China's renminbi 'heading to being the world's strongest reserve currency

Jan Dehn, head of research at the London-based Ashmore Investment Management. [Photo by Cecily Liu/China Daily]

China's bond market is destined to become the new global benchmark in the future, and the renminbi will likely become the world's strongest reserve currency, said Jan Dehn, head of research at the London-based Ashmore Investment Management.

Dehn said in recent months the Chinese government has repeatedly confounded investors by moving faster and more aggressively on capital account liberalization than expected.

These moves come at an opportune time, coinciding with global investors' increasing desire to invest in higher risk adjusted return emerging market fixed income assets. The combination of China's bond market size, its low risk characteristics and increasingly free access will make it the largest fixed income market in the future, he said.

"In the long term, China's bond market will replace the US bond market to be the global benchmark for fixed income market, just like the US bond market replaced the UK bond market as a global benchmark in 1914," said Dehn.

"When that happens in the bond market, the renminbi will replace the dollar as the currency benchmark. It'll be the primary currency of choice for international accounting purposes," he said.

Ashmore was founded in 1992 and is currently listed on the London Stock Exchange. In 2014, it became the first Western asset manager to be awarded a renminbi qualified institutional investor (RQFII) license, which enables it access to China's equity and bond markets.

Ashmore's experience as a pioneering investor in China's growth opportunities has made it a highly respected voice in this sector. And Dehn believes most of the pessimism and doubts that Western investors have about China are due to their lack of understanding of investing in the country, and their current lack of exposure to the Chinese markets.

For example, China's $7 trillion bond market is the world's third largest, but only about 2 percent of this is held by foreign investors. One key reason is the previous lack of access, but in recent months a significant opening up has been achieved.

Late last year the People's Bank of China made it possible for foreign central banks, sovereign wealth funds and supranational institutions to invest in China's interbank bond market.

Similarly, in February the PBoC said it would allow all kinds of financial institutions that are registered outside China to buy bonds in the interbank market and would scrap quotas for medium- and long-term investors. A new policy was announced in May that institutions that have invested in China's interbank debt market will be allowed to remit their funds freely.

These announcements have significantly removed barriers for institutional investors to access China's bond market.

Dehn said the fast pace of the opening of the capital account shows that the Chinese government understands the importance of capital account inflow into China as its current account surplus reduces, so to keep the country's overall balance of payment constant.

In other words, China was able to keep its financial markets closed for foreign investment over the past few decades because its China's export driven growth has generated large current account surplus. But this model is no longer sustainable under China's current structural shift towards a consumption driven economy.

Dehn forecasts that because a significant portion of the increased consumption in China will be for foreign imported products, China will eventually become a current account deficit country, meaning it will then need to finance that current account deficit from foreign capital.

These liberalization measures coincided with a global investors "value rotation" from developed market towards emerging market fixed income instruments.

In the West, interest rates are currently so low that nominal returns on bond investments are mostly eroded by inflation. In Germany, for example, almost 70 percent of bonds have yields of less than zero, according to HSBC data tracking issues of at least 500 million euros. By comparison, Chinese bonds pay yields that are positive in both nominal and real terms.

Dehn said the most tangible evidence of this "value rotation" process is that emerging economy currencies have already risen about 1.5 percent collectively towards the dollar over the past year despite the approach of the US rate hike cycle.

Even given the long term positive outlook of China's investment opportunities, some investors are skeptical about the Chinese market's short term volatility, and in particular the large decrease in China's foreign reserves earlier this year, taking it as a signal of capital flight reflecting investors' forecast in renminbi depreciation.

Dehn believes these fears are unfounded and that renminbi will maintain its long term strength, because the reason for the reserve reduction is not capital flight, but rather is due to Chinese corporate sectors' process of refinancing dollar loans into renminbi loans.

Up until last year, Chinese corporate have commonly favored issuing dollar loans to finance their debt because of the lower cost of borrowing for dollar bonds. And because the renminbi was previously fixed to the dollar, there was no exchange rate risk for such a strategy. Such dollar denominated debt in China's corporate sector amounted $800 billion last year.

This all changed when the International Monetary Fund announced the inclusion of renminbi into its basket of special drawing rights currencies, which is a key milestone in making renminbi a global reserve currency, and a precondition of this change is greater volatility in the currency, driven by market demand and supply.

The Chinese firms realized that as the renminbi becomes a global reserve currency it will no longer be pegged to the dollar and they were uncomfortable with the exchange rate volatility. They decided to refinance their loans with renminbi loans, meaning they needed to raise a large amount of dollars to pay back their foreign lenders.

China's foreign exchange reserves dropped by $28.6 billion to $3.2 trillion in February, the lowest level since 2012, attracting great international attention. Fluctuations have since stabilized and reserves rose in March and April to $3.22 trillion before another small drop towards $3.2 trillion in July, according to the latest figures.

Dehn says Western investors' fear about China's debt size is also unfounded. "China has large debt because it has a large savings rate, which in turn means that deposits in the banking system are high. Banks lend out the money with moderate leverage compared to Western banks. China's debt levels are roughly similar to those of Western economies, but China has ten times higher savings," Dehn says.

China's total debt-to-GDP ratio is 207 percent as of June, a big increase from about 150 percent of a decade ago. But in comparison, the total credit-to-GDP level for the US stands at well over 300 percent.

Dehn says investors' worries about China's debt level shows an "entrenched prejudice in the financial world" that worries about China's debt by assessing it in isolation. Furthermore, the fact that China's debt is funded by domestic savings makes it even less of a worry than the debt of developed markets, which is partly funded by external borrowing from countries like China, shown by China's large dollar reserves.

Going forward, Dehn expects renminbi exchanges will not experience much movement in the medium term. Over the longer term the renminbi will become a dominant global reserve currency, because the dollar is set to depreciate when the effect of the US quantitative easing (QE) in recent years translates into inflation.

"My forecast is that QE currencies are destined to fall, and currently 97 percent of the world's money is in the four reserve currencies: the dollar, pound, euro and yen, all of which have central banks printing money. Now we have a fifth reserve currency, which is the renminbi, so central banks that want to protect their foreign reserves will buy into renminbi," says Dehn.

To contact the reporter: cecily.liu@mail.chinadailyuk.com