Inflation, geopolitics and the renminbi

At a Bank of China (Hong Kong)-sponsored forum, policy‑makers discussed geopolitical developments and China’s macroeconomic outlook as global inflation rises

Central banks are working in “the most challenging environment that I have known”, reported the industry veteran chairing Central Banking’s panel on renminbi in reserves. Financial markets have been hit by sharply increasing interest rates and the end of central bank bond purchases for monetary policy purposes. Cryptocurrency looks more like a highly speculative commodity than an investment, and gold – currently nearing 10-year highs – has resumed its traditional role as a safe haven.

Foreign currency reserves have made global headlines because of the impact of foreign sanctions on reserves. First with the freezing of Afghanistan’s reserves early in the year, and then Russia’s.

In the first case, the Taliban had violently seized power and was not recognised as a legitimate government of Afghanistan by many advanced nations. There are precedents for this, such as in Libya, where foreign central banks withheld the delivery of reserves because it was unclear who was acting as the central bank and government. In the case of Russia, however, reserves were frozen not because the legitimacy of the Russian government was in question, but rather as a tool of resistance by a number of reserve currency nations. It was unexpected and unprecedented, and is ultimately likely to raise fundamental questions regarding the safety and liquidity of financial assets held abroad – two of the three principal criteria for the selection of foreign exchange assets.

As a result, there will be more interest in reserve currency diversification, the chair predicted. There will be more interest in gold, with geographic diversification of vaulting, and there also may be more interest in alternative payment systems, whether from crypto or from Swift.

Both local currency bonds and the Chinese settlement system have been touted as alternatives to US dollar assets and the US dollar-centric financial system because of the size of the market, and the importance of China in global trade.

A European perspective

On the webinar panel were speakers from a bank and from central banks in Europe and Asia, invited to offer their perspectives on the renminbi. The central banker at a European institution said it started investing in renminbi almost 10 years ago. In its asset allocation, the central bank has four aims. The first is to support monetary policy: “We have to maintain some intervention capacity.” The second is to support financial stability: “We should be able to provide foreign currency facilities to our banking system.” Supporting the government through its transactions in foreign currency and its debt management operation is the third.

The fourth “is an interesting one”, the central banker said. The central bank has an international collateral role over foreign currency reserves. “We hold reserves, because it makes investors more calm and satisfied with our financial position.”

The central bank needs a benchmark currency numeraire, which is the euro. This is the currency in which the central bank maintains many of its foreign reserves, and in which it measures the adequacy of its reserves. The euro is the numeraire because the country has close economic ties to the EU area and the country is a member of the EU. As a result, the euro influences monetary policy and the banking system has strong ties with the EU banking system.

The central bank uses quantitative models to drive its asset allocations, but makes exceptions for some currency positions. To provide an example, “if we have a model that tells us to short the US dollar, or US dollar assets”, the central bank may nonetheless reject this “because the US dollar is still the world-leading reserve currency”. The central bank ensures it has a defined minimum amount of US dollars.

The renminbi also features in the central bank’s quantitative considerations. “In our model we don’t have any weight towards renminbi,” they said. “In the past, when we started to think about renminbi, we felt that, due to the economic power – and rising economic power – of China, at some point we should consider renminbi as an asset class.” At the central bank, officials felt it would be “interesting” to invest from a diversification standpoint. It has not been easy to balance the losses they have had in recent months in other asset classes, they said.

The size of the reserves invested in China is small. In this central bank’s case it is between 1% and 2% of reserves. The reason for this is that it is “still an experimental experience” for the central bank to invest in China. “We want to learn about the market,” they said. This incremental approach is also a risk management tool.

“We started by investing in government bonds,” the official said. They added that the central bank wants to improve its operations, and it has broadened the asset classes it invests in. “Last year, we introduced policy bank bonds as a new asset class,” the central banker added. The central bank may consider increasing its renminbi exposure in the future.

The view from Asia

The Asia-based central bank’s economy is more integrated with China than the economy of the central bank based in Europe. It is also a small, open economy that is highly dollarised. Its clearing house uses US dollars. The entire banking system pays loans in US dollars. “Only around 7% of banking deposits are in the local currency.”

For its reserves, the central bank reviews strategic asset allocation every two years, when it decides on asset classes and currencies. Renminbi has the largest share of its total reserves because China is its biggest trade partner and it receives development assistance from China. Tourism is also a factor.

“We started to get into the renminbi, even before the special drawing rights inclusion,” the official said.

