This article was written by David Olsson and Andrew Fei.
The adoption of China's currency, the renminbi (RMB), in cross-border transactions has increased steadily over recent years. New catalysts are emerging that are likely to propel its usage globally over time.
While it's too early to predict whether the RMB will challenge the US dollar as a global reserve currency in the short-to-medium time horizon, the RMB's importance is likely to grow as China's share of global trade and investment continues to increase.
The Belt and Road Initiative
Much of the optimism about the future of the RMB as a global trade and investment currency is built around China's massive Belt and Road Initiative (BRI), which aims to connect China to more than 65 countries in Asia, Africa and Europe by land and sea, boosting cross-border capital and trade flows.
The premise is straight forward: Increased trade along the BRI corridors, coupled with Chinese-led investments and more Chinese companies and financial institutions "going global", will spur more RMB-denominated transactions.
There is growing evidence to support this proposition.
Bilateral trade between China and BRI countries already accounts for roughly a quarter of China's total foreign trade and there are predictions that China's annual trade with BRI countries will surpass US$2.5 trillion (RMB 15.7 trillion) in the next decade.
According to SWIFT, a provider of global payments and financial messaging services, there has been a particularly strong uptake in the use of RMB for trade settlements within ASEAN nations over the last year, with RMB in the region ranked second only to the US dollar. With deepening economic cooperation between China and ASEAN nations this trend is likely to accelerate.
The potential for the use of RMB in investment projects is even greater. BRI-related projects - spanning from the massive infrastructure projects in the China-Pakistan Corridor to Malaysia's new RMB55 billion (US$13 billion) East Coast Rail link – are currently estimated to be worth US$600 billion (RMB 3.8 trillion).
Much of the finance provided by China to support these investments is currently provided in US dollars, but as many of the construction and engineering contracts are with Chinese contractors with RMB liabilities, the use of RMB rather than US dollars makes economic and practical sense.
International payments can be managed efficiently through newly created offshore RMB clearing hubs in BRI countries and around the world, and expanded RMB banking services are being rolled out by Chinese and international banks make it easier to manage FX risks. For example, the second phase of the China International Payments System (CIPS) - a cross-border RMB settlement system – is expected to be rolled out soon. The governments of a number of BRI countries have recently or are about to issue panda bonds – RMB-denominated bonds issued in China's huge onshore debt capital markets.
The combination of policy receptivity, utility of the currency, practical mechanisms and increasing experience with the RMB is likely to facilitate the currency's use along BRI countries. As time goes on, such synergies will become increasingly evident and the use of RMB in the wider offshore markets will rise.
China is one of the world's most significant importers of commodities with iron ore, coal, crude oil and soy together making up almost 20 percent. of the country's imports.
Yet despite China's strong position as a buyer in global markets, it is mainly a price taker relying on non-Chinese exchanges for pricing its goods, and settling transactions almost entirely in US dollars.
So even a partial re-denomination of China's commodity trade into RMB would significantly boost RMB trade flows and liquidity in offshore markets.
The first tangible signs of a move to non-US dollar pricing are already visible with closer ties between China and Saudi Arabia in the oil sector. Saudi Arabia (the world's largest oil exporter) is expected shortly to start accepting RMB as payment for its usually US dollar-denominated oil exports to China (the world's largest oil importer), after oil companies in Russia, Iran and Venezuela have done the same.
Backing this up, China has recently launched its own RMB-denominated crude oil futures contract, a move set to shake up the global crude market currently dominated by US dollar trading in London and New York.
The principal driver behind the choice of this contract is to enable China to develop its own benchmark for oil pricing, while increasing the trade in RMB-denominated oil (dubbed "petro-yuan"). Given the sheer size of the market, such a move will considerably increase the pools of offshore RMB liquidity and enhance its role as a global currency.
This idea has been under development for many years, but now seems to be a reality and is already setting the stage for similar changes with other commodities. Last month the Dalian Commodities Exchange was also granted approval by regulators to launch an RMB-denominated futures contract in iron ore that can be transacted by both local and offshore traders.
The digital revolution
China's central bank, the People's Bank of China (PBoC), is going digital.
As flagged in our earlier report, as China emerges as a global leader in financial technology (fintech), an inevitable next step is the eventual digitisation of the RMB. It is a question of "when" and not "if".
In 2016, China's Ministry of Industry and Information Technology (MIIT) published the country's first official whitepaper on block chain technology highlighting its potential to serve as the basis for China's move towards a cashless society. MIIT is now developing a set of national technical standards for block chain and distributed ledger technology, taking into account relevant international standardisation initiatives.
In June 2017, the PBoC opened the "PBoC Digital Currency Institute", a cryptocurrency research lab tasked with developing prototypes related to digital currency issued by the PBoC. Last month, the PBoC announced that it is currently developing its own digital currency called DCEP, which stands for Digital Currency for Electronic Payment.
Remarks and research papers by PBoC officials show that the central bank's strategy is to eventually roll out a digital RMB alongside the RMB, although there is currently no timetable for this, and the bank seems to be proceeding cautiously. This steady but cautious approach is understandable given the size of China's economy and population, the paramount importance of maintaining financial, economic and social stability and the recent volatility and speculation surrounding cryptocurrencies.
Nonetheless, these developments represent a significant step in China's digital economy. It shows that China is seriously exploring the technical, logistical, and economic challenges involved in deploying digital legal tender, something that could ultimately have broad implications for its economy and for the global financial system.
This is relevant to the RMB internationalisation process in that digital currencies have a tendency to transcend national borders. A successful digital RMB will inevitably promote the usage of China's currency in cross-border trade, investment and finance and become a significant catalyst for the RMB's internationalisation.
China's rapid growth, coupled with smart monetary management by its policymakers and regulatory officials, has internationalised the RMB to an extent that could scarcely be imagined a decade ago.
It's too early to predict whether the RMB will challenge the US dollar as a global reserve currency in the short-to-medium time horizon, but over the last decade or so China has methodically pushed for the acceptance of its currency beyond China's borders.
For the RMB to become a true global currency, it needs the support of deep, open, liquid financial markets – both domestically and abroad.
China may be playing a long and steady game, but the RMB's importance is likely to grow as China's share of global trade and investment is spurred on by the Belt & Road Initiative, by challenges to the US dollar denominated pricing and trading of commodities, and by the emerging forces of technology and currency digitisation.