The year is 2030 and the renminbi is one of the world’s major reserve currencies. Since becoming fully convertible it has been embraced by central banks the world over and is now on track to rival the dollar as the reserve of choice, reflecting the fact that China’s economy is now approaching the size of the USA’s.

It seems a very distant prospect given that the renminbi is not even convertible today. But as the currency does become more international – and every trend of the last five years suggests it will continue to do so – it is almost inevitable that its use by world investors, institutions and central banks will increase dramatically once they have the chance.

“If you talk about the very long term, most people see an international currency as a natural outcome for China,” says Wensheng Peng, head of China research at Barclays Capital and a former China specialist at the Hong Kong Monetary Authority. “A small economy, no matter how hard you try or what policy support you give, will never have an international currency. But if you are one of the largest economies in the world – and this year China is likely to become the second largest – it is natural that your currency will become international. It’s a fundamental driving force and although you can restrict it for some time with policy I don’t think you can prevent it forever.” China already has a relatively open stance on trade, and its currency controls seem increasingly odd in that context. “That disparity will face increasing international pressure as China’s economy grows.”

Others agree. “The goal is definitely a convertible currency,” says Callum Henderson, head of global FX research at Standard Chartered. “It’s part and parcel of the liberalization of the economy. When we get it is a tougher call.” He says most reasonable estimates put it at 10 to 15 years away. “Certainly not immediately, but it’s undoubtedly the goal. Eventually it will be a reserve asset for banks around the world.”

That’s the long-term picture. But getting there is going to take time – few see full convertibility in anything less than a decade – and in the meantime, the debate is preoccupied with the currency’s value and the degree to which China should allow it to shift. Over the years (see box) the currency has drifted through various pegs and managed exchange mechanisms, but since mid-2008 has effectively been pegged to the US dollar with limited scope for gradual variation. Since the dollar itself has gone through dramatic periods of strength and decline in that period, the effect has been that the RMB has moved quite dramatically back and forth against European and Asian currencies through the financial crisis. The question most people have is when the latest dollar peg will be abandoned, and what the path to appreciation will be.

China-watchers got particularly excited about the People’s Bank of China’s third quarter monetary policy statement in November, which in its section on the RMB exchange rate included the words: “With reference to international capital flows and trends in major currencies.” Just as important was what it didn’t say: the usual sentence, about “maintaining the broad stability of the RMB exchange rate at a reasonable equilibrium level,” was gone.

Many took this as an indication that a new exchange framework, and a period of appreciation, were on their way. “We think the central bank did make it clear – as clear as a central bank can be – that in light of the weakening US dollar and increased capital inflows, the RMB is facing increasing appreciation pressure and may need to break the de facto US dollar peg and be more flexible,” says Tao Wang, economist at UBS. He doesn’t expect a change until there’s evidence of exports recovering, but nevertheless he expects the RMB to appreciate to 6.4 or 6.5 against the dollar by the end of 2010, compared to 6.83 at the time of writing. (Tao notes, though, that what really matters is not so much the dollar rate – which has appreciated over 20% in the last few years – but the effective exchange rate against a trade weighted basket of currencies.)

Most other economists and strategists broadly agree, with the only major differences being the degree of change. Peng at Barclays expects a break away from the tight range against the dollar and appreciation against it of “up to 5%” over 2010. Shen Minggao, economist for China at Citigroup Global Markets, is predicting a 3% appreciation in 2010. Henderson is calling a modest decline to 6.7 in 2010 (a 2% appreciation from today’s rates), with a shift away from the de facto peg in the second and third quarter. “Our view is that China continues to approach economic reform in a gradual and very focused way,” he says. “We see the next move as being an expansion of flexibility.”

In any event, while international pressure is clearly there, nobody is really expecting China to do anything other than on its own terms. “China is still showing all the signs of conducting FX policy on the basis of its domestic needs, rather than necessarily what other countries might view as more desirable for them,” says Richard Yetsenga, managing director, Asian FX strategy at HSBC. “That is likely to mean a gradual pace of reform to China’s capital control regime and its openness to global capital. It’s also likely to mean that China moves the RMB in a way which is consistent with its domestic policy settings rather than some global objectives.”

