Ramaa Vasudevan
The internationalization of the Renminbi and the evolution of China’s monetary policy
August 2018 Working Paper 10/2018 Department of Economics The New School for Social Research
The views expressed herein are those of the author(s) and do not necessarily reflect the views of the New School for Social Research. © 2018 by Ramaa Vasudevan. All rights reserved. Short sections of text may be quoted without explicit permission provided that full credit is given to the source.
The internationalization of the Renminbi and the evolution of China’s monetary policy
Ramaa Vasudevan
Colorado State University
Abstract.
This paper explores the evolution of monetary policy in the context of the distinct path
China and the PBoC have adopted in fostering the international role of the renminbi. Instead of
focusing on the PBoC’s negotiation of the impossible trinity of flexible exchange rates, capital
mobility and independent monetary policy, the paper highlights the challenges the PBoC faces as it promotes the use renminbi, in international lending in particular, while simultaneously seeking to contain and discipline the inherent instability and potentially disruptive logic of finance.
JEL Code: F33, F36, G28
Keywords: China, monetary policy, internationalization of renminbi, impossible trinity
1 The Internationalization of the Renminbi and the evolution of China’s monetary policy
1. Introduction
It has been argued that China’s central bank, the People’s bank of China (PBoC) is
negotiating the impossible trinity as it pursues a policy of managing its exchange rate and using
monetary policy to steer domestic demand, while at the same time opening the door to greater
financial integration (Sen 2010, Jian et al 2011, Lo 2015). From this perspective, China’s agenda to promote greater cross-border use of renminbi - internationalize the renminbi by expanding the scope of international capital flows - is forcing China to confront this trilemma. The devaluation of the yuan in the summer of 2015 has been viewed as an acknowledgement of this trilemma.
This paper argues that the deeper challenge China faces is not the impossible trinity, but reconciling the strategy of expanding the international use of the renminbi and the role of financial markets domestically, with a policy framework that seeks to maintain a tight control on finance’s inherent instability.
The validity of the policy trilemma has been questioned, in the context of strong global financial cycles in gross capital flows and credit creation. Independent monetary policy is possible only with some degree of capital controls, so that the trilemma reduces to a dilemma
(Rey 2013). The injection of global liquidity through quantitative easing policies by the US
Federal Reserve in particular has amplified the significance of capital flows. Guofeng and
Wenzhe (2017) put forward a framework where the disproportionate influence of capital flows transforms the trilemma from an equilateral triangle to a scalene triangle. Rather than positing a choice between independent monetary policy and capital mobility as Rey (2013) does, they theorize the problem facing the PBoC as one where the dominance of capital flows makes it necessary to adopt a macro-prudential policy framework to manage capital flows, and coordinate monetary policies, as the exchange rate is made more flexible. This framework provides a rationale for the PboC’s initiatives to curb the outflow of capital since January 2016. It also
2 suggests that the PboC is negotiating a slippery path as it promotes the cross-border use of
renminbi.
Historically the international status of a currency has rested on the pivotal role of the
country in trade and in financial transactions and settlements internationally. Dominance in trade
has underpinned dominance in finance, so that the key currency status does not depend on the
country maintaining a current account surplus but rather on the openness, and liquidity of its
financial markets. The convertibility of the currency and the ease of capital flows across the
issuing country’s borders is crucial to the establishment of international key currency status.
The experimental, pragmatic approach followed by China has been described as ‘crossing the river by feeling the stones’, borrowing from Deng Xiaoping (Subacchi 2016)1. There are a few noteworthy aspects to China’s initiatives to internationalize renminbi.
First, the Chinese state has launched the move to internationalize the renminbi, ahead of the complete opening and liberalizing of its capital account, while its financial sector is in a transitional stage of development (Prasad 2016, McCauley 2011). China’s dominance in trade is not matched by its dominance in financial markets. Its currency does not enjoy global acceptance commensurate with its role in global trade. As a result it has faced the ‘conflicted virtue’ of being a surplus country that cannot lend in its own currency but is forced to lend in dollars. McKinnon and Schnabl (2014, 3) cautioned that, “given China’s role of an immature international creditor, today, exchange rate stability against the dollar, exchange controls on financial inflows, and some repression in interest rates on RMB assets is a better choice than full financial liberalization” (p
3). But China has chosen to push forward with the internationalization of the renminbi and this commitment has propelled it forward with the gradual liberalization of its capital account. The drive towards internationalization is seen as a lever in pushing for liberalization of the financial market and ensuring China’s evolution to a mature creditor that can lend in its own currency (Lo
2016) rather than the outcome of the development of financial sector itself. The off-shore
3 renminbi market was established by the Chinese state as a means of arms-length liberalization of
the capital account, allowing it some measure of control over the pace of capital account
liberalization.
Second, while the state and the central banks have historically been critical to the rise of both the
pound sterling and the dollar as dominant international currencies, the ascendance to dominance
has been in response to the development of the financial sector. Both the Bank of England and the
Federal Reserve promoted the international status of their currencies in response to the interests and demands of the private bankers and financiers who sought to compete and prevail in the international financial market. The role of the Bank of England in underwriting and discounting sterling bills, and its active interventions in the money market were crucial to promoting the
international market for sterling bills. Similarly, the founding of the Federal Reserve (Fed) with
the authority to discount trade bills and acceptances was supported and advocated by New York
bankers because this would buttress their capacity to compete with London discount houses in the
international financial market (Broz, 1997). In fact, Eichengreen and Flandreau (2012) show that
through the 1920’s, purchases by the Federal Reserve were critical in nurturing the global reach
of New York banks in this market, at a stage when the secondary market for acceptances was still
under-developed. They also point to the dilemma the Federal Reserve faced with the onset of the
Great Depression when it had to choose between defending its exchange rate peg and supporting
the nascent market for bills and acceptances. It chose to withdraw, exacerbating the decline in this
market. Chitu et al (2010) in a parallel study underscore that financial deepening was the most
important factor behind the ascent of the US dollar in the international sovereign bond market
between 1918-1932, before the collapse of the banking system led to the shrinking of the US share in this market. What is different in China’s evolution is that the state is attempting to forge and manage the international role of renminbi, while the domestic financial market is still relatively under-developed, strongly dominated by state institutions, and also relatively insulated
4 from international markets. The impetus for expanding the international usage of the renminbi is
for the strategic purpose of getting out of the strait-jacket of the ‘immature creditor’, and the
shadow of dependence on the dollar, rather than as a response to global ambitions of the financial
institutions. In that sense, it is a state-led strategy rather than a state-supported one. China is
distinct, in that internationalization of the currency is being pushed as a national policy objective
as a means to escape the dollar trap rather than as part of the financial sectors drive for a global
presence (Yu 2014). The state-managed flows of renminbi through the off-shore renminbi market
in Hong-Kong is also unprecedented (McCauley 2011, He and McCauley 2010). The off-shore
Eurodollar markets in contrast arose as a result of the actions of private British and US banks and not any official policy of the US state.
