Considerable attention is being paid at the moment to stock exchange and exchange rate developments in the Chinese economy. This is not surprising, given that China has the world’s second largest economy and that rapid Chinese growth has underpinned the global economy in recent years when the United States and the European Union economies have been faltering. Interpretation of these developments is complex for two reasons. First, China is unique in that its economy has market aspects while the country remains under the political control of the Communist Party. Secondly, the economy is not fully transparent, certainly to outsiders and even, in some respects, to the Chinese themselves.
The result is divergent assessments. David Stockman, formerly economic adviser to President Reagan has recently written:
China is the greatest construction boom and credit bubble in recorded history. An entire nation of 1.3 billion has gone mad building, borrowing, speculating, scheming, cheating, lying and stealing…In two short decades, China has erected a monumental Ponzi[1] economy that is economically rotten to the core…Once asset values start falling, its pyramids of debt will stand exposed to withering performance failures and melt-downs.
More politely and technically, the IMF April 2015 World Economic Outlook said:
In China, rebalancing toward domestic demand has so far been driven primarily by rapid growth in investment and credit, an unsustainable pattern of growth that has led to rising vulnerabilities in the corporate, financial, and government sectors. To avoid a further build up of attendant risks, policies need to be carefully calibrated to simultaneously contain vulnerabilities, manage the corresponding slowdown, and unleash sustainable sources of growth.
Charlene Chu, head of Asia at Autonomous Research has written:
Not surprisingly, the most common question I get is ‘Are we going to have a financial crisis in China?’ and that kind of thing is impossible to predict. There is certainly a scenario where you start to go down that path, but there are unique features in China. There’s no over reliance on foreign funding, a closed capital account, and heavy state influence over lenders and borrowers. That contributes to a more stable situation than in other emerging markets.
How do we get our bearings? Let’s step back and deal with a few of the basics.
1. The terms ‘renminbi’ and ‘yuan’ are both used when talking about China’s currency. Why are there two terms?
The way this is usually explained is that ‘renmimbi’ (‘the people’c currency’) refers to the currency as a whole (like ‘sterling’ in the UK) and that ‘yuan’ is the unit of account within it (like ‘pound’ in the UK). On this basis, CNY is used as the international abbreviation for amounts of Chinese currency, just like GBP for British pounds and USD for United States dollars. Not everyone, observes this convention and sometimes you see RMB used in reports of Chinese currency amounts.
2. What is the difference between onshore yuan (CNY) and offshore yuan (CNH)?
Hong Kong was the initial key. In 2004, renminbi deposits were allowed in Hong Kong, with the Bank of China (Hong Kong) designated as the sole offshore renminbi clearing bank. Things have developed rapidly since then, with the establishment of a bond market in 2007, a trade settlement scheme in 2009 and the growth of offshore centres in other countries. In the offshore market, the yuan floats freely, whereas in the onshore market, it is subject to a managed float. The value of the offshore yuan can therefore diverge from the value of the onshore yuan. There are channels through which arbitrage[2] pressures the CNY and CNH to converge, but this does not happen instantaneously, since the channels themselves are managed, and there are limits to the speed at which the CNY can change.
The consequence is that the use of the (offshore) renminbi is increasing rapidly, especially in Asia.
3. How do foreign investors enter mainland China?
Direct investment. On 10 March 2015, the Ministry of Commerce released the Catalogue for the Guidance of Foreign Investment which became effective on 10 April 2015. In it, industries are classified as follows:
- encouraged industries, for which the Chinese government is actively seeking foreign investments and for which investors are able to enjoy certain benefits such as tax incentives, cheaper land cost, simplified approval procedures or other favourable investment terms;
- restricted industries, for which the Chinese government intends to impose restrictions such as foreign shareholding ratio’s, limits on the operation of the company and special approvals;
- prohibited industries, in which no foreign investment is allowed;
- permitted industries, a residual category.
The 2015 Catalogue lists 349 “encouraged”, 38 “restricted” and 36 “prohibited” industries.
The Catalogue also contains rules on foreign ownership restrictions and corporate forms through which an investment must in certain cases be made (typically, an obligation to form an equity or cooperative joint venture).
Portfolio investment. Shares in Chinese companies take the form of H shares in Hong Kong and A shares in mainland China. The Qualified Foreign Institutional Investor programme, started in 2003, allocated individual foreign institutional investors a quota up to which they could invest in H shares. The Renminbi Qualified Foreign Institutional Investor programme, started in 2011, allowed access to A shares as well. The trend is towards global rather than individual quotas. As a case in point, the Hong Kong-Shanghai Stock Connect programme was instituted in 2014. This allows investors to buy a limited number of mainland stocks through their accounts in Hong Kong which are not subject to the mainland’s capital controls. The QFII and RQFII programmes are allowing more foreign institutional investors to trade on the Chinese interbank market.
4. What are China’s objectives in relation to the international use of the renminbi?
One clear objective is to get the renminbi included in the basket of currencies underpinning Special Drawing Rights. This basket is reviewed by the International Monetary Fund every five years. Currently, four currencies are in the basket: the US dollar, the Euro, the Japanese yen and the British pound. There are two criteria for inclusion: the size of exports and the ‘freely usable’ status of the currency. A freely usable currency is one that the IMF determines (i) is, in fact, widely used to make payments for international transactions and (ii) is widely traded in the principal exchange markets. Both elements under this definition, “widely used” and “widely traded,” have to be satisfied.
At the last review in 2011, China clearly met the export criterion, but was judged not to have met the freely used criterion. Whether that situation has changed is being considered by the IMF. Technical analysis alone will not determine the outcome. It ultimately requires judgement by the IMF’s Executive Board, which means that political considerations will play a part. Expect searches for leverage and smoke-filled rooms. Special Drawing Rights do not play a very large role in the international finance system, but inclusion of the renminbi in the basket will serve as a wider stamp of approval for the currency as well as help confirm China’s emerging superpower status.
More generally, however, it is likely that China will retain more restrictions on capital flows than other major economies for many years and will not have full capital account convertibility. Bear in mind, too, that:
- China’s interest in foreign direct investment has been technological transfer, access to international markets and new start-ups. However, as more than one foreign investor has found to their cost, contractual issues do not play out the same way in China as in, say, the United States.
- China may well also need greater access to international capital markets for fiscal reasons.
The second brief will consider the problems in all of this, and their implications for the global economy.
Charles Simkins
Senior Researcher
charles@hsf.co.za
[1] A chain letter is a form of Ponzi scheme. The initiators gain as early participants receive payments, but as the number of letters sent out at every stage increases, later participants lose out.
[2] i.e buying the cheaper version of the currency, converting it to the more expensive version and selling it.
