Lost in Internationalization - Macroprudential Policy and the Rise of China’s Renminbi

Since its launch in the early 2010s, China’s renminbi (‘RMB’) internationalization scheme (the ‘Scheme’) has made impressive progress internationally, as evidenced by IMF’s recent move to include RMB in its Special Drawing Rights basket. Thirty-three countries have signed currency swap agreements with China, and several global financial centers (eg Hong Kong, London, and Singapore) have been competing to become offshore RMB hubs. Asian Infrastructure Investment Bank has been established despite the US’s failed boycott, thus creating a potential platform to increase RMB liquidity offshore. Similar initiatives can also be found in the ‘One Belt, One Road’ scheme and the BRICs Development Bank. All in all, China’s financial diplomacy has been very successful.

Meanwhile, nevertheless, China has been experiencing unprecedented economic turbulence at home as the RMB rises higher on its global ranking. The summer of 2015 saw the largest stock market crash ever since the 1990s, followed by a drastic RMB depreciation and several short yet surprising credit crunches. Worrisome capital flights also hit record high in late 2016. Against this backdrop, how are we to explain the contrasting developments at home and at the global stage, and what implications can we draw?

First of all, the contrasting developments are related to the Scheme. No currency can become a genuine international settlement, investment and reserve currency without full convertibility. As such, China has to deviate its long-lasting financial repression by lifting capital controls, which have guarded its state banking sector during the 1997 Asian and the 2008 global financial crises. A few years ago, I interviewed a senior manager at JP Morgan in charge of the bank’s China investment portfolio. According to him, ‘RMB internationalization is impossible because China wouldn’t lift capital controls and thus subject its economy to foreign influences.’ As it turned out, he was wrong. To carry out an ambitious internationalization timetable—to push the RMB to the pinnacle by mid-2020s, China quickly lifted its capital controls in order to make the RMB fully convertible by 2020. Yet, with all the unexpected turbulence at home, this monetary bullet train has begun to slow down in early 2017 as Beijing decides to tighten up capital controls again.

In a recent article ‘China's Long March to Dismantling the Financial Great Wall: RMB Internationalization and Macroprudential Policy’, I argue that the problem of the Scheme is that Beijing wrongly pitched internationalization of the RMB as an international project. Rather, it should have been a domestic one. The Scheme would not succeed without improving the capacity of China’s domestic financial institutions.  Overemphasis on its global outcomes has distorted the sequence of necessary reforms at home and is likely to destabilize China’s banking and financial sectors, where systemic risk exists. To be specific, China’s banking, financial, and capital markets are highly fragmented, with extremely uneven developments. The capacity of banks to run businesses in more competitive markets varies, and thus the coordination for implementing the Scheme could be problematic. For example, a bank’s branch offices in tier-one cities may be very different from those in tier-three cities in terms of capacity to evaluate borrowers’ creditworthiness, assess the risks of their own financial products, and develop diverse and competitive revenue sources. In the face of low savings’ rates, Chinese households would withdraw their savings from state banks and hold their assets in foreign currency or deposit them elsewhere (eg, informal financial institutions, private banks, or foreign bank branches in China that offer higher savings rates) if they were given the option. As a result, the fast liberalization of capital accounts to purse quick success of the Scheme globally is probably the perfect recipe for failure in the banking sector.

Historically, the lifting of capital controls has proven to be a risky and complex process, as evidenced in some parts of Latin America and Asia characteristic of financial repression. The orthodox solution to undo such financial repression, as economic literature suggests, centers on identifying the sequence for liberalization of capital controls. For instance, liberalization of lending rates should happen earlier than that of savings rates, deregulation for institutional investors prior to individuals, or outbound FDI prior to inbound FDI. A number of East Asian countries including Japan, Korea and Taiwan have arguably demonstrated the ‘right’ sequence of these reforms. China’s banking sector, however, could be a tougher case. The sequence approach assumes that each policy being implemented paves the way for subsequent ones, which can ‘wait’ and are largely segregated from the impact of previous reforms. This linear assumption is more likely to stand in a small economy, or a large but hegemonic economy. In China’s extremely large or heterogeneous markets, however, various sectors and policies are far more interdependent. The larger or more fragmented the market is, the less likely it is that such a linear assumption can stand. Consequently, the quick lifting of capital controls under the mandate of the Scheme would unleash tremendous risks, especially systemic risks, across China’s banking and financial systems.

To mitigate systemic risks, which are especially prominent in China’s massive shadow banking sector (as examined in my article), Beijing needs to inject macro-prudential policies into the Scheme. However, such policies, developed after the 2008 global financial crisis aiming to prevent systemic risks, are missing in the current Scheme. Worse, as I argue in the article, the pro-cyclical nature of the RMB internationalization is entirely at odds with the counter-cyclical nature of macro-prudential thinking, although it is understandable that the main objective of the Scheme is to attract more foreign capital for China’s slowing economy. However, unless Beijing could re-pace the RMB internationalization and focus on macro-prudential policies, the Scheme would trigger further systemic risks inherent in China’s financial and banking systems. It would also impact on the financial stability of foreign countries where RMB reserves are immense. With a realigned focus on domestic institutions and macro-prudential policies, nevertheless, the RMB internationalization scheme could inject fresh dynamics into China’s ongoing banking reforms, thus making China a responsible issuer of a major international reserve currency. Otherwise, backlashes against the RMB would occur, similar to what we have witnessed after the 2008 global financial crisis against the US dollar’s dominant status.

Weitseng Chen is an Assistant Professor at National University of Singapore ('NUS') Faculty of Law and the Deputy Director of NUS Center for Asian Legal Studies.