Third, the pursuit of internationalization of the renminbi is occurring at a time when
China is also attempting to reorient its economy from a dependence on investment and exports to domestic consumption and services. In pursuing the latter goal the PBoC would favor selectively targeting the priority sectors with the purpose of steering the economy. However, the imperatives of internationalizing have tended to propel the PBoC towards relinquishing such directed, allocative policies in favor of a policy that promotes the development and liberalization of the financial sector and financial markets. Epstein (2007, 2013) had pointed out that even central banks like Bank of England and the Federal Reserve that are regarded as ‘macro-oriented’ banks, selectively targeted and promoted the development and internationalization of the financial sector during the classical liberal period. But central bank policy supporting and facilitating the financing of real investment and the building of productive capacity in targeted sectors has very distinct implications from central bank policy that serves to promote the interests of the financial sector as an end in itself. China, after a period of ‘financial repression’ (Mckinnon and Schnabl
2014) that underwrote its economic transformation, has successively dismantled the regime of credit controls and administered interest rates, in order to develop and reform its financial sector
5 in alignment with the objectives of greater financial integration and facilitating the international
use of its currency. However, the PBoC has not yet abandoned its role in steering the economy
and remains active in directing the flow of credit to priority sectors. More significant, while the
Bank of England and the Federal Reserve, in their role in promoting and establishing the
international presence of their financial sector, also helped secure the dominance of finance, the
PBoC agenda of expanding the international usage of the renminbi, and develop its financial
sector seeks to maintain a secure rein over financial sector and ensure that finance serves in the
interests of national priorities.
In this paper, I explore the evolution of monetary policy in the context of the distinct path
China and the PBoC have adopted in fostering the international role of the renminbi. Instead of
focusing on the PBoC’s negotiation of the impossible trinity of flexible exchange rates, capital
mobility and independent monetary policy, the paper highlights the challenges the PBoC faces as
it promotes the use renminbi, in international lending in particular, while simultaneously seeking
to contain and discipline the inherent instability and potentially disruptive logic of finance.
To understand the challenge China faces, we focus on the actions, strategic imperatives
and constraints China’s central bank faces as it pushes the agenda of internationalization. We
begin (Section 2) by highlighting the importance of official reserve holdings (largely US treasury bills) in the balance sheet of the PBoC and the implications of this for China’s balance of payments position. PBoC interventions in the foreign exchange market are a critical determinant of domestic liquidity and money-creation. Despite having persistent balance of payments surpluses and a growing (positive) net international investment position, China displays a pattern of net investment income outflows. This reflects the lower return on in its foreign assets (largely
US treasuries) relative to its foreign liabilities. This outflow thus represents the cost China bears for holding US treasuries and underwriting USA’s role in creating global liquidity. The PBoC balance sheet and China’s balance of payments mirror that of the Fed and USA, and reflect the
6 subordinate position of China in the global monetary hierarchy and the constraints this position imposes for China’s pursuit of independent monetary policy. The next sections (3 and 4) briefly outline the pincer effect of a surge in credit and a reversal of capital outflows and its implications for the PBoC balance sheet. Faced with the double imperatives of preventing excessive volatility of the exchange rate and supporting the financial market through financial turbulence, the PBoC drew down its foreign exchange reserves to bolster the financial system. It also introduced a host of measures to curb the outflows. Crucial to this is the development of the tools and instruments to manage credit creation domestically, while controlling the outflows of capital, in the context of a growing and more globally integrated financial sector. A greater capacity to lend in in its own currency, would allow China to address this constraint. To achieve this China needs to foster the growth of a global market for short-term renminbi liabilities. Section 5 and 6 explores the evolution of China’s monetary policy, and the developments on the path to internationalization of the renminbi respectively, and elaborates the critical constraints and challenges China faces. The problem it faces are not simply that of negotiating the impossible trinity, or of a vexed passage from ‘command to market’ but rather the outcome of its attempt to step out of the shadow of the
US and forge an independent global role for the renminbi, while trying to assert a strong control on the contours of its developing financial sector. The Chinese experiment is in a sense a test of the limits of the capacity of the state to tame finance.
2. Central Banks and Key Currencies
The contrasting balance sheets of People’s Bank of China (PboC) the US Federal Reserve
(Fed) highlight the critical problem that confounds China’s attempt to manoeuver its economy out from under dollar hegemony.
The PBOC ‘s balance sheet is dominated by the growth of foreign reserve assets as a consequence of its export-led model of development and its maintenance of the dollar peg.
Foreign Exchange holdings rose from 43% in 2002 to a peak 84% in 2014, before falling to 71 %
7 in 2016. The PBoC creates reserves against these dollar reserve assets, fuelling monetary
liquidity.
Given the paucity of Central Government bonds, the PboC began issuing special bonds to
sterilize the potential impact of this build-up of bank reserve deposits on credit creation, in 2003.
After peaking in 2008, the issuance of such sterilization bonds has dwindled since 2012 and issuance was stopped in 2013, possibly due to concerns about the costs of sterilization and the need to curb lending following the renewed surge in foreign reserve accumulation after the US financial crisis (Ma et al 2011). Since the crisis, the PboC favored the use the required reserve
ratio as a sterilization tool, compelling banks to raise the amount of reserves they hold, against
deposits2. Thus, the counterpart for the rise in foreign asset holdings is the growth of bank reserves deposits. The share of bank reserve deposits in the PBoC portfolio grew from 46% in
2002 to about 66% in 2016. Instead of drawing down on domestic assets on it balance sheets, the
PBoC expanded its liabilities in response to foreign reserve accumulation. The low return on required reserves did, however, impose a burden on the banking system. This burden depends on the scale of the banking system, the spread between the rates of return on excess reserves and prevailing interest rates and the level of the required reserve ratio (Ma et al 2012).
Figure 1a and 1b here
The balance sheet of the PBoC is, in a sense, a mirror of that of the US Federal Reserve
(Fed). The Fed’s assets (Figure 2a) are largely in the form of US treasury holdings. Since the crisis the asset holdings have expanded to a wider range of asset holdings and securities as it took on the mantle of becoming dealer of last resort, buying and lending against a wider range of assets with Quantitative Easing (Mehrling 2010). This expansion of the Fed’s balance sheet has been financed by a growth of reserve balances and borrowing from the treasury (Figure 2b).
(Figure 2a, 2b here)
8 The key difference is that the PBoC saw its balance sheet expand as a result of foreign asset accumulation in service of the soft dollar peg, while the expansion of the balance sheet of the Fed took place in the context of its actions to provide a backstop to the global financial markets. There has been a broader pattern of expanding central bank balance sheets as the
European Central Bank, the Bank of England and the Bank of Japan resorted to quantitative easing on one hand, and on the other, countries in emerging Asia also saw their central bank balance sheets rise due to the accumulation of foreign exchange reserves as a result of the global financial cycle. But the surge in China, is significantly sharper than other countries in the region and the bulk of these reserves are in the form of dollar reserves3.
(Figure 3 here)
This pattern is explicable in terms of the balance of payments position of China. China
has enjoyed a surplus on both its current account and the non-reserve portion of its financial
account through most of the period from 1994 to 2014 leading to the stockpile of official reserve
assets in the PBoC balance sheet (Figure 3). China thus enjoyed a positive net international
investment position. However, China faced net outflows of investment incomes (Figure 3) despite
the growing cumulative current account balance and accumulating net foreign assets. Drawing
on Hausman and Sturzenegger’s (2006) dark matter metaphor, Yu (2017) characterizes this
‘irrational’ pattern as an import of ‘dark matter’ by China, corresponding to USA’s export of
‘dark matter’. It represents the cost China pays for underwriting USA’s role as the key provider of global liquidity.
The ‘sovereign’ status of renminbi and the fact that China does not face the original sin of
issuing debt in a foreign currency, is not enough to guarantee greater ‘policy space’ (through
fiscal reforms more narrowly) for PboC and the Chinese state, as argued by Liu and Wray (2016).
