMB financing when purchasing Chinese goods. Among the countries that have entered into these RMB swap agreements are Japan, Russia, Singapore, Australia, Hong Kong, and Brazil.
The bilateral currency swap agreements with national trading partners, the cross-border trading program for Chinese companies, and the offshore RMB-market are very important steps forward toward the ultimate goal of liberating the RMB.
Cross Border Arbitrage
At present foreign and domestic companies can access the RMB-debt markets in both Hong Kong and Mainland China through the issuance of Dim Sum and Panda bonds respectively. They can also conduct cross-border transactions, and they can trade in RMB offshore with minimum restrictions. So how come there are two different RMB markets with separate quotations?
Again the issue relates back to China’s stringent capital controls. Corporations will have a natural incentive to buy RMB in the cheapest market and sell them in the priciest, which will limit the divergence between the domestic Yuan (CNY) and the offshore Yuan (CNH). However, as transactions can only be conducted against the background of approved corporate activity, there is no clean cut arbitrage relationship between the two markets.
Thus, as long as the cross-border arbitrage can be based on current account items such as trade and profit repatriation, companies can move RMB relatively easily across the Chinese border and potentially take advantage of the spread between the two markets.
However, the cross-border arbitrage becomes difficult to implement when transaction relates to China’s capital accounts. Under normal circumstances it takes two or three months for a foreign company to inject new capital into a Mainland China foreign-invested entity and the process may potentially be extended by another month when the capital to be injected comes in the form of offshore RMB. Investors have to undergo a similarly cumbersome process when funds are transferred through the QFII and QDII schemes.
Thus, for non-Chinese companies and individuals the capital controls do not put severe restrictions on the currency flow out of the country; the problem is rather getting capital into the country.
The Impossible Trinity
But why does it have to be so complicated? Why bother to establish offshore RMB hubs? Wouldn’t it be more feasible simply to remove the capital controls? The answer to these questions can be traced back to what economists have dubbed “The Impossible Trinity”. Ideally a country’s central bank would like to be able to (1) fix a country’s exchange rate, (2) allow a free capital flow, and (3) lead an independent monetary policy. However, in praxis this is hardly possible and the central bank will have to forfeit one of these three items. While countries such as the United Kingdom and United States of America largely have relinquished their exchange rate controls to maintain free movement of capital and an autonomous monetary policy, the Chinese government chose to sacrifice the free cross-border flow of capital to keep a fixed exchange rate and control money supply.
The Impossible Trinity also highlights the connection between China’s recent moves to lessen capital controls while expanding the daily trading band of the RMB. China may be at a point where it needs to let capital flow more freely in order to facilitate a more efficient distribution. A prime example in this regard is the country’s overheated real estate market, where considerable amounts of Chinese have put their savings due to the lack of alternative investment options. Allowing Chinese companies and individuals to invest more freely abroad could not only help China to deflate some of the domestic asset bubbles, but could also deliver some of the much needed capital for struggling western economies like the ones of Europe.
Furthermore, if Chinese investors and enterprises were less constrained with regards to outbound investments, the People’s Bank of China – China’s central bank – would be less dependent on buying US treasury bonds and could thereby more easily diversify its holdings into other asset classes. The extra outbound investments would most likely cause the RMB to depreciate against the Dollar. In fact, this process may already have begun, as China’s stock of outbound investments continues to increase while its foreign exchange reserves slowly are starting to decline. This development has so far been accompanied by two percent depreciation of the USD/RMB exchange rate since the beginning of May 2012.
China may have a long way to go before it can claim a truly international currency. Meanwhile, the primary obstacles to convertibility are associated with capital accounts restrictions and lack of access to the Chinese capital markets. The ability to raise capital and hedge risk is consequently restricted. Arguably the offshore RMB financing services in Hong Kong and elsewhere are fit to aid companies raising capital to be injected in Mainland entities or to settle trade. Hong Kong also provides sophisticated services to manage risk.
Besides a US Dollar settled non-deliverable CNY forward market, Hong Kong also offers deliverable USD-CNH forwards, swaps and foreign exchange options. The interest rate risk can be managed through CNH interest rate swaps or alternatively through cross-currency swaps that under normal circumstances provide higher liquidity. Hypothetically, this means that companies with access to both markets potentially may benefit from the interest differentials.
While the process of liberating the country’s capital account has been rather slow, it seems imminent that capital flows in and out of China will be less constrained in the near future. Looser capital controls and a less constricted RMB exchange rate may in fact not only turn into a win-win situation for China, but also for the global community as a whole.
Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia.
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