Introduction

China’s rise to prominence in the financial sphere - at last beginning to catch up with its long-standing powerful economic growth and growing importance in world trade - was symbolized in April 2007, when mainland China’s stock exchanges in Shanghai and Shenzhen for the first time over­took Hong Kong in terms of total market capitalization.

There have been reports of the Shanghai Stock Exchange making new efforts to encourage listings by prominent foreign companies like HSBC (Dyer and Tucker, 2007). An HSBC listing would have special historic

¹As quoted by Kwan (2006a).

The author is grateful to Tom Willett and Yanjie Feng Burdekin for their helpful comments.

Table 10.1 Markets with Top Ten Initial Public Offering (IPO) Volumes in 2006

Source: Nie (2007)

significance, given the major role the bank has played in Shanghai, and mainland China generally (Chapter 5).^[170] Despite the relatively undeveloped nature of China’s financial markets overall, the increasing liquidity in the nation’s debt markets, and broadening array of financial instruments, have been accompanied almost overnight by the emergence of the Shanghai Stock Exchange into the world spotlight. The market’s rise has not only caught the world’s attention but also led to a major influx of funds from China’s vast horde of personal savings accounts. Although these new investors should not be counting on the kind of gains registered by the market in 2006-2007, such growing interest in the nation’s financial markets offers some hope that China will be able to evolve away from its historically near-total reliance on bank credit as a form of finance (see Chapters 7 and 8).

It is certainly high time for China’s financial system to start emulating the breathtaking growth registered in the real economy, not to mention the tremendous expansion in exports that has recently received so much attention, and ire, in the United States. As discussed in Chapter 2, China’s import growth has actually been nearly as great as its export growth - seemingly belying any allegations that it has operated as a closed econ­omy.

China’s ongoing surpluses with the United States have already had the effect of making it a major player in the market for US Treasuries and other dollar assets. Thus far, most of the reserves accumulated by China have been kept in US dollar assets (Chapter 2). Should that change, any sudden sale of these holdings would likely exert significant new downward pressure on the dollar as well as on the price of US government bonds. Although such a move would cause China itself to incur losses on remaining dollar­based holdings, there remains some real vulnerability on the US side that is perhaps not sufficiently recognized. China’s move to create a new sovereign wealth fund to invest some of its massive reserve holdings in higher-yielding assets has not so far been accompanied by any announced shift away from dollar assets - but rather from lower-risk, lower-return dollar holdings of Treasuries to higher-risk, potentially higher-return areas like China’s 2007 investment in the Blackstone Group IPO (Chapter 2).

It is hard to say how much, if any, currency diversification would be jus­tified on purely economic terms (cf. Papaioannou, Portes, and Siourounis, 2006). The actual share of the US dollar in worldwide reserve holdings has, in fact, remained fairly stable - with the dollar’s approximate two-thirds share in 2006 being essentially in line with the levels of the mid-1990s. The euro remained in distant second place in 2006, followed by the pound sterling, which - in a striking advance - has taken third place ahead of the Japanese yen (see Galati and Wooldridge, 2006). With the renminbi still not convertible for capital account purposes, the immediate prospects of China’s currency emerging as another contending world reserve currency remain distant. According to Eichengreen (2007, p. 147):

While the renminbi is many people’s favorite candidate for the new reserve-currency champion four or five decades from now, such hopes, in my opinion, are highly premature.

Although Eichengreen could end up being proven correct, this volume's examination of monetary developments in China shows that dramatic, unexpected shifts are more the norm than the exception. As recently as 2005, for example, China’s stock markets appeared totally moribund and a paucity of funds flowing into the market was the concern - in stark contrast to the later worries about having too much of a good thing. Meanwhile, in the late 1990s China faced deflation and devaluation seemed so inevitable that a survey was distributed in March 1998 to gauge the likely psychological impact of such a devaluation on financial market participants in Hong Kong (Wei et al., 2000)!

There are, in fact, already some early signs of an expanding role of the renminbi within Asia, especially in Hong Kong.

Although the total amount of renminbi in Hong Kong is not very large, about 25 billion HK dollars, I think that with further co-operation and integration between Hong Kong and the Mainland in terms of financial and monetary instruments, the pool can only grow.^[172]

The People’s Bank of China (2005b) reported that, as of November 1, 2005, there were already thirty-eight banks in Hong Kong - represent­ing almost all banks offering retail services - providing personal renminbi business to their clients. One source of renminbi circulation outside the mainland has been through its use by the rising numbers of visitors travel­ing to Hong Kong from the mainland since individual visas, as well as group visas, were permitted in 2004.5 The renminbi has also been used in bor­der trade with neighboring economies like Taiwan, Malaysia, and Thailand. Renminbi circulation arising from this border trade was estimated at RMB 23.7 billion in 2002, and in 2003 such transactions were legitimized under a new Chinese government policy permitting the use of the renminbi as a settlement currency for border trade (Li, 2004). According to Zhang (2006, p. 34) this “carries the eventuality that the Chinese currency will become a vehicle currency for international trade and a currency for international settlement.” It does appear that at least some meaningful internationaliza­tion of the renminbi has taken place in spite of the ongoing capital account restrictions.