This is because liquidity creation in China, in contrast to USA in particular, remains tied to the foreign exchange interventions of the PBoC. The global financial crisis underscored the urgent
9 need to address the stockpile of official reserves denominated in dollars. This imperative is a key
factor behind the policy initiatives to expand the international role of renminbi (Yu 2012, 2014).
In the absence of wide and liquid private markets for RMB denominated financial assets the PBoC acts as ‘the lender of first resort’, absorbing the brunt of foreign exchange risk associated with the growing dollar exposure due to the current account surplus and capital inflows
(Berne et al 2016). The asymmetric influence US policy rates on the conduct of monetary policy by the PBoC since 2002 (Girardin et al 2017), also derives from the limited role and subordinate status of renminbi assets in the international financial markets4. The PBoC has stressed the need
to extend the international use of the renminbi beyond trade settlement to the international capital
markets in order to broaden the scope for independent monetary policy as it navigates the policy
trilemma. Through its reforms, China is undertaking to develop its money and capital markets,
while continuing to channel the growth of the financial sector and harness this growth in service
of the developmental priorities (Xiachuan 2012, Xiaolian, H 2012)5. The extraordinary expansion
of scale and complexity of the global financial system, and its resurgence after the global
financial crisis makes the challenge even more formidable (Berne et al 2014).
3. The Growth of Credit, Shadow Lending and Financial Fragility
The analysis of the PBoC balance sheet, in the previous section, highlights two concerns.
First, the foreign exchange interventions of the PBoC imply that the PBoC bears the bulk of foreign exchange risk. Second, the PBoC has been financing this build-up of foreign exchange assets by expanding its liabilities, creating an overhang of liquidity. The problem for the PBoC is not just the prospect of a dollar devaluation that undermines its asset base. It is also, that the expansion of its balance sheet fuels a credit boom.
The credit regime in China has been characterized a system of controlled lending and deposit rates and targeted credit to ensure cheap financing of investment projects in priority sectors. Four large state-owned commercial banks, and three policy banks have dominated the banking sector
10 (which also comprises large joint stock commercial banks, smaller urban commercial banks and
rural credit cooperatives) and provided loans at low rates to large state-owned enterprises. Thus the large banks were able to corner the large low- cost deposit base and fund low-risk state
enterprises. Small and medium private enterprises did not enjoy the same access to bank credit
(Subacchi 2016, Lo 2016).
The regime of controlled exchange rates, deposit rates and lending rates has helped
promote the accumulation of reserves, the growth of shadow banking and the expansion of bank
credit. About 30 percent of credit was channeled through the shadow banking system (defined
here as channels of lending other than bank loans) in 2016, compared to 9 percent in 2002. The
shadow banking system grew more than fourfold between 2009-2016 (Figure 4). Lending through
the shadow banking system grew from about 11 percent of GDP to nearly 61 percent of GDP in
2016, while bank loan lending grew from about 117 percent of GDP to 145 percent of GDP in the
same period (Figure 5).
(Figure 4 and 5 here)
The investment demand created by the $586 billion (4 trillion RMB) stimulus package
that China launched in response to the onset of global financial crisis, alongside the rapid
accumulation of foreign reserves in the context of current account surpluses and capital inflows,
created a huge demand for credit. Given the constraints of the credit regime, and the high cost
burden the required reserve ratio imposed on the banking system, this demand led to a rapid
growth in credit through the shadow banking system rather than traditional lending6.
In response to the growth in demand following the stimulus package, commercial banks started to move financial intermediation off their balance sheets by setting up trust companies and through instruments like entrusted loans, wealth-management products, trust beneficiary rights, and directional asset management plans. A major plank of the stimulus was bank lending to local governments. Local governments could not borrow directly from banks and were barred from
11 issuing bonds under 1994 fiscal reforms, and thus began to borrow through local government
financial vehicles (LGFVs) that used the collateral of land and allowed local governments to pre- empt these constraints and borrow off-balance sheet from the state-owned banks. In 2014, LGFVs
debt peaked at 14 percent of GDP (IMF 2017, Appendix Table 6). The trusts channeled funds
from retail and institutional investors towards small and medium private enterprises or municipal
industrial projects that do not enjoy easy access to bank loans. Entrusted loans allowed companies
to lend to each other through intermediating banks. Wealth management products provided high-
return alternatives to deposits, attracting funds from the wealthier depositors.
The shadow banking system served as an alternative channel through which the demand
for financing could be met, pre-empting state control of credit channels and facilitating the
intermediation of savings to private firms with less access bank loans (Ehlers et al 2018). It was,
in a sense, liberalization by stealth (Lo 2016) independent of the design of policy makers. What
is noteworthy, however, is that state-dominated commercial banks, including the smaller joint
stock and urban commercial banks play a dominant role in the shadow banking, and are in effect
acting as guarantors of unregulated credit their shadow (Ehlers et al 2018). Further, unlike
shadow banking in the USA and Europe, securitization and market-based instruments have played a relatively limited role in China’s shadow bank channels (Ehlers et al 2018). While shadow banking in China is taking more complex and structured forms (in particular with reclassification of loans as investment receivables), it had not initially developed on the basis of the proliferation of complex tradable securities but primarily through the growth channels and
instruments of credit beyond bank loans. There has been, however, a shift in the pattern of
shadow banking from providing funding to sectors that have less access to bank loans, to being
driven increasingly by the demand for high-yield financial instruments (Ehlers et al 2018). The
recent introduction of structured instruments based on the collateralization of bank loans, and the
IMF promoted moves towards securitization of non-performing loans have led to an increase in
12 the share of tradable securities in the total social financing. These developments are bringing the
China’s distinctive shadow banking system closer to shadow banking in USA and Europe.
However, the relative insulation of these markets from global financial markets implies that the price of funding and lending is determined domestically.
While the growth of shadow banking has broadened financial channels and reduced dependence on traditional bank-loans, it has also undermined the mechanisms by which the state
set investment priorities. Further, the sharp growth in shadow credit with lower prudential
standards, safety margins and less stringent regulation, alongside the implicit guarantees of the
state or the big banks, has fueled speculative activity (Elliott and Qiao 2015, Elliot et al 2015)7.
The surge in shadow banking system fueled the property boom. About 45 percent of debt
(excluding debt of the financial sector) went to real estate and related industries (McKinsey
2014). As the Chinese government clamped down on the heavy exposure to real estate, the trusts shifted to investing in the capital market and over the counter instruments, stoking the stock market bubble in 2015. The PBoC responded by launching a barrage of measures to prevent the collapse of the stock market and quell the resurgence of a bubble.8 Since then, the surge of
corporate debt, which rose from 73 percent of GDP in 2014 to 129 percent of GDP in 2016, has
emerged as a new source of fragility (IMF 2016, IMF 2017).
The financial turmoil that has beset China since the summer of 2015, highlights the
dilemma the PBoC faces, as its commitment to fostering the development of broader channels of credit creation as part of the ongoing financial reforms threatens to erode its grip over credit creation and financial stability. With a monetary policy framework that was geared to bank lending, it had yet to develop the tools and mechanisms for controlling credit creation through the alternative channels. It responded to each outbreak of a speculative bubble by cracking down on actors and activities in the sector, while continuing to keep the overall monetary policy stance loose, so that growth and investment targets were maintained. This approach of injecting liquidity
13 to prop up the developing financial markets, while using the heavy arm of the state to contain fragility and leverage is confronting the inherent instability of finance. Even if the PBoC succeeded in containing volatility in a particular market, a new site of speculative flare-up has emerged, demanding new interventions.
