China is the world’s second largest economy constituting approximately 10% of the world’s total GDP. Its current account surplus enables China to play an increasingly important role as a global lender, as well as being a major beneficiary of foreign direct investment, yet China remains a largely domestic financial system with only a partial engagement with the rest of the world. This is all set to change as China aspires to transform the renminbi (RMB) into an international currency. What are the challenges China faces upon the internationalisation of the RMB? What tools does China need in place to see this through? Will the government lessen its hold on markets so they can freely perform their roles? What future tests will confront the “Chinese Dream” of re-emergence on the international finance scene?
The SWIFT Institute called on Andrew Sheng, President of the Fung Global Institute, well known in global financial circles as a former central banker, Asian financial regulator and a commentator on global finance, to help examine these questions.
“The Renminbi Goes Out”
Dr Sheng’s central message is that China is currently in a time of transition. The Chinese financial system may be large in scale but it is still emerging and is not considered highly sophisticated. Banking still dominates, capital markets are relatively shallow, and the number of institutional investors remains relatively small.
As the “Renminbi goes out” (the Chinese government’s official title for the internationalisation of the RMB), the global market – and the domestic intermediaries of the global market – will have to undergo a major learning exercise during this transition phase. As Dr Sheng emphasises, “People tend to forget that the Chinese reforms have only existed throughout the last 30 years. Market tools and practices in America and the European countries have evolved over 200 years, and rule of law over a much longer period of time. With regard to China, nothing can be achieved over night.”
Internal tensions exist between central and local governments. Reforming the current direct taxation system into an indirect system incorporating value-added tax, for example, leads to “complications” since the bulk of tax revenue is collected centrally and expenditure made at a local level.
The Chinese banking system is also contending with how to identify, control and manage its shadow banking system. It is considered a much more rudimentary system than the West, composed of intermediary firms, trust companies and local government financing platforms all seeking ways to arbitrage within the segmented regulated system that exists today. Dr Sheng explains, “It’s a very different animal caused partly by adjustments in interest rate policies. The challenges are not trivial and the Chinese government has demonstrated a strong determination to deal with the status quo. Over the next 24 months or so we can anticipate a string of reforms. It may surprise some people – and disappoint others – but we must remember that the reforms have to be sequenced in a manner that is not always obvious to an outsider.“ When questioned on the recent movement in inter-bank interest rates, Dr Sheng regarded the situation as a positive indication that the authorities are keen to move in the direction of an open market. “Fed Chairman Bernanke did not actually adjust anything, he only talked about tapering QE and then markets reacted hugely globally. So would you be surprised if actual interest rates started moving in China and the markets wouldn’t react?”
The Four Arrows
Sheng believes that the Chinese Government needs four tools, what Abenomics call “four arrows”, in order to ease the RMB into the international financial system:
- Macroeconomic financial arrow: namely monetary policy, including interest rate policy and exchange rate policy, overseen by the central bank and regulators;
- Fiscal arrow: an overall fiscal stability is needed to help engage China on a financial basis. Advanced economies are currently facing a problem of excess debt-to-GDP ratio. The average OECD level is now just under 100% of GDP and Japan is 245% of GDP, with Italy somewhere in between. The problem is that very large debt-to-GDP ratios lead to vulnerabilities, particularly if the majority of that debt is foreign-owned. China finds itself in a position of net lender, however, refinement is still needed for the Chinese monetary and fiscal tools.
- Structural arrow: the domestic economy must fit into the global economy. Some economies are dealing with what Dr Sheng calls a “dual economy” problem: a highly tradable manufacturing sector engaging with global markets can be self-sufficient on the one hand; however the non-tradable service sector engaged in the domestic market can be extremely inefficient on the other because it is protected either by labour laws or provincial rules. The result leads to a higher domestic price tag for certain items than you would pay globally. For example, the price of imported food in China is quite high due to a lack of a refrigerated distribution system, and an Apple iPhone assembled in China will cost more in China than in the U.S. due to different profit margins and distribution systems. Dr Sheng concludes that an effective domestic distribution system is mandatory in order to hook up with the rest of the world;
- Macro-prudential framework arrow: Macro-prudential rules and capital controls need to be put in place within China, including bank regulation rules and systems for deposit insurance and financial exit and resolution mechanisms, as well as robust payment and clearing systems.
All of the above four arrows need to be refined and further deepened in China, and will take some time to develop given the sheer scale of the country and the complex challenges ahead.
Crossing the river
An interesting debate in China exists over to what extent state-owned enterprises should maintain dominance in certain sectors, and in which industries the private sector should play a larger role. When asked for his views, Dr Sheng was keen to point out that this was not an either/or game, explaining, “The debate is on the table and we won’t be able to give a definitive signal for quite some time. One must cross the river by feeling the stones. This is the signature Chinese method of experimenting with reforms and moving forward when you are more sure of whether you can move on a broad front. You reverse course when your direction is proved wrong by experience: you don’t know how deep the water is, not sure how fast the water is flowing, you feel for one stone until you are fairly certain it is stable, then you step onto the next stone before deciding on which next stone you want to cross.”
Dr Sheng pointed out that two important elements are involved in ‘crossing the river’. The first is that the Chinese economy has discovered that the ‘shore’, in the image of the advanced economies, has experienced challenges in the wake of the financial crisis, and is now wondering if it is indeed the right shore to aim for. The second is that you cannot cross a river without getting wet. Decision-making and implementation are occurring under a situation of grave uncertainty. Dr Sheng continued the analogy; “Crossing the river is always by two legs, you try to step on one stone and you have to use the other leg for the next step. In China’s case the government represents one leg, the other leg is the market. You hope that both legs will work together. If they don’t work together we will find ourselves in difficult water.”
Governments and markets actually go hand and hand, Dr Sheng insists. The more sophisticated the market, the more complex the financial regulations, overseen by a growing number of regulators in turn involving huge budgets. Chinese government expenditure in comparison to GDP is relatively small compared to advanced OECD countries (not counting Chinese state-owned enterprises). There are certain areas, he acknowledged, that only the rule of government can provide, such as sound regulation, the enforcement of the rule of law, and the provision of social security. There are, however, various economic areas involving greater complexities and these should be left to market forces. Dr Sheng concluded, “The government needs to focus on what it does well. The market needs to do the same.”
The Chinese Dream
China perceives itself as a re-emerging, rather than an emerging economy. China has an ancient culture that has gone through very long and deep cycles and is now returning to play its role on the global stage that it left soon after the 18th century.
Much talk has been made of the “Chinese Dream” put forward by President Xi Jinping in his first address to the nation as head of state. Dr Sheng admits that there are many versions of The Dream but by and large he believes it encompasses the idea of China playing a bigger role in international finance, one that sees the RMB increasing its global turnover to match the position of China’s present economic strength. As Dr Sheng states, “The Dream is really about playing its rightful role in the global community. It will be a peaceful and hopefully a contributory role.”
The challenges of achieving The Chinese Dream are not insignificant. A large percentage of China’s population still remains poor, huge demographic changes will soon occur (with them a concern that China will grow old before it grows rich), and there is expected to be an unprecedented rate of urbanisation with 1% of the population migrating to the cities each year. These challenges are met within the realities of this age of social media and China is exposing itself to the outside world meeting both converging and diverging linguistic, cultural and value differences head on. Dr Sheng reminded us, “Not only does China need to understand the world, the world needs to understand China.” The Chinese proverb, “It takes more than one cold day for a river to freeze three feet deep” perhaps best encapsulates the reality of the challenge of crossing the river ahead.