Author: Wang Yong, Peking University For those interested in the internationalisation of China’s national currency, the renminbi, and hence anyone interested in the future of the global currency system, Vice Premier Li Keqiang’s recent visit to Hong Kong was an important event. The Vice Premier announced on 17 August 2011 the central government’s ‘Six Measures’ to support Hong Kong’s economic development — a move welcomed by Chinese media and businesses. The measures include a quota of RMB20 billion (US$3 billion) for renminbi Qualified Foreign Institutional Investors (RQFIIs) to invest in mainland China’s RMB-denominated securities market; allowing mainland Chinese investors to conduct business in the Hong Kong Stock Exchange’s exchange-traded funds; and issuing RMB20 billion in RMB-denominated bonds in Hong Kong. The new measures are a significant step forward in promoting China’s national currency as a major international reserve currency. Beijing began considering the unique role that Hong Kong could play as an offshore RMB centre given its attributes — a pool of financial talent, its deep and liquid financial market and position as a free trade port — and its openness to international markets, in the early 2000s. This combination of factors consistently keeps Hong Kong at the top of the Index of Economic Freedom , and allowing its investors to move into mainland China’s A-share markets will give more support to Hong Kong as a global financial centre. But Chinese authorities have taken a cautious approach . The experimentation started with the creation of incentives and institutional infrastructure to settle trade transactions in this currency. At the same time, central monetary and financial regulators were careful about managing the opening of China’s domestic capital markets to overseas RMB-denominated investment. They have focused on managing the pace and scope of Chinese currency internationalisation to ensure that national economic security interests are protected. Despite this cautiousness, the announcements are a major step forward — obviously the US debt ceiling crisis helped Chinese leaders to speed up the efforts to internationalise RMB. Chinese financial institutions have purchased over US$1 trillion in Treasury bills, making China the largest official creditor to the US government. But more people are considering the inherent pitfalls of holding too much US debt, and the sentiment is growing that, given its large dollar-denominated holdings, China is exposed to immense risk. The Chinese believe the growing challenges experienced by the US in managing its massive debt burden and a weakening dollar are threatening future returns on these bonds. The extended saga over the US debt ceiling has made clear the potential hazards of maintaining massive dollar holdings. Growing public criticism of US bond operations inside China has even forced the country’s leadership to show that they are now giving serious consideration to measures aimed at reducing China’s role in financing American debt. Li Keqiang’s recent policy announcement to allow more investment scope for RQFIIs should be seen as partially motivated by the public outcry. Although internationalising the Chinese currency may seem desirable, the process is laden with risk. There is debate at the top of the party and government leadership over whether the time is ripe to dramatically move ahead on such currency reforms, or whether to wait and continue cautiously and incrementally. There are also enduring factors at play in internationalising the currency. The cultivation of Hong Kong as an offshore RMB centre was already written into China’s Twelfth Five-Year Plan . Hong Kong’s renminbi savings, or deposits, reached RMB550 billion (US$86 billion) at the end of June 2011, and the Hong Kong-based banking industry has lobbied Beijing heavily to open more investment windows. These business interests worked hard to convince Beijing that the expected risks in allowing these savings back into the mainland’s capital markets could be managed, and that the time was right to further expand Hong Kong’s role. Now, the worsening sovereign debt crises in the EU and the US are further adding to the internal Chinese financial market integration arguments. In recent months, the renminbi exchange rate has appreciated faster than before, and consensus is emerging that the conditions are right for China to promote the renminbi as the third global reserve currency, joining the US dollar and the euro. Despite growing pressure, Beijing will most likely continue to take a careful approach. The RMB20 billion quota assigned to Hong Kong investors is evidence of such caution. Given the considerations, it is clear that prudence is justified. Internationalising the renminbi requires China to fundamentally restructure its system of capital controls and the existing foreign exchange regime to allow for greater capital account convertibility; marketise interest rates; and further open domestic financial markets. Only through such measures will China be able to increase the attractiveness — albeit over the longer term — of holding renminbi assets for international investors. Wang Yong is Professor at the School of International Studies, Peking University. A version of this post was first published here on the Centre for International Governance Innovation website. On China’s renminbi becoming a world currency What China is after financially Krugman’s Chinese renminbi fallacy