4. Capital Outflows and Falling Reserves
While the high domestic savings rate, low external debt and current account surpluses did reduce the China’s vulnerabilities on account of the credit bubble (IMF 2017) the crucial role of foreign exchange interventions in liquidity generation by the PBoC, had implications for the
PBoC response to the financial turmoil. In the absence of domestic assets to back liquidity creation, the PBoC drew down its foreign exchange assets to prop up the financial market and inject liquidity. The running down of PBoC foreign reserves was compounded by the reversal of capital flows in 2014 (Figure 5). The rise in foreign direct investment and portfolio flows both reversed after 2013, with the latter displaying a sharper reversal. The sharpest reversal and surge in outflows was in Other Direct Investment, which includes items like loans, currency and deposits and trade credits.
This shift in pattern reflects the increase in Chinese investments abroad, which was led by the drive for mergers and acquisitions abroad as Chinese companies expand globally, and by the appetite of Chinese citizens for acquiring property and real estate overseas. A significant role has also have been played by changes in lending, trade financing, cash management practices
(Wildau 2016b). There has been a reduction in foreign currency borrowing by the Chinese state controlled corporations, and a parallel trend in redeeming foreign currency loans (McCauley 2015
McCauley and Shu 2016). The incentives for holding long-renminbi, short-dollar positions waned and foreign currency liabilities that had been built up in the context of expectations of renminbi appreciation were wound down.
14 As long as expectations of renminbi appreciation had prevailed, cross-border renminbi deposits (on account of trade settlement) grew, in response to the incentives for settlement of imports through offshore renminbi accounts. A larger share of imports was settled in renminbi compared to exports, promoting the growth of offshore renminbi deposits and also, as a consequence, the build-up of foreign exchange reserves with the PBoC (Yu 2012, Yu 2014,
McCauley and Ma 2014, Nixon et al 2015). The accumulation of offshore renminbi deposits, which had been driven largely by the incentives of arbitraging renminbi appreciation, also reversed with the expectation of depreciation, further contributing to the outflow (McCauley and
Shu 2016). To the extent that the outflow has been fueled by Chinese residents seeking investment opportunities abroad or desiring to reduce their foreign currency liabilities, and not by foreign investors fleeing; the capital outflow is by itself not a cause for concern (McCauley 2015)
It is also a part of the dynamics of ‘liberalization’ and internationalization that China has been pursuing.
However, China’s balance of payment also displays another curious feature (Figure 6).
Since 2010 China’s NIIP position has diverged significantly from its cumulative current account balance. Between 2016 and 2010, net foreign asset accumulation represented by China’s cumulative current account balance was about 1.24 trillion USD. In the same period the net foreign asset accumulation represented by NIIP accumulated 112 billion USD. This is a contrast to the period between 2005 to 2010 when the cumulative current account balances grew by 1.48 trillion USD compared to a 1.28 trillion USD increase in the NIIP. While discrepancies between the NIIP and the cumulative balances can be ascribed to valuation changes and statistical errors and omissions, Yu (2017) suggests that this huge gap represents non-official foreign assets accumulation that have failed to appear in the NIIP - including activities like unwinding carry trade and capital outflows which increase the deficit on the financial account (excluding reserves) without leading to an increase in assets or a decrease in liabilities. The gap reflects the increased
15 importance of non-official foreign assets held privately, relative to official reserve holdings held
by the PBoC, in China’s international position, along with the leakage of some of these assets out
of China. The sharp (negative) rise in the errors and omissions term in China’s balance of
payments (Figure 5) is another indicator of unregistered outflows.
In so far as the outflows reflect such leakages, they do not constitute a strengthening of
China’s position as a net renminbi lender. A deficit on the financial account, and the provision of
offsetting capital flows is key for country that provides global liquidity. While private capital
flows have played a critical role in supporting the dollar’s role in global liquidity creation, these non-officials outflows, which reflect arbitrage operations (Yu 2014, Yu 2017), do not represent an increase in the provision of renminbi liquidity, globally. On the contrary, this highlights the
challenge that China and the PBoC faces on the path to internationalizing the renminbi.
One implication of the outflows is that China ended its long run of accumulation of
foreign exchange reserves (Figure 5). Its reserves fell from a peak of nearly 4 trillion USD in June
2014 to a below 3 trillion USD in January 2017, before rising slightly to 3.1 trillion USD in
December 2017 (Figure 7).
The persistent outflows of capital through 2016 set in motion various forms of capital
controls to stem the efflux. Stricter rules and tighter approvals for foreign acquisitions, and
restrictions on foreign exchange conversions for the purposes of purchase of property,
entertainment and sports assets, certain types of securities or insurance products were put in
place, in what could be viewed as a retreat from the liberalization agenda (Wildau 2016a). The
institution of capital controls and a macro-prudential policy framework to curb financial
instability are in line with the functional approach that has characterized the agenda to expand the
international status of the renminbi. They signify that China’s road-map to internationalizing
renminbi is a work-in-progress that is adapting to unfolding developments both domestically and
globally. But in order to further the agenda of integrating into the evolving global financial
16 system, while protecting the space to use monetary policy towards developmental priorities, the
PBoC has to establish its capacity to independently manage and calibrate credit flows in globally
integrated markets. The contrast of the PBoC balance sheet with that of the Federal Reserve
underscores the fundamental asymmetry in the manner of China’s integration and the particular
constraints that the PBoC has to contend with in this path.
(Figure 6,7,8 here)
5. The evolution of monetary policy
The US Fed expanded its balance sheet to restore the financial system after the crash of
Lehman in 2008. The expansion of the Fed’s balance sheet was buttressed by Fed borrowings from the US Treasury. However, the wide and liquid international market for US treasuries was critical to this expansion of US public debt. This led to global spillovers of liquidity.
The expanding balance sheets of PBoC was the result of both this build-up of liquidity
and the massive stimulus package it launched in response to the crisis. The accumulation of
reserves helped fuel the growth of credit and the build-up financial fragility. The PBoC had taken
foreign exchange risk on to its balance sheet with the accumulation of foreign reserves. Managing
financial fragility, however, depends on its ability to absorb credit risk from its rapidly growing
financial sector. In contrast to the US Fed that expanded its borrowings in response to the
financial crisis, the PBoC initially reduced its balance sheet as it ran down its foreign reserves to
prop up the financial markets following the bursting of the credit bubble. This is because
renminbi does not enjoy the same privileged status as the dollar, which is a dominant key
international currency. There was no corresponding liquid market for renminbi assets, either
domestically or globally. The constraint is not the ability to issue its own liability, but more
fundamentally to issue a liability that is widely demanded and traded.
17 The gradual liberalization of the exchange rate9 and interest rate regime10 in China reflect the
evolution of PBoC’s policy as it negotiates its way through the changing financial landscape of the post-crisis world. But the reform of the interest rate regime involves both “the establishment of a robust private system of liquidity creation through money markets, and a change in the flows of liquidity through the financial system and beyond” (Neilson 2016, 6).
Girardin et al (2017) demarcate two distinct monetary policy regimes in China in the recent decades. The period after the sharp devaluation in 1994 until the accession to the World Trade
Organization in 2001 is marked by an expansionary, inflation-accommodating regime characterized by large, infrequent policy interventions. The subsequent period with the large balance of payments surpluses and foreign exchange inflows is seen to display a more contractionary, anti-inflationary approach, with more frequent, smaller interventions. External factors driven by the US federal funds rate also exercised a greater impact in this period.
