Ramaa Vasudevan

The internationalization of the and the evolution of ’s

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 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 .

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 , the People’s (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 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 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 have historically been critical to the rise of both the

pound sterling and the dollar as dominant international , 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 -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 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 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 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 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 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 .

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 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 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 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

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.

References

Bank of International Settlement. 2017. Triennial Central Bank survey of foreign exchange and

OTC derivative markets in 2016, available at www.bis.org

Bernes, T. P. Jenkins, P.Mehrling, and D.H Neilson. 2014. China’s engagement with and

evolving international monetary system: A payments perspective. Center for International

Governance Innovation and Institute for New Economic Thinking.

Borio, C., and P. 2010. Unconventional monetary policies: an appraisal. The Manchester

School, 78, s1, 53–89.

Borst, N. 2016 The Growing importance of China’s money market. Pacific exchange blog, https://www.frbsf.org/banking/asia-program/pacific-exchange-blog/china-money-market-growth/

Federal Reserve Bank of San Fransisco,

Chitu, L, Eichengreen, B and A. Mehl 2012, When did the dollar overtake sterling as international currency? Evidence from bond markets. European Central Bank Working Paper

1433

Dobbs, R, S Lund, J Woetzel and M. Mutafchieva. 2015. Debt and not much deleveraging,

McKinsey Global Institute (http://www.mckinsey.com/global-themes/employment-and- growth/debt-and-not-much-deleveraging)

Ehlers, T. Kong S. and F Zhu. 2018. Mapping shadow banking in China: structure and dynamics.

BIS working Papers 701

30 Eichengreen B. and M. Flandreau . 2012. The Federal Reserve, The Bank of England and the rise

of the dollar as an international currency 1914-1939. Open Economies Review 23,1 57-87.

Elliott, D., Kroeber, A., and Y. Qiao. 2015. Shadow Banking in China: A primer. The Brookings

Institution, Economic Studies at Brookings. available at https://www.brookings.edu/research/shadow-banking-in-china-a-primer/

Elliot, D. and Y. Qiao. 2015 Reforming shadow banking in China The Brookings Institution,

Economic Studies at Brookings. available at https://www.brookings.edu/wp-

content/uploads/2016/06/Elliott-Shadow-Banking-2.pdf

Epstein, G. 2007. Central Banks as Agents of , in H. Chang ed

Institutional Change and Economic Development, Unite Nations University and Anthem Press,

New York 95-113.

Filarado, A. and J. Yetman, 2012 The expansion of central bank balalnce sheet in emerging Asia:

what are the risks? BIS Quarterly Review , June

Gabor D. and J. Vestergaard. Towards a theory of shadow money. INET Working paper

available at

https://www.ineteconomics.org/uploads/papers/Towards_Theory_Shadow_Money_GV_INET.pd

f

Giradin E, Lunven, S., and G. Ma. 2017. China’s evolving monetary policy rule: from inflation

accommodating to anti-inflation policy. BIS working papers No 641

Guofeng, S. 2015. Reforms in China’s monetary policy: A frontbenchers view. New York:

Palgrave Macmillan

Guofeng S. and L. Wenzhe. 2017. Monetary Policy, Exchange rate and capital flow: From

‘quadrilateral triangle’ to ‘scalene triangle’. The Peoples Bank of China Working Paper Series

2017/3.

31 Haldane A. and P Alessandri . 2009. Banking on the state, presentation delivered at the Federal

Reserve Bank of Chicago twelfth annual International Banking Conference on “The International

Financial Crisis: Have the Rules of Finance Changed?”, Chicago, 25 September 2009.

Hancock, T, Sender, H and A. Woodhouse 2018. China seizes Anbang in latest move to curb

dealmakers. Financial Times February 23.

Hausmann, R. and Sturzenegger, F. 2006 Global Imbalances or Bad Accounting? The Missing

Dark Matter in the Wealth of Nations. KSG Working Paper No. RWP06-003; Harvard CID

Working Paper No. 124. Available

at https://ssrn.com/abstract=878096 or http://dx.doi.org/10.2139/ssrn.878096

He, D .and R. McCauley 2010. Offshore markets for domestic currency: monetary and stability

issues. BIS Working Papers, no 320

He, D. and R. McCauley 2012 Eurodollar banking and currency internationalization. BIS quarterly Review June 33-46

Hong, S. 2017. Widening gap between rates is making it hard for central bank to guide the economy. Wall Street Journal, Dec 1.

Hong, S. 2018 In China, ‘foreign’ is all relative. Wall Street Journal, Jan 10.

