Will the Renminbi’s Fate be Determined in Hong Kong?

China will have to demonstrate that rule of law and judicial independence apply to its international financial affairs. From this perspective, recent events in Hong Kong are discouraging. A column by Barry Eichengreen.

Barry Eichengreen
«We already hear tales of wealthy Hong Kong residents shifting funds to Singapore and of financial institutions looking in that direction.»

China’s announcement on May 22nd of a new national security law aimed at curtailing civil liberties in Hong Kong has elicited protests in London, Washington, D.C. and, of course, Hong Kong itself. Commentators have asked whether this resolution, approved by the National People’s Congress, spells the death knell for «One Country, Two Systems.» They have asked what it implies for Hong Kong’s future as an international financial center. And they have pondered how international banks such as HSBC and Standard Chartered will deal with the dilemma of whether to support the change or risk losing Beijing’s goodwill and, who knows, maybe even their business licenses.

[info 1R]What wasn’t asked was how the new security law and the manner of its imposition will affect not China’s campaign to rein in Hong Kong but, rather, its push to internationalize the renminbi. For more than a decade, China has been seeking to encourage greater cross-border use of its currency, not just by China exporters and investors themselves, but by the banks, firms and governments of other countries, with which China does business.

Behind this renminbi internationalization push lie several objectives. Doing cross-border business in their own currency has convenience value for Chinese companies. Freeing them from having to depend on the U.S. dollar, the dollar currently being the lingua franca of international markets, reduces China’s vulnerability to U.S. financial power. Chinese officials are well aware of how the Trump Administration has threatened banks and governments doing business with Iran, in violation of U.S. sanctions, with loss of access to U.S. banks and dollar credit.

Dim sum bonds

At the same time, renminbi internationalization is something of a vanity project.  Just as every great power has an aircraft carrier (China has two), it has an international currency – or so it is sometimes said.  Whether this is an important objective can be debated. What is beyond question is that China is intent on pursuing it.

To this end, the People’s Bank of China has set up renminbi swap lines with foreign central banks. It has designated one of the four big Chinese commercial banks as the official clearing bank for each global financial center, assuring other financial institutions that they will be able to settle their renminbi transactions efficiently. China has partially opened its domestic financial markets to foreign investors.  It has encouraged the issuance of renminbi-denominated bonds outside the Chinese mainland.

Specifically, it has encouraged the issuance of those bonds in Hong Kong, that being where the majority of so-called dim sum bonds are issued and traded. A principal conduit for foreign investment in China’s financial markets is the Shanghai-Hong Kong Stock Connect, through which participants on the Hong Kong market can also trade in Shanghai and vice versa. Hong Kong is the global hub for trade settlement in renminbi. Foreign exchange market turnover (trades of the renminbi against all other currencies) are higher in Hong Kong than in all of Mainland China combined, according to the latest triennual survey of the Bank for International Settlements. And Hong Kong is where the majority of renminbi-related hedging instruments, with which banks and companies insure their balance sheets against unexpected exchange-rate changes, are created and traded.

Discouraging the use of the digital renminbi

What will China’s crackdown on Hong Kong mean for these arrangements? Most obviously, there could be an exodus of finance professionals who refuse to live under Beijing’s iron fist. There could even be the exodus of banks themselves. We already hear tales of wealthy Hong Kong residents shifting funds to Singapore and of financial institutions looking in that direction.

Of course, there is no reason why a financial center wholly outside China could not become the leading venue for renminbi transactions. London, after all, is the leading center for trading the euro – not to mention the Swiss franc. Shifting business from Hong Kong to Singapore might not be especially disruptive for China. To be sure, accommodating this shift would require some rejiggering. The Shanghai-Hong Kong Stock Connection would have to be replaced by a Shanghai-Singapore Stock Connect, for example. But there is no reason why, in and of itself, this should discourage international use of the renminbi.

A more serious concern is that Beijing’s move against Hong Kong will discourage use of the digital renminbi, in particular. The PBOC has been moving faster than any other central bank to create a central bank digital currency, or CBDC, partly in the hope that a digital version of the renminbi will be attractive for foreign merchants doing business with China. Already there are signs of a readiness of merchants in South Korea, for example, to accept Alipay, the digital service of the Chinese e-Commerce giant Alibaba, in transactions with Chinese nationals. The PBOC’s expectation, evidently, is that a digital unit issued by the central bank itself would be even more attractive.

Privacy concerns

But events in Hong Kong are a reminder that a CBDC could have an ID built into it, enabling the Chinese authorities to track the transactions of those using it. The same kind of privacy concerns that that were voiced when Facebook announced its proposed digital currency, Libra, would also arise in this connection. (Whether Facebook or the Chinese government is the more benign actor, I leave to your judgement, dear reader.)

Fundamentally, Chinese action against Hong Kong raises questions regarding rule of law and political checks and balances, concerns that bear directly on international currency status.  Investors when holding and using the renminbi want to know that the rules governing its use won’t be changed arbitrarily, in the way that the security law was changed in Hong Kong. Investors want to know that their voices register. They want assurance that there are checks on the arbitrary exercise of executive authority. Hong King is known for its rule of law and independent judiciary. Now, suddenly, there are questions about whether it will retain either.

Investors need to be protected

As I like to put it when I give talks on this subject in China, every leading international and reserve currency in history has been the currency of a political republic or democracy. This is true of the United States today.  It was true of the United Kingdom before that. It was also true of the Dutch Republic (notice again that word) in the 17th and 18th centuries. And it was again true of the republican city states of Genoa, Florence and Venice in the 13th and 14th centuries. These republics all had representative assemblies with which the king, prince or other executive had to consult, and whose consent was required on consequential financial matters. Investors were prominently represented in those assemblies. This reassured not just the representatives in question but also third parties that their financial interests would be respected and protected.

This doesn’t mean that China will have to experience its own democratic spring before the renminbi becomes a consequential international currency. But it does mean that it will have to demonstrate that rule of law and judicial independence apply to its international financial affairs. From this perspective, recent events in Hong Kong send a discouraging signal.