Cross border settlement - PBOC regulations
Last week, China took a small but significant step toward opening its capital account, and therefore to 1) losing control of the exchange rate and 2) promoting the international role of the RMB. That step was the publication by the People’s Bank of China (PBOC) of regulations governing the use of the RMB to settle cross border trade transactions.
Till now, according to the PBOC, 90% of China’s cross border trade has been settled in a third currency (ie the US dollar). The PBOC argue that with fluctuations in the dollar’s value, China’s importers and exporters are subject to unnecessary currency risk, cost, and inconvenience. Using RMB will be cheaper, more convenient, and less risky.
So far so straightforward, but there are also broader implications. Increasing the use of the RMB as a trade settlement currency will create demand for further steps toward the loosening of China’s capital controls. For example, as foreign firms hold RMB in order to settle transactions with Chinese firms, they will demand less restricted access to China’s capital markets, and a broader range of financial instruments in order to manage the associated risk.
A few years down the line, if the RMB has become a convertible currency (which is the same as saying that capital controls have been removed), then one of the most significant barriers to the use of the RMB as an international reserve currency will have been removed. The cost to the Chinese government will be that without capital controls they will not be able to control the exchange rate. Steps toward the internationalisation of the RMB, therefore, will have to be accompanied by steps to reform the mainland’s economic model and reduce the reliance on trade, or at least reduce the reliance of exporters on an undervalued RMB to boost their competitiveness.
You can see the regulations governing cross border settlement, in English, here. The main points to note from the regulations are:
Only approved enterprises can participate in the pilot scheme. Provincial government can propose enterprises for participation and they are then vetted by various government departments, including the PBOC. Apparently Shanghai, which is one of the pilot areas for the scheme, has just 100 firms participating. There is clearly a risk that enterprises will use the new scheme to speculate on the appreciation or depreciation of the RMB by faking trade transactions as an excuse to move money in and out of the country. When the scheme is fully implemented it will be impossible to stop this happening, but this strict vetting of enterprises will prevent abuse at the pilot stage.
The regulations also specify that ‘cross border receipt and payment in RMB should be based on actual trade transactions’ and requires that banks verify these transactions. This sounds like a burdensome requirement on the banks and, again, is grounded in concerns about abuse of the scheme for currency speculation.
Participation by banks is subject to approval by the PBOC. Participating banks must be either mainland or Hong Kong or Macao banks. These banks can act as agents for overseas commercial banks to participate in the scheme. Foreign banks can open RMB accounts and domestic banks can provide them with trade financing services. Here is where the pilot scheme will, through its own internal logic, force further opening of the capital account and a deepening and sophistication of China’s financial markets. Foreign banks, and their clients, will be a strong voice calling for greater access to China’s capital markets and more sophisticated financial instruments in those markets as they attempt to hedge the risk of holding RMB. Their Chinese trade partners will also have an interest in seeing the same opening and deepening as it will reduce costs for their foreign counterparties and make it more likely they are willing to settle transactions in RMB.
The PBOC can exercise control over the aggregate amount of RMB settlement in accordance with the needs of the macro-economy and to prevent systemic risk. This is basically for the same reason as the strict vetting of enterprises - to stop abuse of the system to speculate on exchange rates. Ever since the 1997 Asian Financial Crisis (AFC) the Chinese government has had a horror of the threat of sudden capital outflows and their destabilizing impact on the economy. In fact, before the AFC in the mid 1990s, plans were in place for loosening of capital controls. But the government in Beijing was so horrified at the economic and social instability in Thailand and elsewhere as a reuslt of rapid capitla outflows that they put the plans on ice for more than a decade.
Finally, participants in the scheme will be eligible for the usual export tax rebates and banks will be responsible for verifying the accuracy of their claims (another compliance burden on the banks). According to an article in Caijing, this was a problematic point in the development of the scheme as without the same rights to tax rebates companies would not wish to participate.
That’s it for the regulations. One final point from Dow Jones reporter Denis McMahon. In a recent article he notes that China’s foreign exchange regulator, SAFE, believes that ongoing appreciation of the RMB is a precondition for cross border settlement to work. In a recent report SAFE say:
“The ongoing strengthening of the yuan’s exchange rate is a market precondition for launching the yuan as a settlement currency,”
and
“If the yuan depreciates then the currency will have no appeal, but if the yuan is relatively stable and appreciates, then it will be easy to use to settle international trade.”
The irony of SAFE’s statement is that, with a closed capital account, Beijing can manage the exchange rate up or down as they wish. But as the capital account becomes more porous, and eventually a few years down the line completely open, managing the exchange rate will no longer be possible. And it is the cross border settlement scheme that is one of the first steps down that road.
It’s all about balance.