“A stronger RMB is likely to be desirable whether the dollar is weakening particularly sharply at that time or not,” he adds.

But why is that? We all know why the rest of the world wants a stronger yuan – for trade and export reasons, particularly when unemployment is high in developed countries – but why is it China’s interests? One key reason is inflation, which is back on an upward track. “Renminbi appreciation will likely create more winners than losers over time,” Shen says. Larger firms can shift the burden of a stronger yuan to their customers, he says; importing firms get cheaper imported goods and expanded domestic markets; H share companies become relatively more profitable in dollar terms; and capital inflows support property prices. “However, as a stronger yuan will boost imports, overcapacity problems could worsen in sectors that don’t have comparative cost advantages,” he says.

There’s also the issues of China’s vast reserves to consider. Opinion varies on what the effect of the falling value of China’s dollar-denominated holdings – whether cash or treasury reserves or physical assets held through the China Investment Corporation sovereign fund – will have on policy. “The dollar has a major impact,” says Henderson. “If you have roughly $2 trillion of FX reserves and the majority is in dollars there is obviously a valuation effect on your reserves, which theoretically has a P&L impact. It doesn’t in reality until you realise it, but it definitely has resulted in an increased focus on diversification.”

Peng sees it differently. “If you are a government or a central bank, you manage your wealth not for the next three to five years but for the next generation, so you need to take a very long term investment horizon,” he says. “In that investment horizon it is difficult to forecast exchange rates. So diversification is not about the currency, per se; it’s more about the assets. As a side effect that may give rise to a reduction in the share of US dollar denominated assets, but it’s not one of the motivations.”

If appreciation is eventually to lead to full convertibility and a totally open exchange rate, a number of structural changes need to take place, and some are expected in the near future. Ditching the peg for a wider trading band and a link to a basket of currencies would be a start. Others would like to see the development of better yuan asset markets.

 “A lot of the basic infrastructure is already in place,” says Yetsenga. “There is already a mature spot market and something of a forward market, some cogniscence about currency volatility and how to manage it. But many of the systems and institutions which surround those issues have not been exposed to significant currency volatility, and third markets don’t necessarily support some of the derivative markets which in other developed economies appear necessary for hedging forex risk.”

Another element to China’s forex debate is the liberalization of its capital account. FDI is clearly still strong and brings money in to China, but a trend of recent years has been for China to acquire more resources and companies overseas. As Chinese companies (and the State) become more comfortable about investing abroad – as its resource companies and the CIC demonstrate – then those outflows should help to offset the FDI inflows. China’s recent approvals for QDII (qualified domestic institutional investor) licences and mandates also creates a source of outflows, while the QFII program (qualified foreign institutional investors), under quota, allows foreign money to participate in Chinese domestic securities.

“Significant process has been made in the last decade,” says Peng. “Basically all the direct investment, inward and outward, has been liberalized. China attracts a lot of FDI, and in recent years we have seen significant Chinese investment abroad: Chinese companies investing in Australia, Africa, Latin America, Russia, as well as domestic markets.”

Peng envisages that these ventures may also become testing grounds for a greater use of renminbi outside China, because at the moment, restrictions on the currency are a natural barrier to practical trade settlement. “If a Chinese exporter pays RMB to its exporters, those exporters have no place to invest their assets. And if a Chinese exporter says it wants to receive RMB from foreign importers, where will that foreign importer get the RMB from? The only source is from China.” So, for that to start to happen, he predicts some ad hoc arrangements could be made for, say, an oil company to pay in RMB to offshore exporters, and allow that exporter to invest in RMB assets. Going further, he believes foreign central banks would like to set up QFII-style arrangements with the PBOC in order to buy RMB bonds in China as part of their reserves.

So, if China were to become a reserve currency, how powerful would it be? The Hong Kong Institute for Monetary Research put out a detailed study in May – jointly authored by Peng in his HKMA days – about just what the renminbi’s potential as a reserve currency could be. Using different models they came up with figures of 10% and 3%, but that’s based on the size of China’s economy today rather than at the point when convertibility is possible, by which time it will presumably be much larger. “These results suggest that at present the renminbi’s potential as a reserve currency would be comparable to that of the Japanese yen and British pound,” the report says.

