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In the decade since China unpegged its currency from the US dollar, its economy has averaged 10 per cent annual growth, more than doubling in size to become the world’s largest economy in purchasing-power terms. The time is now right for a final push towards full convertibility for the currency, alongside planned structural reforms.
Before the 1980s, China’s economy was still mostly closed – total trade was less than 10 per cent of GDP – so the renminbi could be fixed and inconvertible with fewer drawbacks. Now, however, prices and markets are increasingly important in providing signals for producers and consumers in a globalised China. The currency regime therefore becomes a key mechanism for balancing internal and external demand.
The course of liberalisation never ran smoothly, though, as the long evolution from a dual exchange rate to a conventional hard peg and then to today’s managed float demonstrates. Progress paused during the financial crises of 1997 and 2008, but the direction remained consistent: China’s economy and currency are both becoming more open over time.
Policymakers have consistently pushed for currency reforms and the renminbi’s internationalisation because they are integral parts of China’s economic balancing and domestic financial reforms. Viewing the renminbi’s internationalisation in its proper context – within the broader package of economic reform – means policymakers will likely bring about full convertibility sooner than many expect.
China’s economic development in the coming decade should tip the cost/benefit analysis further towards capital-account liberalisation and a free-floating exchange regime. An open capital account will be an important catalyst for improving China’s financial market efficiency through greater competition increasing market liquidity, and making local government finances more sustainable. However, it will require reforms, such as domestic interest-rate liberalisation and removing barriers to foreign investor participation.
There are risks associated with more openness to international currency flows and setting the currency free, but the economy is now better able to cope. China has a manageable stock of foreign-currency debt relative to its economy and has the potential to denominate external debt in its own currency. It should be insulated from the kind of balance-sheet shocks that hit economies forced to borrow in foreign currency.
The next steps could include a further widening of the onshore renminbi trading band. The exchange rate would then be determined increasingly by the market, leading to the eventual convergence of onshore and offshore exchange rates into a single renminbi rate. The globalisation of China’s trade and investment also makes it logical to finance overseas activity in renminbi, accelerating the growth of offshore renminbi hubs.
Finally, restrictions on firms’ currency transactions could soon be loosened further, with personal currency quotas increased or even removed.
We expect the renminbi to move further towards becoming a free-floating currency. This will complement China’s financial reforms and, in turn, make inclusion in the International Monetary Fund’s Special Drawing Rights basket inevitable. The renminbi will have gone from a hard peg, behind tight capital controls, only a decade ago to being an anchor of global trade, investment and finance.