Note (Sept. 2021) This post is now largely superseded by a working paper available from the Soon Parted github repo.

It is not possible, I think, for a single person to be fully informed about China's financial system. Just in the last couple of months, there has been a significant acceleration of involvement of US banks in China, at least superficially in contradiction with the country's recent crackdown on fintech groups. At the same time, the country has made an extremely rapid push toward the launch of its DC/EP digital currency platform.

There is no substitute for detailed knowledge of each of these situations. But there are at least two important issues that can be understood, at least partly, on their own, and which frame the others: the internationalization of the renminbi and the central bank's balance sheet. This post draws from my contributions to joint work on this CIGI piece on the RMB. I'll come back to the PBOC balance sheet in a future edition of Soon Parted.

Offshore RMB: two mechanisms

There has been and continues to be a lot of noise about internationalizing the RMB. Usually this is cast as a contest for global hegemony between the US and China. Regardless of one's stance in that debate, it seems helpful to understand the mechanics by which China allows offshore users of its currency to bring their funds into China.

To be clear about how it works, we have to be clear about the terminology: renminbi is the name of the currency, yuan is the unit in which it is denominated (so "yuan" is to "renminbi" as "pound" is to "sterling"). CNY is the symbol for onshore renminbi, i.e. funds on deposit or invested in securities that trade in mainland China. CNH is the symbol for offshore renminbi funds, i.e. on deposit or invested in securities that trade outside of mainland China. Hong Kong is the most established trading hub for CNH (thus the "H"), but substantial volumes of CNH now trade elsewhere as well. RMB is either (when used carefully) shorthand for the combined CNY–CNH system, or (when used sloppily) a generic symbol for either CNY or CNH.

The CNY–CNH structure is comparable to on- and offshore markets for other currencies. For example, banks around the world create dollar deposits, most famously in London. Whether in dollars or in renminbi, the crux of the matter is whether and how these funds can be used in their respective home financial systems. China allows such remittance in two main ways.

In the first scenario, dollars are received by an offshore bank authorized to transact with the PBOC. Typically this is the foreign office of a mainland bank, for example Bank of China's Hong Kong branch, BOC (HK). At this point, the offshore bank has offshore CNH deposits against a reserve position in onshore CNY. It can then use the onshore reserves to complete payment on behalf of its depositor:

A second, slightly more involved mechanism achieves the same result using correspondent banking. Instead of the offshore bank transacting directly with the PBOC, an onshore bank can serve as its agent. The mainland bank has access to reserve money at the central bank, while the offshore bank is able to issue deposits outside of mainland China. A correspondent relationship connects the two. The onshore bank creates a channel by which the offshore funds can reach the onshore, CNY-denominated payment system:

Comments

1. The PBOC still has to purchase dollars, even though payments are being made using offshore RMB. Internationalization by itself doesn't stop the accumulation of FX reserves.

2. To bring offshore CNH onshore for domestic payments in China, there must be a bank that transacts in both. In the first example, this is BOC (HK); in the second, the offshore correspondent bank. Either way, this bank has offshore liabilities and onshore assets, and makes a market between them. Whether this market can be made, and whether the price is stable at one, is the main issue for internationalization.

Previously on Soon Parted

Prices and flows

• Lira troubles: balance sheet whack-a-mole

• Stablecoins: It's cheaper to pretend

• Inflation and Minsky's two-price model

Digital currencies

• E-krona

• CBDCs