The decline of foreign exchange reserves and the reversal of capital flows since 2013 has, signaled a new stage in the evolution of monetary policy. The capital outflows posed a challenge to the ability of the PBoC to manage liquidity and credit creation in the context of the developments in the financial sector. To pursue the agenda of establishing monetary policy autonomy, the PBoC had to develop its capacity to control and calibrate credit creation in the broader financial markets.
The PBoC introduced new tools to inject liquidity after 2013, in the wake of ‘unstable external conditions and volatility in capital flows’ that were confounding the provision of short term liquidity through the money markets. These innovations were instituted to increase the effectiveness of monetary policy and address volatility in short term money markets on a discretionary basis (Monetary Analysis Group 2013). The Short-Term Liquidity Operation
(SLO) was introduced in 2013, to provide direct credit to selected banks (primary dealers) for upto 7 days. The PBoC also began to inject liquidity through a variety of other new facilities
18 through which it could lend to a wider range of banks and financial institutions, against highly
rated financial assets (mainly central government, policy bank and state-owned enterprise bonds).
This includes the Standing Lending Facility (SLF) to provide loans for up to 3 months and the
Medium-Term Lending Facility (MLF) to provide loans for up to one year. It also set up the
Pledged Supplementary Lending Facility, to provide long-term loans of up to a few years to policy banks (the China Development bank and the Agricultural Development Bank), in order to support lending to priority sectors11.
These new tools provided a backstop against a monetary tightening due to the fall in foreign exchange reserves. These injections of liquidity were effected, by expanding its reserve money base without any foreign exchange interventions. The expansion in PBoC balance sheet after 2013 occurs through an expansion in claims on other depository and financial institutions, which grew by 190 percent between December 2013 and December 2016), even as foreign reserve holdings declined (Figure 1a). The Supplementary Facility, in particular, is also a means to reassert control over the sectoral flow of credit through targeted monetary easing that directed credit to priority sectors like social housing, agriculture small and medium companies and infrastructure, while avoiding a more broad-based injection of liquidity (Lo 2016). The PBoC is
thus attempting to regain the control over the excessive build-up of debt through both the banking
and shadow banking system through these facilities (Lo 2016).
PBoC also increased its recourse to open-market operations (OMO’s), instead of the required reserve ratio, to provide offsetting liquidity injections. Open market operations went from being conducted twice a week to daily interventions in February 2016. Unlike the earlier operations in PBoC bills, which were geared towards sterilizing foreign exchange inflows, the open market operations have been employed in this period is as an active monetary policy tool.
The open market operations of the PBoC are dominated by repos in the interbank market. Wholesale funding through the interbank market has emerged as an important source of
19 short-term liquidity in China (Xu 2007, Thurston 2007, Shevlin and Wu 2015, Shevlin and
Wang 2015, Borst 2016) and a critical channel for transmission of monetary policy through the money markets (Neilson 2016, Kendal and Lees 2016). Compared to the interbank lending market, which was more restricted and primarily meant to settle temporary shortfalls in the accounts of banks, the interbank repo market is open to a wider range of institutions, including
trusts, pension funds, and subsidiaries of non-financial entities (Thurston 2007, Porter and Xu
2009, Neilson 2016). Large state owned commercial banks, which held the bulk of deposits, have
been the main lenders, while smaller banks, including urban commercial banks have been the
main borrowers (Xu 2007, Borst 2016, Kendal and Lees 2016). This pattern of a one-way flow
has been a key issue for the growing market and also impeded the functioning of the interest
formation mechanisms (Xu 2007).
While the growth of the repo markets is in line with financial reforms that aligns China’s
monetary system more closely with that of advanced capitalist countries, two features of the
interbank repo market distinguishes it from the repo markets in USA and Europe, in particular
(Shevlin and Wang 2015). First, the bulk of the transactions are ‘pledged repos’ where the
collateral offered cannot be rehypothecated. Second, transactions do not involve the collateral
valuation mechanisms of collateral assets based on marking to market and margin requirements
that render these markets particularly susceptible to fragility (Gabor and Vestergaard 2016).
There have however been some new trends observed in the inter-bank repo market. One
development is that policy banks have also begun to increase the pace of lending in this market
supported by their greater access to funds through bond issuance, and through the Pledged
Supplementary Lending Facility (Kendall and Lees 2016). On the borrowing side, asset
managers (including securities companies, and non-bank financial institutions) have also stepped
up their transactions in the inter-bank repo markets and account for a significant share of
borrowing. While the repo market is a critical tool for liquidity management, it has increasingly
20 come to be used to fund bond carry-trade, with asset managers funding bond purchases by borrowing through short-term repo transactions, and making profits from the spread between the yields on short-term repos and long-term bonds purchased (Borst 2016, and Kendall and Lees
2016). At the same time, informal repo agreements (called dai chi) that are transacted outside the interbank market also gained ground and are by some estimates twice as large as the formal interbank repo market (Kendall and Lees 2016). In response to the build-up of risk and volatility in the financial system, the PBoC moved from biweekly to daily open market operations and also extended its open market operations to 14 and 28 day repos in 2016, as part of its effort to manage liquidity more actively.
What is emerging from the PBoC’s approach is the gradual implementation of an ‘interest corridor system’ (IMF 2016, 2017, Monetary Analysis Group 2016, 2017, Guofeng 2015). The rate at which the PBoC lends through its Standing Lending Facilities, and Medium Lending
Facilities are emerging as the upper bound of the corridor, while the rate it offers on excess reserves sets the lower bound. The PBoC is moving towards a system, where it uses its short-term repo rates and the Standing Lending Facility (SLF) to calibrate short-term market rates (the seven-day inter-bank repo rate or the SHIBOR) while targeting the Medium-Term Lending
Facility (MLF) and Pledged Supplementary Lending (PSL) to calibrate mid- and long-term market rates (IMF 2016).
PBoC is thus adopting a two-pronged approach in its path towards establishing credit- based mechanisms of liquidity that are backed by the state rather being anchored to dollar reserves. On one hand, it has been liberalizing interest rates and diversifying the financial system, while intervening directly to calibrate liquidity creation (through relending, OMO’s and the
SLOs) and ensure financial stability by influencing the rates in inter-bank money market. As a result, the assets backing money creation by the PBoC are shifting from foreign reserves to
21 domestic assets. What is notable is that the PBoC domestic asset holdings have seen an increase
in claims on financial system rather than an increase in the government assets.
On the other hand, the PBoC is using its new lending facilities not only to lower funding
costs and manage liquidity, but also to channel credit to target sectors and curtail the financial
sector excesses that fueled the shadow banking system and the build-up of overcapacity, the
property bubble, and local government and corporate sector vulnerabilities. The relending
operations are directed at the large state-owned commercial banks and policy banks, against
backing of government bonds rather than through an increase in holdings of government bonds by
the PBoC.
However, effective calibration of the target interest rate depends on the ability of the PBoC to
be a market-maker while accommodating macroeconomic shifts and the pressures of global
integration (Neilson 2016)12. The PBoC also needs to coordinate the supply of safe assets, which
can serve as a benchmark and hedge for broader markets and provide safe collateral for money
markets. The market for central government bonds is a critical anchor for the repo market(Gabor
and Vestergaard 2016). Chinese government bonds, together with bonds issued by China’s policy
banks, account for nearly 90 per cent of repo collateral (Kendall and Lees 2016). This underscores the importance of developing the market for central government bonds, both for the evolution of China’s monetary policy and for the smooth functioning of the repo markets.