The report makes another telling conclusion too: “Whether the renminbi realises its potential as an international currency that is line with the size of the Chinese economy will be a market choice.” And it will, more than anything, be China’s choice, done at China’s pace. “Deng Xiaoping said so many years ago that he was crossing the river while feeling the stones with his feet,” says Henderson. “It’s a very well-worn cliché but it’s very appropriate in terms of what’s happening in monetary reform.”

BOX: The RMB bond market in Hong Kong

Over the years China has undertaken a few experiments involving the use of the currency outside its borders. These have included increased use of the yuan in Hong Kong and Macau, bilateral agreements with countries including Brazil and Malaysia.

The Hong Kong RMB bond market is, in many people’s eyes, the most significant of those experiments. At RMB38 billion outstanding it’s not a huge market – the RMB6 billion sale of government bonds to Hong Kong retail investors in September was the largest ever deal in this market, and only the 13^th in total since the China Development Bank kicked off the market in July 2007 – but it’s really not about the size.

“I think it’s very significant,” says Simon Jin, head of fixed income for China at UBS in Beijing. “If you look at the trends and discussions that are going on around the internationalization of the RMB, it’s clearly an interesting strategy to develop an RMB market that’s not just functional in the domestic market but potentially other markets.”

The market works because retail investors and local merchants have been accumulating RMB deposits and need to be able to do something with them other than putting them in hopelessly low-yielding deposit accounts. Today, potential investors are strictly limited, but if other buyers were allowed in the appetite would likely be insatiable, and this may well be the long term plan. “Hong Kong is the perfect candidate,” Jin adds. “It’s so interlinked with mainland China, people understand China well and are very bullish on the economy, and there is a need for the currency.”

The experience helps China to get to grips with RMB outside the mainland.  “It seems China’s intention, at least partly, is to build up a pool of RMB offshore that can be gradually used to settle outside the country,” says Yetsenga. “The perception seems to be this will take some pressure off China’s balance of payments.”

It’s also seen as a significant step towards convertibility. Says Jin: “If you look at the big picture in terms of RMB internationalization, this is an integral part of that process.”

BOX: Yuan reform

Back in the 1950s and 60s, China frequently changed its foreign exchange rates in order to encourage exports and restrict imports, first pegging to the dollar, then to the pound. After the Bretton Woods system – the post-war monetary agreement signed by the world’s industrial states in 1944  – broke down in 1971, China moved instead to a broad basket.

Next came a multiple FX rate structure with a controlled float in the 1980s, followed by a more market-determined FX rate in the 90s as China sought admission to the General Agreement on Tariffs and Trade (GATT). By 1994 the official rate had become the prevailing swap rate, where the yuan’s external value would be managed against an undisclosed basket of currencies. This lasted just 16 months: after a period of volatility in global currency markets in April and May of 1995, China moved back to a straight peg, at RMB8.28 to the dollar. Current account convertibility came in 1996; capital account liberalisation was interrupted by the Asian financial crisis, although China was applauded at the time for shoring up the peg and avoiding further regional devaluations.

In July 2005, the peg was abandoned for a managed float against a reference basket, which was calculated using elements including the composition of China’s trade, inward direct investment and foreign debt. Since then spot dollar/yuan cross rates have been cautiously adjusted as economic conditions change. In 2005 the daily fluctuation range was set at plus or minus 0.3%, and was widened to 0.5% in May 2007. The ranges have been much wider for non-dollar currencies: originally plus or minus 1.5%, but since 2005, 3%. As the global financial crisis kicked in in September 2008, China informally moved back to a peg to the dollar, and now the debate is when it will relinquish it.

Part of this material is abridged from Deutsche Bank research

In September Hong Kong’s renminbi bond market took a major step forward. To that point, it had been a fascinating but fairly insubstantial new venture, attracting some interesting credits but lacking the scale or liquidity to have broader impact. But then China’s Ministry of Finance launched a RMB6 billion sale of government bonds to retail investors in Hong Kong – and by the time the offer closed on October 20 had attracted bids for three times that much.