IMF. 2015. Review of the method of valuation of the SDR. IMF policy paper. Nov 15. Available at https://www.imf.org/en/Publications/Policy-Papers/Issues/2016/12/31/Review-of-the-Method- of-Valuation-of-the-SDR-PP5002

IMF 2016 The Peoples Republic of China: Selected issues. IMF Country Report No 16/271

IMF 2017. The Peoples Republic of China: Selected issues. IMF Country Report No 17/248

Jenkins, P, T.A. Bernes, P. Mehrling, and D Neilson. 2014. China’s engagement with the international monetary system: a payments perspective, CIGI Special Report .

32 Jian, H. Shaoyi, C and S Yanzhi. 2011. Capital inflows and the impossible trinity in China.

Journal of International and Global Studies. 4.2 30-46.

Jones, 2018 Panda bond sales slump in 2017 but modest bounce may beckon this year. reuters available at https://www.reuters.com/article/markets-china-bonds/panda-bond-sales-slump-in-

2017-but-modest-bounce-may-beckon-this-year-idUSL8N1P55DI

Kendall, R and J Lee. 2017.The China interbank repo market. In China’s new sources of

economic growth: human capital, innovation and technological change edited by Song L.,

Garnaut R., Fang C., & Johnston L. (Eds.), Australia: ANU Press.

Liu, X. and L. R. Wray. 2016 A sovereign currency approach to China’s policy options. The

Chinese Economy, 49, 173-198.

Ma G.and Yao. 2016 Can the Chinese bond market facilitate a globalizing renminbi BOFIT

Discussion papers1/2-16

Ma, G, X. Yan and X. Liu (2011): “China’s evolving reserve requirements”, BIS Working

Papers, no 360

Massoudi, A. and L. Hornby China prob e shines light on top deal makers. Financial Times June

22McCauley, R. N. 2011 Renminbi Internationalization and China’s Financial Development BIS

Quarterly Review, December.

McCauley, R. N. 2015 Capital flowed out of China through BIS reporting banks in Q1 2015, BIS

Quarterly Review September.

McCauley R and G. Ma 2015 Transforming central bank liabilities into government debt: The case of China. China and the world economy 23-4 1-18

McCauley R.N. and C Shu, 2016. Dollars and renminbi flowed out of China. BIS Quarterly

Review. March, 26-7)

33 McKinnon R and G Schnabl, 2014. China’s Exchange Rate and Financial Repression: The

conflicted emergence of the Renminbi as International Currency Stanford Center for

International Development Working Paper.

Mehrling P. 2012. The Inherent Hierarchy of Money. in L. Taylor, A. Rezai and T. Michl edited,

Social Fairness and Economics: Economic Essays in the Spirit of Duncan Foley. Routledge: New

York.

Mehrling, P. 2013. Essential hybridity: A money of FX. Journal of Comparative Economics. 41,

2: 355-363

Mehrling, P. 2015. Elasticity and discipline in the global swap network. International Journal of

Political Economy 44(4): 311–24

Mehrling P. 2016. Re-imagining Central Banking. In: Stiglitz J.E., Guzman M. (eds)

Contemporary Issues in . International Economic Association Series.

Palgrave Macmillan, London

Mitchell T. 2017. Ease capital controls says outgoing PBoC head. Financial Times. October 9.

Monetary Analysis Group of the Peoples Bank of China. 2013. China Monetary Policy Report

Quarter 3, 2013 Quarter 1, People’s Bmoney market rather than borrowing from CBank of China.

Monetary Analysis Group of the Peoples Bank of China. 2017. China Monetary Policy Report

Quarter 4, 2016, People’s Bank of China.

Monetary Analysis Group of the Peoples Bank of China. 2018. China Monetary Policy Report

Quarter 3, 2017, People’s Bank of China.

Neilson D. 2015. The structure of China’s money markets, and implications for liquidity

Shanghai Development Research Foundation Working Paper, available at http://www.sdrf.org.cn/upfile/2016/03/16/20160316111845_709.pdf

34 Nixon, W., Hatzvi, E., and M. Wright. The offshore renminbi market and Renminbi

internationalization in L Song, R Garnaut, C Fang and L Johnston, eds, China’s domestic

transformation in a global context, Canberra, ANU Press 271-296

People’s Bank of China (PBoC). 2017.Macroprudential goals, implementation and cross border

communication. in Macroprudential frameworks, implementation and relationship with other

policies, BIS paper 94, 99-102 (available at https://www.bis.org/publ/bppdf/bispap94.htm)

Porter, N and Xu, T. 2009. What drives China’s interbank market. IMF working paper 09/189

Prasad E. S. 2016 China’s efforts to expand the international use of the renminbi. Reprt prepared

for the US China Economic Security Review Commission available at

https://www.brookings.edu/research/chinas-efforts-to-expand-the-international-use-of-the-

renminbi/

Prasad, E. S. and Rumbaugh, Thomas and Wang, Qing, Putting the Cart Before the Horse?