An active market in government bonds would also allow the PBoC to finance its foreign exchange holdings by the sale of liquid treasury bonds, rather than through captive, illiquid, required reserves (McCauley and Ma 2015). This would grant PBoC more space in navigating the trilemma, through a more effective management of the twin pincer of credit and exchange rate risks. The dependence on the required reserve ratio had, as we have seen, contributed to the credit boom and the build-up of foreign exchange risk on the PBoC balance sheet. Thus, the small size, fragmentation, and lack of depth and liquidity in the central government bond market constrains
22 the capacity of the PBoC to calibrate the flow of liquidity and credit through interventions in the
money market.
The total value of bonds outstanding in China was only about 47 percent of GDP in 2014
(Figure 9). While issuance was dominated by government or policy bank issued bonds13, the
investor base was dominated by the large commercial banks, policy banks and the PBoC, which held about 70 percent of the bonds, while non-bank financial institutions, insurance pensions and other funds held only 23 percent (Ma and Yao 2016). The market was also characterized by less active trade14.
Since 2014, Chinese policy makers have been consciously fostering the broader
development of the bond market to support the conduct of monetary policy, and to help establish
the international usage of renminbi as an international reserve currency. Give the relatively small
burden of central government debt, the scope for expanding the market is limited by the relatively small scale of issuance of central government bonds. The strategy of ‘closing the backdoor while opening the front door’ has led to tightening regulations on shadow banking, including LGFVs, while consciously widening access the bond market. The new budget law of 2014 that allowed local governments to issue bonds and the debt-swap program launched the same year to convert
LGFV loans into municipal bonds also provided some impetus to the issuance of local bonds. At same time, non-financial enterprises have also been pushed to finance investments directly through bonds (and equities) instead of the traditional reliance on loans. Policy banks have also been encouraged to increase their resort to bond issuance. The bond market has grown fairly rapidly, by 77 % from the end of 2014 to January 2018, and is now about 70 percent of GDP
(Figure 9). The corporate bond market grew by about 55 percent (compared to 116 percent growth in the market for government and policy bank bonds) between 2014 and 2017.
A recent development, associated with regulatory changes, is the use of bank-issued wealth management products as a channel for retail investors to invest in bond market, bypassing
23 rules that restrict market access to financial institutions, thus generating tight inter-linkages
between banks, shadow banking and the bond markets. These inter-linkages further imply that the
capacity of the bond market to diversify channels of corporate financing beyond bank credit is
circumscribed (Ehlers et al 2018). While retail investors trading stocks on margins had fueled the stock bubble, a new form of leverage based on financing bond purchases through repo transactions (bond-carry trade) has emerged. The policy-led curtailing of interest rates and
volatility in the repo market had in effect helped the further build-up of fragility through a
stepping up of such leveraged bond investments and the consequent maturity mismatch on the
balance sheets of the financial institutions (Kendall and Lees 2016). This has once again raised
the prospect of credit risk.
In response, along with the campaign to tighten supervision of shadow banking segments,
the PboC has also announced new rules to regulate bond trading as part of coordinated attack on
excessive leverage and regulatory arbitrage, slowing the growth of this market. The future of the
Chinese bond market faces the same tightrope of promoting the growth, while clamping down on
speculative tendencies that the Chinese state has faced in other financial markets.
Borio and Disyatat (2010) distinguish between two modes of implementing monetary policy:
interest policy and balance sheet policy. The development of the scale and range of financial
markets circumscribes the ability of central banks to influence the pace of credit creation, solely
through the manipulation the policy interest rate, since this rate can be associated with a wide range of monetary and credit conditions. The ‘unconventional monetary policies’ that central banks, including the Federal Reserve have deployed in the wake of the crisis, seek to impact broader financial conditions through changes in the size composition and risk profile of the central bank balance sheet. These balance sheet policies reflect the extension of foreign exchange intervention to wider class of assets and markets (Borio and Disyatat 2010, Mehrling 2016). The
PBoC is, thus, moving from a policy regime focused on direct control of interest rates governing
24 bank loans towards a policy regime where it uses its interventions in the money markets (and
forward guidance) to influence overall financial conditions, in a context where unregulated
channels of lending beyond bank loans have grown in importance in the financial system.
Alongside this development of PBoC interest rate policy, the PBoC’s has also moved from using
its balance sheet to target the exchange rate through foreign exchange interventions to actively using its balance sheet as a credit policy tool by supplying funding for specific purposes and markets. The gradual move to liberalization of the exchange rate and interest rates has opened the space for the PBoC to use its balance sheet to target domestic credit conditions rather than the
exchange rate.
However, monetary policy remains just one pillar of its policy framework. The macro-
prudential policy regime and the macro-prudential policy assessment system, is the second pillar
that works in concert with monetary policy to reduce systemic financial risks, through direct interventions in the financial system to control debt and leverage (Xiaochuan 2017, PBoC 2017).
China’s recent experience with the dealing with the rapid growth of its financial sector is evidence that the growth of credit, even in a system dominated by state controlled financial institutions, remains prone to instability. Controlling speculative impulse has demanded more aggressive measures than policy induced deleveraging15. China has recently launched the
Financial Stability and Development Committee to monitor system risk and oversee financial reforms. The need for the strong arm of the state to contain the unruly impulses of finance, however, poses a constraint to the agenda of internationalization and the fostering of borrowing and lending in renminbi by non-Chinese overseas investors.
6. Internationalizing the Renminbi
China’s strategic push to promote the use of renminbi internationally has had an impact establishing an international presence for the renminbi. The share of renminbi in average daily turnover (on a net-net basis adjusted for cross-border interdealer double counting) of foreign
25 exchange instruments rose from 0.5 percent in 2007 at the onset of the global financial crisis, to
3.9 percent (rising to rank 8) in 2016 (BIS 2017). The renminbi has risen from being ranked at
20th to being the 8th, in terms of average daily turnover in this period. However, the renminbi continues to be dwarfed by the dollar, which comprises 88 percent of average daily turnover of foreign exchange transactions. The average daily turnover of renminbi instruments stands at 4.5 percent of average daily turnover of US dollars, globally. The SWIFT (2018) report on cross- border payments reveals the same story. The renminbi was propelled from being 20th most-used currency for cross-border payments at the start of 2012, to rise to fifth place in December 2015.
But following the restrictions on capital outflows and depreciation pressures, its share fell from
2.38 percent in December 2015 to 1.61 percent by December 2017 (compared to USA’s share of
41 percent). About 97 percent of renminbi trading is against the US dollar (SWIFT 2018).
The renminbi despite its rapid emergence on the global stage, thus, remains in the shadow of the US dollar. It is yet to transcend its current role as a bulwark to the global monetary system hinged around the provision of dollar liquidity, through its holding of US treasuries - the pivot of the international monetary system. It has also helped prop up the private mechanisms of dollar liquidity through the global money markets through the network of 33 bilateral swaps it established since the global financial crisis. These private mechanisms have evolved around the euro-dollar market. The swaplines set up between the consortium of six top tier central banks -
Federal Reserve, European Central Bank, Bank of Japan, Bank of England, Swiss National Bank,
and Bank of Canada (the C-6) were critical to restoring global dollar liquidity after the global
financial crisis and the institutionalization of this arrangement serves as a backstop to
international euro-dollar money markets in the post crisis monetary system (Mehrling 2015). Five
of the PBoC’s swaplines link it to the C-6 (other than the US Federal Reserve). The remaining
swaplines allow China to engage in local currency swaps with central banks of trading partners,
26 thus providing a backstop to their holdings of international reserves and form another rung in the
institutional hierarchy of global money (Mehrling 2015).