The deal was significant on a number of grounds. The 13^th RMB bond issue in Hong Kong, it was the biggest, the first by a sovereign, the first to come in multiple maturities, and it increased the market’s curve from three to five years. Not only did it provide a government pricing benchmark to this new market, it also represented the first time the Chinese sovereign had issued an RMB bond anywhere outside the Chinese mainland. And, in so doing, it heightened the sense that what’s happening with this market in Hong Kong is a tentative but vital step towards convertibility of the Chinese currency.

“China obviously doesn’t need the money for fiscal purposes, so you have to ask why they are issuing,” says Tim Condon, chief economist for Asia at ING Financial Markets. “The answer is to prepare to give the renminbi a wider circulation outside of China – and so a small step towards internationalizing the renminbi. I see these small steps as being towards the end of full convertibility.”

Hong Kong’s RMB bond market started out with a RMB5 billion issue – still the second biggest to date – from China Development Bank in July 2007, and was followed by other Chinese state-linked agencies (Export-Import Bank of China in August that year) and major mainland banks (Bank of China in September 2007 and again a year later, and Bank of Communications and China Construction Bank in July and August 2008). The next milestone was allowing foreign banks with incorporation on the mainland to issue too through their Chinese subsidiaries: HSBC (China) was first, with a RMB1 billion institutional bond, the market’s first floating rate issue, in June 2009, followed by Bank of East Asia (China) with a RMB4 billion raising the following month. HSBC was back again in August with a RMB2 billion deal, this time chiefly for retail buyers.

With the Ministry of Finance deal, the total raised now stands at RMB38 billion from eight issuers, with tenors from two to five years and coupons between 2.45 and 3.4%.

Whatever China’s broader ambitions for the currency, the Hong Kong RMB bond market is underpinned by a pragmatic rationale: the steady accumulation of the Chinese currency outside of China. “Although as a percentage it’s small, it’s something that China has allowed and wanted to see,” says Anita Fung, treasurer and head of global markets for Asia Pacific at HSBC. “It started with the growth of renminbi deposits, and the RMB bond market in Hong Kong reflects the fact that it’s important to give investors a wider choice of investments than just those deposits.” Hong Kong resident retail investors can accumulate RMB20,000 a day, and by September 2009 RMB deposits in the city’s banks stood at RMB58.2 billion.

Aside from retail, selected specialist merchants can open RMB accounts with banks – those groups who naturally accumulate Chinese currency in the course of their business, such as international trading companies that accept RMB from their Chinese mainland counterparties. It’s a limited field: even these businesses must get approval from the Hong Kong Monetary Authority before being allowed to open an RMB deposit account with a Hong Kong commercial bank.

Between them, these two groups have created a modest institutional market too, made up of the banks in Hong Kong who offer the accounts that service those retail and merchant clients. “The RMB bond market in Hong Kong provides a means for the banks in Hong Kong to diversify their RMB assets from just placing them with the clearing bank,” says Fung. There is only one clearing bank licensed to handle RMB today – Bank of China (Hong Kong) – and it pays just under 1% interest, hopelessly unattractive for an institution. “If you have RMB deposits, you can invest them in RMB bonds at a more attractive yield without compromising the risk, if it’s a quality issuer.”

Consequently there is healthy appetite for any new issue. “Renmimbi retail deposits in Hong Kong receive a very low deposit rate, below 1%,” says John Sun, executive director of fixed income at Citic Securities International. “Anyone who has an RMB bank account in Hong Kong is going to receive that interest rate; compare that against 2.7% [the rate on the three-year tranche] for a bond from the Chinese government. That’s why the response is so good from retail.”

Between retail and the modest permitted institutional market described above, there’s already more demand than supply has yet been able to cater for. But if the net was broadened to a greater range of buyers, that demand would become truly insatiable. “When the MOF issued this bond I got a lot of calls to see if they could buy this bond – from Taiwan, the Middle East, Europe,” says Sun. “A three year bond offering 2.75% yield, and the potential appreciation of the renminibi – which on a two year trade is probably roughly 5% – means in US$ terms this bond offers more than 5% yield. It’s very attractive when US treasuries and yen offer so little. But unfortunately none of them can be involved in the deal.”