Capital Account Liberalization and Exchange Rate Flexibility in China (January 2005). IMF

Policy Discussion Paper No. 05/1.

Prasad, E and L. Ye 2012. Will the renminbi rule. Finance and Development. 49.1

Rey, Hélène, 2013, "Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy

Independence.", Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve of

Kansas City Economic Symposium, p 285-333.

Sen, S. 2010 China in the Global Economy. Levy Economis Institute, Working Paper Series

642.Shevlin A and A Chang 2015 China’s Repo Market JP Morgan Liquidity Insightsavaliable

at https://am.jpmorgan.com/blob-gim/1383258499796/83456/WP-GL-China-repo-market.pdf

Shevlin A and L Wu 2015. China: Path to interest rate liberalization JP Morgan Liquidity

Insights ( available at https://am.jpmorgan.com/blob-gim/1383216432861/83456/WP-GL-China-

The-path-to-interest-rate-liberalization.pdf)

35 Subacchi, P. 2016 The Peoples Money: How China is building a global currency. Columbia

University Press, New York.

SWIFT 2018 RMB internationalisation:Where we are and what we can expect in 2018. RMB

Tracker January 2017, (Special Report) available at https://www.swift.com/our-

solutions/compliance-and-shared-services/business-intelligence/renminbi/rmb-tracker/document-

centre.

Thurston, T. 2007. China’aMoney Markets: Policies and the Banks in S. Neftci and M Y.

Menager-Yu ed China’s Finacial Markets an Insiders View to how markets work, Eleseview

Academic Pess, London

Vernengo, M. Kicking away the ladder too: Inside Central banks. Journal of Economic Issues 50,

2 452 460Xiaochuan, Z. 2012 Reforming Financial gvernance and promoting development of the real economy, opening speech at Lujazhui Forum 2012: Reforming global financial goverenace for real economic growth, June 28-30. (available at http://en.sjr.sh.gov.cn/coverage/lujiazui/pdf/2012-forum.pdf)

Wildau, G. 2016.Why China is cracking down on outbound deals. Financial Times. November

29

Wildau, G. 2016. China capital outflows: bank loans dwarf foreign deals. Financial Times

December 17.

Wildau G. 2017. China’s Central bank warns of Minsky moment. Financial Times. October 19.

Xiaochuan, Z. 2017. Hold the Bottom Line of No Systemic Financial Risks. Contribution to

Ancillary Reading for the Report delivered at the 19th CPC National Congress available at

http://www.pbc.gov.cn/english/130721/3442671/index.html

Xiaolian, H. 2012 RMB internationalization and the globalization of China’s financial sector,

speech at Lujazhui Forum 2012: Reforming global financial governance for real economic

36 growth, Shanghai June 28-30. (available at http://en.sjr.sh.gov.cn/coverage/lujiazui/pdf/2012-

forum.pdf

Xu, Z. 2007 China’s money Markets in S. Neftci and M Y. Menager-Yu ed China’s Finacial

Markets an Insiders View to how markets work, Eleseview Academic Pess, London

Yan, L. 2007, China’s foreign exchange marketsin S. Neftci and M Y. Menager-Yu ed China’s

Financial Markets: An insiders view to how markets work, Eleseview Academic Pess, London.

Yu, Y. 2012. Revisiting the Internationalization of the Yuan. ADBI Working Paper 366. Tokyo:

Asian Development Bank Institute. Available: http://www.adbi.org/working- paper/2012/07/04/5137.revisiting.internationalization.yuan/

Yu, Y. 2014. How Far Can Renminbi Internationalization Go? ADBI Working Paper 461. Tokyo:

Asian Development Bank Institute. Available: http://www.adbi.org/working- paper/2014/02/13/6136.how.far.can.renminbi.internationalization.go/

Yu, Y. 2017 Imbalances in China’s International Payments System. Instititute of New Economic

Thinking (available at https://www.ineteconomics.org/perspectives/blog/imbalances-in-chinas- international-payments-system)

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 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