In the present era of financial globalization, the establishment of global dominance of a nation’s currency requires the establishment of the currency as a vehicle for funding the globally linked money markets. For the renminbi this would hinge on establishing the role of PBoC as the
backstop of international money markets and the provision of a renminbi denominated safe asset
globally. In attempting to transform China’s subordinate position in the hierarchy of global
money markets, by easing access to foreign investors to its developing financial system, while at
the same time insulating this financial system from the pressures of the global financial cycle,
China is traversing uncharted and choppy waters.
China has been gradually opening its bond market to foreign investors in order to support the
agenda of expanding the international use of renminbi16. The gradual and selective widening of
the base of foreign investors is viewed as key to the policy of expanding the international usage
of renminbi and the emergence of China as a supplier of safe assets globally (Ma and Yao 2016).
The balance of all bonds held by foreign investors has grown in the period between 2014 and
2016, by 85 percent, however the share of foreign investors has only risen slightly from 1.8
percent to 2 percent of total bonds outstanding17. A select number of foreign reserve managers and offshore renminbi clearing and settlement banks that participate in the interbank market were also granted permission to conduct repo transactions interbank repo markets in 2015. However, access to the interbank repo market remains limited to overseas investors.
Hong Kong is the largest off shore clearing center for cross-border renminbi payments and is responsible for about 76 percent of clearing activity (SWIFT 2018). Unlike the euro-dollar market which functions as a market for ‘pure’ offshore intermediation between non-residents and a
channel for round-tripping flows by residents, the Hong Kong offshore renminbi market has
primarily served as a conduit for net renminbi borrowing flows from the rest of the world to the
27 mainland. The market has yet to evolve as a mechanism for the intermediation of renminbi flows
between overseas borrowers and lenders (He and McCauley 2012).
The issuance of dimsum bonds - renminbi denominated bonds issued in the off-shore market
- an important plank of the internationalization of the renminbi, also declined in response to curbs
of capital outflows and declining off-shore renminbi deposits and tighter monetary conditions domestically through 2016 and 2017. This again underscores the need to view the rapid growth in
renminbi use with some circumspection. To the extent to which this expansion has been fueled by
the quest for arbitrage opportunities, it does not signal the gradual ascent of renminbi as a global
safe haven.
While the recognition of renminbi as part of the basket of currencies constituting the SDR
in 2016 is an important, if symbolic milestone, China has a long way to go before it can break out
of its subordinate status in the global dollar system. This transformation would also demand a
restructuring of international monetary system that has been the lifeblood of the neoliberal period
of financial globalization As China attempts to reign in finance’s speculative impulses, it has to
contend with pressures from global finance, dominated by US and European financial institutions,
to embrace financial markets as a precondition for establishing the renminbi’s role international
status. Its gradualist path is more than ‘crossing the river by feeling the stones’. Its path also seeks
to go upstream against the current of financial globalization. Ten days after the outgoing
Governor of the PBoC Zhou Xiaochang urged an easing of capital controls and a revival of the
stalled liberalization of China’s capital account (Mitchel 2017), he warned that the excessive debt
and speculative investments were leading China towards a Minsky moment (Wildau 2017)
7. Conclusion
There is, historically, an umbilical link between the state and the banking system
(Haldane and Alessandro 2009). Central banks have evolved from being fiscal agents of the state
to becoming financiers of the last resort for the banking and financial system (Epstein 2007,
28 Goodhart 2010, Vernengo 2016)18. The huge expansion of the scale and scope of state support to the banking system through central bank lender of last resort has fueled greater risk-taking by the financial institutions and sharply bloated the costs of central bank bail-outs in a continuously growing doom loop (Haldane and Alessandro 2009). The evolution of PBoC’s role and policy interventions in the recent years is significant in this context.
There is a conscious strategy of pursuing reforms that would transform the financial landscape from one dominated by state controlled banks that channel credit from a captive deposit base to state-owned non-financial enterprises to one where other direct channels of financing and ‘multi-layered capital markets’ have developed more fully ( Xiaochuan 2017). This strategy to foster and shape the development of the financial system is guided not simply by the need to develop the financial sector to better serve the needs of the domestic economy but also more significantly to steer the position of the renminbi in the hierarchy of the global financial system.
The central bank facilities are being used to channel the growth of credit in desired directions, while money market interventions are being used to inject liquidity or push deleveraging more broadly in the non-bank loan, shadow channels of credit. However, these shadow channels have continued to depend on central bank support and implicit guarantees.
Further the deep engagement of the state and central bank has not mitigated the inherent instability of finance or quelled the impulse to evade regulatory control. These tendencies have called forth strong interventions by the state to discipline markets and institutional actors as speculative tendencies arose in one market after another. This clampdown on speculation, confounds the agenda of internationalizing the renminbi.
Money, as Mehrling (2012, 2013) stresses is inherently hierarchical and essentially hybrid. The rocky passage of the renminbi on the path to an international currency also underlines the how the status of renminbi in international financial markets remains embedded in the state
29 and central bank’s capacity to manage the wider private financial markets. The ability of the state
to control and regulate the growing financial sector is not absolute, and is being continually
tested. The reorientation of China’s monetary policy to its domestic priorities and financial
stability reflects this tension.
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37 Figure 1a PBoC Balance Sheet: Assets (RMB billion)
Figure 1b: PBoC Balance Sheet: Liabilities ( RMB billion)
Source: CEIC
38 Figure 2a: Federal Reserve Balance Sheet: Assets (USD million)
Figure 2b: Federal Reserve Balance Sheet: Liabilities (USD million)
Source: Federal Reserve
39 Figure 3: China’s Balance of payments ( USD million)
Note: Net Investment Income on (RHS) Source: CEIC Figure 4 Total Social Financing (RMB billion)
40 Source CEIC, National Bureau of Statistics
Figure 5 Bank Lending and Shadow lending as a share of GDP
Source: CEIC, National Bureau of Statistics
41 Figure 6: China: Capital Flows (USD billion)
Source: CEIC, SAFE
Figure 7: Cumulative Current Account Balance and Net International Investment position of
China (USD 100 million)CK
Source: CEIC, SAFE
42 Figure 8: The Reserve Holdings of the PBoC (USD million)
Source SAFE
Figure 9: China’s Bond Market (percent of GDP)
Source: AsiaBond
43
44 Endnotes
1 Since 2010 the renminbi, which had a negligible international presence, has made substantial gains. China has stepped up settlement of trade in renminbi and promoted trade and investment treaties in local currencies, enhancing the renminbi’s role in trade settlements. The Chinese government has also begun the process of revamping and opening its financial system and gradually liberalizing capital inflows and outflows. An important part of its strategy has been to allow freer global use of the renminbi through offshore centers, promoting liberalization and internationalization at arms-length. It has set up 17 official renminbi clearing centers that serve as hubs for provision of renminbi liquidity, globally. In particular, China has been using Hong Kong SAR, a global financial hub as a platform to launch and develop an offshore market in renminbi. Since 2009 China has set up bilateral swaplines with 33 central banks across the globe, another critical piece in the emergence of the renminbi’s international role. China has also set up an international payments infrastructure for cross border renminbi payments, the Cross-border Interbank Payments System ( CIPS ), that is parallel and independent from the SWIFT system. Prasad and Le (2012), Yu ( 2012, 2014), IMF (2015), Prasad (2016), Subacchi (2016) discuss the evolution of the international standing of renminbi. 