One consequence of this is a market that lacks liquidity. Deals fly out the door, but don’t then tend to trade. “Because of a lack of participants, the secondary market is not active,” says Sun. “Retail use these bonds as a replacement for their deposits, and so hold them. And commercial banks do the same thing – there’s no other way for them to invest their renminbi.”

More broadly, the market helps develop expertise, opportunity and familiarity. “By having an RMB bond market in Hong Kong it expands the range of RMB products and services outside China,” Fung says. “It’s part of integrating into international trade and financial markets, and it complements QFII, QDII and other initiatives to open up the financial sector.” QFII refers to qualified foreign institutional investors, a system whereby selected foreigners are permitted to invest in domestically-listed securities in China; QDII, or qualified domestic institutional investors, is the reverse process, where mainland asset managers can invest outside of China and launch mutual funds giving domestic investors exposure to world markets. Both have long been seen as early experiments in opening up China’s financial markets while improving the expertise of domestic participants.

In this context the Ministry of Finance bond was particularly important, since quite apart from soaking up available deposits in Hong Kong, it demonstrated the conviction in government towards this process of gradual openness. “It’s very significant,” says Fung. “It provides a sovereign bond curve, provides a wider range of investment tenors, and provides a pricing reference for future issuance. It also arguably provides a foundation for building an offshore interest rate swap market, or even a cross-currency swap market, as and when regulations permit.”

But she cautions against going too far. “People tend to mix up this market with the liberalization of the currency, saying it’s going to appreciate faster or means we have a faster timetable for capital account convertibility. I don’t think that’s the right way to look at it. It’s more a continuing process of gradual opening up of the financial market, becoming more internationalised, more market driven.”

From an issuer’s perspective, for the foreigners, RMB bonds in Hong Kong are not really about the money. “In terms of our funding needs we are well funded in RMB in China,” says Fung. “When we issued RMB in Hong Kong, it was not because we don’t have the RMB deposits to fulfil our local ratio of assets and liabilities. We issue because we think it very important to broaden the investor base and the types of investment products available in Hong Kong. We want to be the front runner in terms of the development of the RMB market for onshore and offshore.”

There are really only three major RMB deposit banks in Hong Kong: Bank of China (Hong Kong), HSBC and Standard Chartered. Bank of China (at the parent level) and HSBC have both tapped the market already, so all eyes are on Standard Chartered, which instead has more frequently been linked in the trade press with RMB issuance in China itself. Asked about Standard Chartered’s intentions, Sundeep Bandari, regional head of global markets, says: “As an active capital markets participant in Hong Kong, Standard Chartered is very keen to be involved in the development of the market.”

Whatever Stanchart decides, or is permitted to do, the trend appears to be towards a greater range of issuers. “We have seen good progress over the last two years,” says Bandari. “Initially only a few select Chinese banks were allowed to tap the market. Since this year, it has broadened to include the China subsidiaries of Hong Kong-based banks as well as the sovereign.” Bandari notes the China subsidiaries of Hong Kong’s banks, rather than the banks themselves, were permitted to launch RMB bonds in Hong Kong. “This is significant as it signals the Chinese regulators may be willing to consider non-Chinese issuers to tap the RMB market in Hong Kong, and may pave the way for possible future consideration of other foreign issuers.”

Fung’s perspective is also useful as an arranger, since HSBC has held a lead arranger role on nine of the 13 issues to date. “Issuing an RMB bond in many ways is no different to issuing a bond in other emerging currencies, but there’s a lot of work and coordination required in bringing these to market as it’s about transcending between the Hong Kong and mainland Chinese markets,” she says. “Coordination and setting the price discovery processes is critical to ensure it’s not a one off transaction, but benefits investors as well as setting a good benchmark for issuers, and this requires a lot of cross-border work, including with the regulators on both sides.” HSBC wasn’t a lead on the MOF deal, which instead was handled by Bank of China (Hong Kong) and Bank of Communications as bookrunners.

So what next? In launching the Ministry of Finance bond, vice finance minister Li Yong said that investor response to the issue would determine whether the Chinese sovereign issues more RMB sovereign debt in Hong Kong. Judging by the reception, they’ll be back.