The trend is for the renminbi to become fully convertible. But before the renminbi is convertible, Hong Kong will be given priority to attempt any new product launches.

Dai Xianglong
Governor of People's Bank of China
18 February 2002

In February, Governor Dai Xianglong of the People's Bank of China responded favourably to the question of banks in Hong Kong accepting renminbi deposits during a visit to the Special Administrative Region (SAR). As the renminbi is yet to be freely convertible, the initiative, if realised, would make the SAR the natural choice for offshore centre for the renminbi in the interim. Already, the renminbi is increasingly accepted for payment at local retail outlets with the rise in Mainland travellers in recent years. It is a matter of time before the renminbi becomes freely convertible. An offshore centre in the SAR would not only facilitate the evolution to its full convertibility but also endorse Hong Kong's position as a leading international financial centre of China and the Asia-Pacific Region.

RMB Offshore Centre

Since the late 1970s when China opened up its economy for foreign trade and investment, capital flows in and out of China have increased rapidly. Total merchandise trade increased tenfold in US dollar terms between 1981 and 2001. Foreign direct investment (FDI) inflows totalled USD350 billion during 1993-2001, accounting for more than half of the FDI poured into Asia outside Japan during the period. China's capital outflow, albeit less noticed, has also been on the rise, making China the world's eighth largest FDI provider in the mid-1990s.

China's economic realignment with the world has given rise to demand for the renminbi and this demand will grow as the country's economic prowess becomes increasingly visible on the international stage. A World Bank report forecasts that mainland China's share of world exports would double from 3.5% in 1999 to 7.3% by 2005. China's pledge to gradually open up its services and financial sectors to foreign players upon its World Trade Organization (WTO) entry would in particular create demand for the renminbi. Participation of foreign investors in the domestic equity market as well as insurance and fund management industries is being gradually liberalised, and the renminbi business opened up to foreign banks.

China abolished all exchange control on current account transactions in 1996, in a bid to facilitate increasing external trade and investment. However, the renminbi is still not freely convertible into other currencies as China has maintained exchange control on capital account transactions. Approval is still required for changing the renminbi into foreign currencies for acquisition of foreign assets or for repatriation of funds. Travellers are allowed to carry a maximum of RMB6,000 cash when leaving the Mainland.

As is the case for most developing economies, capital control is essential to protect the Mainland financial system from excessive capital flows. Also, the unpredictable and probably erratic behaviour of China's external balances in the initial years of its WTO entry would make China cautious in liberalising its capital control.

An offshore currency market would inevitably emerge if the pace of capital account liberalisation is not synchronised with the growth of external demand for a currency. For instance, the emergence of the Eurodollar market in the 1950s was the response to the reluctance of ex-Socialist countries to place their US dollars back into the United States for fear that their assets would be confiscated by the US government. US residents' shift of US dollars offshore to circumvent the interest rate ceiling imposed on domestic US dollar deposits since the 1930s also contributed to the growth of an offshore US dollar market in Europe.

The euroyen businesses transacted in overseas financial centres such as Hong Kong and Singapore are another case in point. The rapidly rising yen and Japan's huge current account surpluses in the 1970s, a result of its highly competitive manufactured products in the world market, prompted its companies to relocate their processing plants to low-cost areas in other parts of Asia. The increasing yen circulation abroad coupled with the policy of maintaining tight restrictions on Japanese residents opening offshore yen accounts or engaging in foreign exchange transactions gave rise to offshore yen transactions. China's economic development and the pace of liberalising exchange control are likely to lead to similar demands for an offshore renminbi centre.


One Country, Two Currencies

Hong Kong has been in the forefront in the renminbi's circulation outside the Mainland given the deepening economic integration between the two places. Bilateral trade between Hong Kong and mainland China climbed from HKD501 billion in 1991 to HKD1,228 billion in 2001, while cross-boundary passengers increased by 180% to over 56 million during the same period. The sizeable flows of people and goods between the two places have led to significant demand for the renminbi outside the Mainland as well as increasing circulation of renminbi notes in Hong Kong. Similarly, the Hong Kong dollar is also popular in the Mainland and a recent research work has suggested that currency substitution probably exists between the Hong Kong dollar and renminbi in South China.