Until July 2005, the Hong Kong dollar and the renminbi were effec­tively linked via each currency’s fixed exchange rate with the US dollar. The post-2005 appreciation of the renminbi against the dollar has led to accompanying appreciation against the Hong Kong dollar, however, as Hong Kong stuck to its “currency board” with the US dollar.^{[173] [174] Von Furstenberg and Wei (2004, p. 39) argue that such a move is actually likely to end up hurting Hong Kong insofar as it “raises Hong Kong’s cost of inputs used in its exports to the dollar zone more than the [Hong Kong dollar] value of the proceeds from Hong Kong’s final sales to the mainland.” At the very least, the de-linking of the Hong Kong dollar and the renminbi adds to the potential benefits of adopting a common currency by taking the exchange rate fluctuations of the post-2005 period out of the mix. Given the existing seemingly high degree of economic integration between the two economies, based on output and inflation co-movements, interest rate convergence, and trade linkages, the costs to Hong Kong of such an arrangement may well be smaller than the benefits (cf. Cheung and Yuen, 2005; Cheung, Chinn, and Fujii, 2007a; Cavoli and Rajan, 2007).}

Although Xu (2006) argues that lack of coordination of business cycles in mainland China and Hong Kong could be a potential pitfall, integration seems certain to only increase going forward and this is likely to increase syn­chronization. Additional impetus stems from the 2004 “Closer Economic Partnership Arrangement” between mainland China and Hong Kong, which offers zero tariffs on goods going in both directions as well as lower entry barriers for banking institutions and other service sectors. Indeed, the Chi­nese authorities appear to have already begun the process of expanding renminbi usage in Hong Kong and continued, albeit gradual, advancement seems inevitable. This could culminate in Hong Kong finding it “econom­ically sensible to [if not] adopt the RMB... at least peg to the RMB while maintaining some sort of convertibility agreement with the mainland simi­lar to Singapore and Brunei, or... Hong Kong and Macau... ” (Cavoli and Rajan, 2007, p. 32).

Although limitations on renminbi capital account convertibility make it implausible that the renminbi could completely supersede the Hong Kong dollar in the very near term, the barriers to renminbi circulation have already been significantly lessened in recent years. Zhang (2006, p. 29), lists a number of ways in which the renminbi was, de facto, at least partially convertible on the capital account by 2006:

There are no restrictions on foreign debts incurred by foreign invested enterprises. No approval is required for short-term and trade-related financing (three months or less). Non-residents can purchase both A shares and B shares, government bonds, commercial papers, H shares and [Non-tradable] shares. Foreign investors in China are allowed to repatriate to their home countries profits from direct investment and other investment. There are no restrictions on loans to foreign establishments by their parent or affiliated firms. And neither is international lending by foreign invested enterprises in China subject to restrictions.

Based on trade linkages and general economic interdependence between mainland China and Taiwan (Chapter 9), a case could be made on economic grounds for a currency union extending to Taiwan rather than just Hong Kong and mainland China (Cheung and Yuen, 2005). Cheung, Chinn, and Fujii (2007a) go further and consider an expanded currency union including other Asian economies such as Japan, Korea, and Singapore. Realistically, however, neitherremaininglimitations on renminbiconvertibilitynor polit­ical acceptability leave any prospect of the renminbi being adopted by these other states in the foreseeable future.

Monetary integration extending beyond just mainland China and Hong Kong would likely require a common currency basket as suggested, for example, by Williamson (2005). The practicability of such an arrangement, as well as how the system would be anchored, remains open to question, though. Mundell’s (2003) suggestion that a fully dollarized Hong Kong might be the best anchor for such a system has surely been definitively ruled out by recent events, as has the idea of a generalized link to the US dollar among the different East Asian economies. Hefeker and Nabor (2005) suggest that the renminbi is the natural future anchor for such a system, but recognize that it is not yet ready to fulfill such a role. They propose setting up a currency basket system that allows the respective currency weights to change over time, suggesting that the weight attached to the Japanese yen should decline over time whereas the weight attached to the renminbi should increase. Indeed, Hefeker and Nabor (2005) draw parallels with the European experience whereby, starting from an initially more symmetric system, the Deutsche mark gradually emerged as the anchor currency.^[175]

The proposed Asian Currency Unit (ACU) might conceivably serve as a first step in this direction. This concept derives from the earlier European Currency Unit, which came into being as an internal accounting unit in March 1979 and enjoyed some limited use in international financial trans­actions prior to the January 1999 introduction of the euro. Although the Asian Development Bank has been considering the launch of the ACU for some time, the proposed set of included currencies, and their respective weights, had still not been announced as of year end 2007. Meanwhile, Gen- berg (2006) argues that the East Asian economies should not, at least for now, adopt an exchange rate anchor of any kind owing to potential insta­bility stemming from high degrees of financial market integration. Genberg argues in favor of a common pursuit of inflation targeting by separate inde­pendent central banks, which could help make full monetary integration feasible (much) further down the road.

Just how big a role the renminbi will play in Asia’s future is, of course, unclear, as is the time frame. Yet it seems likely that we will see its role expand substantially within the forty- to fifty-year timeline referred to by Eichengreen (2007). Continued renminbi penetration in Hong Kong, and its eventual dominance there, seems assured within the next decade, if not sooner. Although the renminbi is certainly not yet ready to be the centerpiece of any broader common currency arrangements in Asia, even assuming other economies were willing to accept it, the absence of any other obvious contender within the region suggests that it is the most viable long­term option there as well.^[176] Meanwhile, rising renminbi usage as a vehicle currency outside mainland China-Hong Kong, as well as continued slow but steady capital account liberalization, should help pave the way for the much larger future role it seems destined to achieve. From Li’s (2007, p. 42) perspective:

As the renminbi comes to serve as the vehicle currency in Asian trade and financial transactions, it will not only serve as a reserve asset for the public and for enterprises, but also as an intervention asset for the government, that is, as a part of reserve currency... The Chinese financial market will be more open and the renminbi will autonomously become the nominal anchor for some countries.