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China last week reported that GDP growth slowed in the first quarter to the slowest pace seen since early 2009. While disappointing, we would not let this one data point overwhelm what is a much bigger, entrenched story: China is redefining global currency markets, and the “G-3” in particular.
For more than a decade, any foreign-exchange watcher mentioning the “G-3” would be referring to the U.S. dollar, the euro and the Japanese yen. These three currencies accounted for more than 70% of all FX transactions in recent years, but we would argue that the G-3 is structurally changing. Even with China’s closed capital account, the influence of China and the Chinese renminbi on global markets has overtaken the yen on a number of fronts.
The key driver behind these changing currency relationships is trade. Data from the International Monetary Fund show that by 2010, China had overtaken both Japan and Germany in terms of its importance as a global trade partner. As global trade patterns evolve, so do financing needs. Countries around the world trading with China have had to find ways to manage currency risk and ensure sufficient liquidity, closed Chinese capital account or not.
Two events just in March help illustrate the trend. During the month, Australia’s central bank signed a “swap” deal with the Chinese central bank under which the two central banks can exchange local currency for up to RMB200 billion, helping to ensure RMB liquidity for Australian companies trading with China. Some 16 additional “swap” deals have been signed with China to date, although Australia’s has been the largest so far. Separately in March, Japan announced it had obtained permission from China to buy RMB65 billion worth of Chinese government bonds and would try to set up an offshore RMB trading center in Tokyo.
The interest in renminbi is quickly moving beyond solely trade and public-sector entities. Private demand is fueling a surge in renminbi-denominated assets, including “dim sum” bonds and offshore renminbi certificates of deposit.
It all gets reflected in global currency markets. Consider the Bank for International Settlement’s global currency turnover data. Back in 2001, the yen accounted for some 12% of global FX trading volume, versus about 2.5% of total volume represented by the currencies of Korea, Singapore, India, China, Taiwan, Malaysia, Thailand and Hong Kong combined. Less than a decade later, Japan’s share had fallen to less than 10%, while the emerging-Asian group’s share had nearly doubled.
Another way to appreciate the shift in influence is to look at relationships between the yen and the Chinese renminbi, or CNY (the latter proxied by its 1-year non-deliverable forward, or NDF) against other currencies. (To note, an NDF is similar to a regular forward currency contract, except at maturity the NDF is settled in U.S. dollars.)
The Korean won provides a good case study. Back in the 1990s, the Korean central bank actively managed the won to stay competitive vis-à-vis the Japanese yen, given both the amount of Korean exports to Japan and the competition between the two countries for third-party export destinations like the U.S. If the yen weakened, Korea was more likely to try to keep the won weak as well, and vice versa.
Fast forward to today. This last decade has seen that USD/JPY and USD/KRW relationship flip-flop. The currencies now move inversely to each other much of the time. Meanwhile, the same period has seen a significant correlation emerge between USD/CNY 1-year NDFs and USD/KRW - significant, though not surprising given that China is now Korea’s largest export destination (around 22% of total Korean exports).
Does all this mean China is about to overtake the dollar as the world’s reserve currency? Not anytime soon. A reserve currency, in our view, requires deep and credible government bond markets, an open capital account and critical mass in global financial systems. China’s central bank has laid out a 10-year plan for “internationalization” of its currency. China’s FX bands are widening, but in an incredibly cautious way. Dollar holders need not panic.
That said, investors should still make a point of watching the renminbi, even if only via its derivative NDFs. The dollar, euro and yen are not about to disappear but each faces its own significant challenges. In contrast, sentiment towards the world’s second-largest economy, reflected in the renminbi, increasingly tells us not just where local Chinese markets may be headed, but also the direction of global growth sentiment and an array of investments across the world.
Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.