Despite the reunification in 1997, Hong Kong and the Mainland have remained two distinct currency regimes. Under the principle of "one country, two systems", Hong Kong essentially acts as a special currency regime in China running on free market principles with its own currency. On the other hand, the Mainland has continued to implement capital control to maintain its currency and financial stability.

Yet there exists a delicate relationship between the renminbi and the Hong Kong dollar as both are linked to the US dollar, although in different ways. The Hong Kong dollar has been pegged to the US dollar through a currency board system since 1983, while the exchange rate of the renminbi has been kept within a tight range of the US dollar in the past eight years even in the midst of the Asian financial crisis. The tripartite relationship among the renminbi, the Hong Kong dollar and the US dollar is unique and conducive to the development of an offshore centre for the renminbi in Hong Kong.

Over the past decade, Mainland enterprises have made use of Hong Kong's eminent financial status in the country to gain access to the global capital market through Hong Kong's stock market. In the past 10 years, the bulk of Mainland enterprises' foreign equity capital has been raised through Hong Kong in the form of H-shares of state-owned enterprises or through "red-chip" companies. Thus, Hong Kong has become a major conduit for overseas investments into the Mainland.

Hong Kong -- A Natural Offshore Centre for the RMB

The proposal for banks in Hong Kong to accept renminbi deposits can pave the way for Hong Kong to become an offshore centre for the renminbi and extend its role as a key financial centre. While the initial concept appears to focus on letting local banks absorb the renminbi notes circulating outside the Mainland as deposits, a more meaningful and full-fledged business of renminbi deposits must include allowing Hong Kong dollar deposits to be switched into renminbi deposits, and vice versa.

Hong Kong's unique position makes it a natural and preferred choice for an offshore centre for the renminbi. Among the world's top 100 banks, a total of 79 have a presence in the territory. Hong Kong's currency and banking systems are separately managed from those of the Mainland, yet Hong Kong is a SAR of China. However, the main concern lies in the different pace of exchange control between Hong Kong and the Mainland, since accommodating full-fledged renminbi deposits in Hong Kong is conditional on a relaxation of China's current exchange control practices.

As the Hong Kong dollar is freely convertible into other currencies and there is no capital control in Hong Kong, an offshore centre for the renminbi in Hong Kong would in essence affect Mainland's exchange control in the capital account. The major challenge therefore is to find a means of relaxing the Mainland's capital control with respect to Hong Kong only.

Some proposed capital market reforms currently under consideration by the Mainland government virtually touch on the same issue. For instance, the Qualified Domestic Institutional Investors (QDII) scheme, which would allow Mainland investors to invest in Hong Kong's stocks in a controlled manner, and the Chinese Depository Receipts (CDR) scheme, which would enable Hong Kong-listed companies to raise funds in China's stock market, involve transactions in both the Hong Kong dollar and the renminbi. Exchange control on capital account transactions would be an unavoidable issue when China further deregulates and opens up its financial markets.

The technical complexity of the relaxation of capital control for making renminbi deposits in Hong Kong possible should not be underestimated. Such relaxation would involve managing money flows between Hong Kong and the Mainland without jeopardising the Mainland's objective of maintaining financial and currency stability. It is unlikely that the control over capital account convertibility would be totally liberalised in the next few years, as the Mainland government has concerns about financial stability. In the circumstances, any move towards making Hong Kong an offshore renminbi centre needs to complement the development of the Mainland's financial and currency systems.

Conclusion

If an offshore centre for the renminbi were to be realised in Hong Kong, it would be probably the most unique offshore centre ever. After all, the tripartite relationship among the renminbi, Hong Kong dollar and US dollar is also distinctive. In this light, the technicalities involved should not be underestimated. As the exchange control over the capital account is unlikely to be dispensed with shortly, the challenge would be setting up an offshore renminbi centre compatible with the Mainland's capital control rules in the interim. To the Mainland, it is essential that the proposed offshore centre would not upset the timetable of liberalising the currency, giving rise to undesirable consequences.