2 The loan to deposit ratio was also used to curb bank lending, until it was scrapped in 2012 3 Between 2001 and 2011, the PBoC balance sheet grew six fold while that of central banks in the rest of emerging Asia (Hong Kong, SAR, Singapore, Philippines, Malaysia, Thailand, S. Korea, India and Indonesia together grew threefold (Filardo and Yetman 2012). 4 While USD dollar assets comprised 46 percent of international debt securities in 2014, yuan denominated assets were just 0.6 percent (IMF 2015) 5 Subacchi (2016 ) notes that there was a widespread consensus in the views of state functionaries that the financial sector should serve the real sector and not vice versa. The Monetary Analysis Group of the PBoC the PBoC emphasizes that - “based on the principle of making the financial system serve the real economy, continued efforts will be made to earnestly prevent and mitigate systemic financial risks so as to safeguard financial security and stability” (Monetary Analysis Group of the PBoC 2017, 57). 6 The burden of the RRR, estimated at 2/3 percent of GDP in 2014, had doubled from an average of about 1/3 percent in the period between 2004 and 2010 (Ma et al 2012). 7 Curbs on sales of WMPs, and stricter rules for bank involvement in entrusted loans, and prohibitions on announcements of guaranteed rates of return have been announced to quell speculative bubbles. 8 These include banning short-selling, freeze trading of shares of 50% or more listed companies, ban on sales of stocks by major owners of shares; encouraging margin trading, suspending IPOs (listed through ChiNext) to boost secondary trades, ‘encouraging’ state owned pension and sovereign wealth funds and investors to buy shares, and pledging around 20 billion USD to the China Security Fund – the channel through which PboC funded stock purchases by brokerage firms. After another slide in the market, later in 2015, another series of measures including punitive steps to target insider trading and short selling was announced. In January 2016, China resorted to the newly instituted circuit breakers two times in four days and finally abandoned the measure since it was fueling investor jitters. 9 The yuan was pegged to the dollar in 1994 when China began the process of ‘opening up’. This hard peg was critical in containing the fallout of the 1997 Asian crisis. The peg was maintained till 2005 when the PBoC gradually loosened the peg allowing movement within a 2 percent band. The major state-owned banks and other major market makers submitted their dollar exchange rates to the PBoC. The official parity was the average of the submitted rates. The Bank was responsible for maintaining the peg within 2 percent of this ‘mid-point’. On August 11 2015, the PboC announced that the new reference rate would now be set taking into account at the previous day’s closing value with the exchange rate being allowed to move within a 2 percent bank of this new benchmark on a given day. Since then there has been a continued tinkering with the formula – In December 2016 the number of currencies in the reference basket was increased from 13-24, and in February 2017 a reduction in the reference period of yuan trading against its trade-weighted basket to 15 hours was announced. On May 26 2017, in the context of growing depreciation
45 pressures, the PboC communicated another change in to the method of calculating the reference rate which now included a new counter- cyclical adjustment factor with the aim of checking volatility. In January 2018, as the depreciation expectations eased the PBoC notified financial institutions that they could now determine the adjustment for counter cyclical factors independently – a move that could reduce the significance of this factor. 10 The liberalization of the interbank lending market in 1996, with the setting up new unified China interbank offer rate (CHIBOR), followed by the liberalization of the interbank bond market can be seen as the first steps towards a more liberalized interest rate regime. The Shanghai interbank offer rate (SHIBOR), set in a manner similar to fixing of the LIBOR, was established in 2007, marking a further move towards more market- sensitive interest rates. However, while interest rates in the wholesale markets were being liberalized, since the late nineties, the PBoC continued to maintain a control over benchmark lending and deposit rates by setting floors and ceilings on the lending and deposit rates for a longer period. Since 2003 it has been easing its regime of administered rates by gradually widening the range between which the market in rates could move. In 2003 the floor on the lending rate and the ceiling were removed so that the PbOC now set the floor of the lending rate and ceiling on deposit rates. The floor on the lending rate of banks was raised in stages, until it was finally abolished in 2013. The ceiling on deposit rate in parallel manner was raised in steps and finally lifted completely in 2015. 11 There is also the Credit Asset Relending program that allows banks to refinance by collateralizing wider range of high quality assets (other than government bonds) including loans, in order to provide targeted support to agriculture, urban renewal and small businesses. 12 The widening of the spread between the PBoC seven day repo rate and the market repo rate in December, 2017 highlights the dilemma the PBoC faces (Hong 2017). The spread creates opportunities for interest arbitrage and speculative risk taking and signals the limited capacity of the PBoC to exercise control over the market rate, but withdrawing liquidity in response to the rise market rates indicates a tightening of monetary policy that contradicts the ‘neutral’ policy stance the PBoC is seeking to maintain. In the end, the PBoC raised the seven day repo rate and the rate on the medium term loan facility right after the Federal reserve raised its interest rate in December. 13 The value of all bonds outstanding was 193 percent of GDP in USA and 235 percent in Japan. The size of the market for government bonds relative to GDP were 152 percent and 71 percent respectively. The Chinese bond market, while being the third largest in absolute terms globally, ranked tenth when market size was scaled to GDP, was less than 15 percent the size the size of the US bond market and provided less than 20% total domestic financing. (Ma and Yao 2016). 14 This is evident in the low turnover ratio (Value of bonds traded / Average amount of bonds outstanding), which indicates a low frequency at which outstanding issues have been traded. In 2014 the turnover ratio for central government bonds was only about 0.7 compared to a turnover ratio of 10 in the market for US treasuries Ma and Yao 2016). 15 In September 2017 the Chinese government announced new rules tightening regulations on the large private Money Market Funds, like Alibaba group’s financial affiliate -Ant Financial’s Yu e Bao fund, so as to limit their exposure to single borrowers and assets with low credit rating. The recent probe into activities Dalian Wanda, Fosun International, HNA and Anbang, the private conglomerates spearheading the recent cross border mergers and acquisitions, followed by the detention of the head of Anbang insurance group and its takeover by the state is another case in point (Massoudi and Hornby 2017, Hancock et al 2018) 16 Foreign central banks and sovereign wealth funds had been granted access to the interbank bond market in 2015. The interbank bond market was opened in February 2016 to foreign commercial banks, insurance and securities companies and investment funds. The setting up, in July 2017, of the Bond Connect (in a similar manner to the Stock Connect) which links exchanges in Shanghai and Shenzen with that in Hongkong, allowed overseas investors to buy local debt in mainland China via Hong Kong and was aimed at widening access to this market. 17 This is based on calculations from the data available from Chinabond data base http://www.chinabond.com.cn/Channel/147253508?BBND=2015&BBYF=1&sPageType=2#. This share is significantly dwarfed by the market for US treasuries, where about 40 percent of US treasuries are held by foreigners (Ma and Yao 2016). Hong (2018) suggests that the growth of the share of foreign investors 46 may not suggest a significant increase overseas investors interest in the Chinese bond market. The 291 overseas buyers listed in 2017, 101 were overseas subsidiaries of Chinese banks and brokerages 59 are Hongkong, Taiwan and Macau banks (Hong 2018). 18 Four periods have been discerned in this evolution. The initial period where the central bank was a fiscal agent for the state (Vernego 2016) , the Victorian period of sound finance when the central bank was charged with the burden of preserving the principle of sound finance, the post-Depression period when the state exercised a strong control over the exercise of monetary policy, and the banking system and the recent neoliberal period where central bank independence and inflation targeting have been promoted as the pillars of central bank policy (Goodhart 2010 Vernego, 2016). The global financial crisis marks another break and the beginning of a new period (Borio and Dystat 2010, Mehrling 2016).
47