<b>Shyam Saran:</b> Is internationalisation of RMB stalling?

The dollar will continue to reign as China is unlikely to accept the volatility that full capital convertibility is likely to bring

On October 1 this year, the Chinese currency, Renminbi (RMB), will formally become one of the benchmark currencies included in the basket the International Monetary Fund (IMF) uses to determine the value of its Special Drawing Rights (SDR) which constitute the funds available to assist member states in managing their balance of payments. This recognition as an IMF reserve currency comes even though the RMB is not freely convertible as the other currencies in the basket, ie the US dollar, the British pound, the Euro, the Japanese yen and the Swiss franc. However, it is nevertheless a recognition of the significant strides that China has made in the internationalisation of its currency in a series of gradual steps. It is also an encouragement to it to advance further in the direction of financial reform and liberalisation. China's financial sector continues to lag behind the rapid growth of its economy, its steady globalisation and the expansion of its external economic engagement.

I have followed the progress of internationalisation of the RMB in earlier columns for Business Standard. This may be a good occasion to take stock and examine the outlook for the future.

The drivers of RMB internationalisation are:

• The expanding scale of the Chinese economy, which is now a $10-trillion economy, second only to the US, constituting 13 per cent of global GDP;
• The volume of China's external trade at $4 trillion (2015) is 11 per cent of global trade and makes the country the world's largest trading nation;
• The role of China as one of the most important destinations for foreign fund inflows as well as a source of such flows to the rest of the world; and
• The rising volume of its external assets and liabilities which now total as much as its GDP

China also seeks recognition of RMB as an international reserve currency for political reasons, befitting a country that sees itself in the same league as the US. It has long sought to reduce the salience of the dollar in the global economy and the signorial privilege this accords the US.

The internationalisation project has advanced faster in some respects but lagged in others. Today 25 per cent of China's external trade is settled in RMB. But this figures fall short of the 30 per cent planned to be achieved in 2015. RMB is still used for a fraction of the global payment for goods and services - three per cent - and RMB trades are only two per cent of global turnover in foreign exchange transactions worldwide. The RMB is now the fourth most used currency in global transactions from being seventh only a couple of years ago. The gap with the dollar, however, continues to be very wide.

Between 2005 and 2015, 17 offshore clearing banks have been authorised to engage in RMB transactions. Bilateral swap arrangements now exist with 30 foreign banks totalling $486 billion. RMB now constitutes five per cent of global foreign exchange reserves maintained by central banks.

In October 2015, China adopted the International Payment System, which has made RMB transactions and banking operations much more efficient.

China has allowed the market to play a progressively greater role in determining the RMB's rate of exchange. In 2005, a daily variation of only 0.3 per cent of the benchmark set by the People's Bank of China (PBOC) was allowed. In 2014, this range was increased to two per cent, and later, the daily benchmark was set based on the previous day's closing. However, when acute volatility hit the currency market last year the PBOC reverted to administrative controls. It is unlikely that the authorities will risk such volatility in the future. Market principles will apply within fairly narrow limits.

There has been progress in financial market reform. Interest rates both for deposits and loans have been liberalised and a deposit insurance scheme has been introduced. There has been a controlled and calibrated opening of the capital account. Under the Qualified Foreign Institutional Investor (QFII) programme, foreigners can now invest up to $5 billion in Chinese securities, up from $1 billion earlier. As of now, there are $79 billion invested in QFII by 277 entities, including eight central banks and 10 Sovereign Wealth Funds. Since 2011, foreigners can also invest offshore RMB in Chinese securities under the RQFII programme. The total funds invested under this scheme had reached $68.4 billion in 2015.

Since 2006, designated Chinese entities have also been allowed to invest funds abroad under the Qualified Domestic Institutional Investor Scheme. These entities are now 132 in number and have invested $90 billion as of November 2015. Another reform which is yet to take off is the Qualified Domestic Individual Investor scheme under which domestic investors with at least RMB 1 million in assets may invest in foreign financial products.

It is expected that the limits prescribed under these schemes will likely be relaxed further, but in careful and incremental steps.

The government announced in 2013 the setting up of the Shanghai Free Trade Zone as a pilot scheme to test out policies of capital convertibility and liberalised financial transactions. The zone applied a so-called "negative list" approach, listing activities which were prohibited or regulated, but allowing unrestricted operation by entities within the zone in respect of cross-border financial transactions. The Shanghai experiment has not been particularly successful mainly because the regulatory and legal regimes remain unclear. Three new Free Trade Zones have been established in April 2015 in the provinces of Guangdong, Fujian and the city of Tianjin for this purpose. However, even Chinese economists concede that the policies are unlikely to be applied nationwide in the foreseeable future.

There is no doubt that China's project for the internationalisation of its currency is proceeding apace but not in the critical area of capital convertibility. The IMF issues an annual report on Exchange Arrangements and Exchange Restrictions, which analyses capital convertibility against a series of benchmarks, 15 applicable to the category of capital inflows and 16 with respect to outflows. According to this report, China does not measure up against any of these benchmarks.

The RMB is likely to acquire greater salience as a currency used in trade transactions. It will also acquire more prominence as its own security and debt markets become accessible to foreign entities in measured steps. However, China's current political dispensation is unlikely to accept the inevitable volatility and unpredictability that full capital convertibility and even market determined exchange rates are likely to bring in their wake. In short, the dollar will continue to reign as a global currency.

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The writer is a former Foreign Secretary
He is currently Chairman,RIS and Senior Fellow CPR