The central bank tried to get into renminbi using a quota, but its economy and the transaction amount were too small for the requirements of the Chinese central bank. It gained access to the renminbi by using its external asset manager, which allowed it to invest in the onshore China market.

At the time, in terms of the central bank’s reserve calculation, the International Monetary Fund did not include renminbi. So, whenever the central bank bought renminbi, its ‘official’ total reserves decreased.

Now, both the central bank’s total reserves and the proportion of renminbi are increasing. The central bank has among the largest total renminbi reserve proportions in the world, they said.

Liquidity has also improved. In the past, even focusing on the short end of the curve, it could not execute trades. Moving forward, the panel made the point that Chinese banks should consider supporting the Chinese government market further with bigger trading books and extended trading hours. This would help towards achieving 24-hour liquidity, as is the case in US treasuries.

More recently, the introduction of the Chinese market benchmark has been very important for the central bank to calculate its performance and risk management report, they said.

The central bank also invests in the policy bank bond market in China. This has been a bittersweet experience because, through the private sector, it had to pay tax.

Compared with the other central bank on the panel, “we are not in the learning space”, the official said, but in a “very strategic and tactical management” phase in terms of the renminbi portfolio. It’s easier for the central bank’s team to trade because of the shared time zone with China for settlement.

Macroeconomic situation

China has demonstrated economic resilience over the past years, the economist from the private bank on the panel said. According to the National Bureau of Statistics of China, China’s economy continues to recover with a stable start to 2022. The Chinese economy grew by 1.3% quarter-on-quarter (Q4 2021–Q1 2022) – higher than the first three quarters last year. GDP reached RMB27 trillion ($4.2 trillion) in the first quarter, which means it remained the world’s second-largest economy.

Per capita disposable personal income grew by 5.1% in real terms, outperforming GDP growth. The fixed income market recovered well, with more investment in the secondary market. However, with China’s Covid-19 outbreak and developed countries’ monetary policy shifts, China will encounter some pressure on economic recovery.

Nonetheless, in the economist’s view, renminbi assets have attracted global investors – mainly because of their low correlation with other assets, achieving risk diversification while providing stable returns.

The economist said that long-term investors don’t seek to speculate on short-term interest rates, but seek a relatively stable mid- to long-term return. While global economic growth is turning weak. China’s economic growth is one of highest among major economies, and inflation is at a lower level, potentially making the renminbi a safe haven asset.

Multiple factors have contributed to some developed countries encountering high inflation, but China’s April consumer price index was only 2.1%. China has a relatively stable environment in energy and food prices. As a global manufacturing country, China’s strong global industrial position in supply chains and production have contributed to its economic stability.

The exchange rate will remain another important factor when investing in renminbi assets alongside the renminbi’s gradual internationalisation, the economist said. The exchange rate experienced considerable fluctuations from late April to early May. The main reasons for this were that China’s economy was affected by regional Covid‑19 outbreaks, as well as the US Federal Reserve’s decision to raise interest rates in early May and shrink its balance sheet in June. The US decision to tighten monetary policy contrasts with China’s monetary policy stance, causing central bank policy divergence.

The US-China government bond yield spread narrowed and even inverted sometimes, causing foreign capital to change its position, due to sentiment risks in the foreign exchange market. But the renminbi market correction came to an end and the Chinese currency, which has outperformed the euro, yen and sterling, has started to rally.

In recent years, through the development of China’s real economy, China’s balance of payment surplus has become an important source of support for the steady renminbi exchange rate, the economist said. Because of the geopolitical situation, the exchange rate is expected to fluctuate in the short term. Looking forward, the narrowing and even inverted government bond yield spread may continue for a while, because of divergence in monetary policy between China and the other major economies.

However, in the long term, with China’s steady opening up of financial markets, in the economist’s view, renminbi assets remain attractive to foreign investors. The fundamentals of China’s economy remain unchanged and, with sufficient policy tools, the exchange rate is expected to remain stable, at an appropriate level.

Risk

The central banker from the Asian institution said their first priority is capital preservation. China’s credit rating is good, they said, and the recent currency depreciation is not viewed as a problem because the central bank does not trade it mark-to-market or make money from FX. “We hold the currency to maturity,” they said.

Though the return on renminbi assets is now a little lower compared with the US dollar due to interest rate hikes, for the Asian central bank “there isn’t huge market risk from a government bond investor perspective”. Liquidity, the bank’s second priority, is also there. They see appropriate reactions from the authorities and necessary central banking policy. Chinese government bond yields decreased in the global market, they pointed out, with one panellist reporting a risk that China may reverse its policy to open up markets.

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