The International Monetary Fund’s decision to include the Chinese renminbi as a reserve currency marked a political triumph for Beijing. It gives the currency the same gravitas as the US dollar, yen, euro, and British pound.
Was it truly deserved? Not so much.
The IMF trumpeted that the renminbi is "freely usable", meaning that it is widely used both for foreign exchange trading and global trade payments. Yet while Swift, the company that monitors international bank payments, reports that the renminbi is the world's fifth-most used currency, the fact of the matter is that non-Chinese usage of the renminbi is heavily predicated upon Hong Kong – a territory that is administered separately but is nonetheless part of the People's Republic of China.
Part of the reason the renminbi hasn’t gained more standing across the world is because its valuation remains beholden to the preferences of China’s government. And this can make for a lot of uncertainty, as Beijing showed when abruptly devaluing the renminbi against the dollar in August.
But there’s a more practical reason the renminbi isn’t being used more too: there simply isn’t much that overseas companies, banks, and investors can do with it. Not yet anyway.
Typically, the safest and easiest investments of choice in another currency is another country's government bonds. Central banks in particular favour this option as the instruments tend to be liquid and relatively secure.
But China’s local bond market is extremely limited to investment from outside investors. They can only access local bonds via qualified foreign institutional investor schemes.
Beyond mainland China there are so-called dim sum, or offshore renminbi-denominated, bonds but these are limited in volume and tend to have thin levels of secondary trading. The People’s Bank of China made something of a statement when selling a Rmb5 billion ($781.5 million) bond in October, its first ever-offshore deal – but it was only a one-year deal.
Beijing’s reluctance to allow international investors greater access to its domestic bond market stems from a few real fears among the country’s policymakers. Key among them is the concomitant need for the PBoC to liberalise capital flows, giving the government less control over its currency.
Such a move would also expose the bond market to the tides of fickle foreign capital entering and leaving on a whim, and put pressure on the renminbi to appreciate as international investors swap their currencies in order to buy onshore bonds.
Debt swap
However, there are still sensible reasons for opening up the onshore bond market – even for the control-obsessed powers that be in China.
For a start if the renminbi is to become a truly global currency China needs to stop effectively pegging it to the US dollar, albeit within a trading range, by allowing it to float more freely. Doing so might lead to a depreciation in its value; many analysts think the currency has become overvalued due to the way it is managed against the dollar, which has been appreciating.
A depreciation would make the renminbi less appealing for offshore holders. However, by encouraging offshore investors to buy its onshore government bonds, Beijing could help to moderate or even nullify that process.
Opening the Chinese bond market could also be part of a broader strategy to help the nation manage its debts.
China’s overall debt-to-GDP ratio stood at 282%, according to a McKinsey Global Institute report in May. Government debt is a manageable 55% of GDP but over half of it is owed by local governments – or more accurately local government funding vehicles, the financial companies used by these provincial and municipal authorities to get around a moratorium on borrowing.
While the total isn’t a danger to the country’s health, McKinsey noted that local government debt has risen by 27% a year since 2007, with LGFV debts reaching $1.7 trillion last year. And there are concerns that local governments haven’t necessarily used the money they have borrowed very wisely.
McKinsey said that a 2014 audit report found that local governments used over 20% of recent loans purely to pay older debts, while 40% of land sales (their traditionally largest revenue source) were used for debt servicing. So with land sales declining and many property markets softening, the ability of local governments to keep servicing debts could well come under pressure.
Beijing has said that it will let local governments swap loans for municipal bonds, and municipalities are beginning to issue bonds, but the programme is limited in scope.
It might well prove more sensible for the central government to pay off the debts of the local governments by issuing central government bonds. It could do so by having the local governments apply for Beijing to pay off specific maturing debts – which it would do in return for getting a good look at what the money was spent on (thus supporting the country’s ongoing anti-corruption drive).
Plus, the central government could impose strict caps on how much local governments can borrow in the future – along with harsh penalties for any breaches.
By shifting debt from the regional to national level, China could build a very deep government bond market. It could then open this up to local and foreign institutional investors, who would then have something to invest their renminbi in.
Overseas central banks would likely also be enthusiastic holders, becoming large and stable owners of the bonds. And by doing so they would help China’s currency become a reserve currency in truth.
A large and open Chinese government bond market should have knock-on effects for local corporate bonds too as foreign capital gradually spreads out into them, making them cheaper.
In sum, as China continues to rebalance its economy and strives to get a handle on its mounting levels of debt, it will need to make searing structural reforms. Freeing up the renminbi and enlarging its government bond market would be a good way to begin this process.
