SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION - Revisiting internationalization of the Renminbi in 2013 (Part 1) - The stalled growth dynamic and the way forward - A commentary on Basel III and Asia
The Fortnight In Brief (7th January to 20th January)

ISSUE 31 21 JANUARY 2013

US: The recovery of the housing market

The US housing market rose to its highest level in three years with combined purchases of new and existing properties hitting a 5.49 million annual rate. 954,000 new homes were added in December, indicating that the housing market is contributing to economic growth. Retail sales also saw a 0.5% rise in December from the prior month, with car sales experiencing a 1.8% increase. These optimistic figures come at a time Democrats and Republicans continue their squabbling over US debt problem.

IN COLLABORATION WITH

Asia Pacific ex-Japan: Hot Money Flows into Asia

Chinas economy grew 7.9% in the last quarter of 2012 compared to 7.4% in the prior quarter. Though this is an improvement, the years overall growth was 7.8%, the lowest in the entire decade. Meanwhile, Asian currencies experienced its fourth weekly gain, with the BloombergJPMorgan Asia Dollar Index climbing 0.2% in the week, upon the release of optimistic economic data globally.

EU: A Long Drawn-out Crisis

Last week, the Euro was trading near a 10-month high of $1.34 against the dollar. This raised concerns that export competitiveness might be adversely affected. The Euros rise is particularly worrisome for Germany, where exporters are already saddled with increasing labour costs. In fact, Germanys 2013 growth forecast has been cut to 0.4%, down from 0.7% last year. With Germany being regarded by many as a pillar of confidence for Europe, many are concerned that a fall in exports will further hamper the European economic growth. In addition, output in the 17-nation Euro zone has been flat to sinking since late 2011, with unemployment at an alarming 16% in Portugal and 27% in Spain.

PROUDLY SUPPORTED BY

Revisiting the Internationalization of Reminbi in 2013 (Part 1)

By Henry Chan and Tong Kah Haw, Singapore Management University
The year of 2012 didnt spell the end of the world as predicted by the Mayan Calendar, but it did end with an optimistic note that Chinas slowdown could be nearing its end. Chinas official purchasing managers index (PMI) has held steady above 50 from October to December, signaling an expansion of the factory sector. Furthermore, Chinas inflationary pressure has remained relatively stable by hovering around the 2% range, providing the macroeconomic stability that will allow Peoples Bank of China (PBoC) to conduct a more flexible monetary and exchange rate policy. In such times where other major developed economies are in doldrums, many welcome Chinas imminent recovery. In fact, Chinas labour costs experienced an approximately 100% increase in the last 5 years, yet its export market share of manufactured goods reached an unprecedented high. The inherent strength of the Chinese economy took many analysts by surprise and indirectly supported many developing countries on export performance of raw materials. In the intelligence briefing for incoming President Obama prepared by National Intelligence Council, called "Global Trend 2030", the US government admitted that Chinas GDP will exceed that of the US a few years before 2030 in nominal term. Scenario analysis by the Asian Development Bank and Professor Eichengreen all point to the same conclusion in their base case barring any black swan type event. Hence, it is worthwhile to revisit the issue of Renminbi (RMB) internationalization, especially when the current international monetary system anchored by the USD as the leading international currency is plagued with so many underlying problems. RMB internationalization means the acceptance of RMB to function as money by other countries. Generally, economists have defined three functions of money. Firstly, it has to be the medium of exchange. This means that RMB will be used in global trade and service settlements. Secondly, RMB will be used as the unit of account in commodity pricing. Thirdly, it has to function as a store of value and standard of deferred payment. This means that RMB loans and deposits are not only used by the central bank as reserve to meet import needs, but also by the public worldwide. Conventional wisdom focuses on the opening of Chinas capital account as the signpost of RMB internationalization. Yet, Chinas view is apparently different. In the "Report on the Internationalization of RMB 2012" released by the International Monetary Institute of Renmin University, it suggested China should focus on growth and to expand its GDP share in the world economy as the primary driving force to promote RMB internationalization. It also acknowledges the weakness of the Chinese financial sector and urges the country to adopt a creeping RMB internationalization approach. Pertaining to this, IMF has formally declared that retaining some capital controls rather than achieving full capital account convertibility are deemed to be more strategic. The institute also formulated the RMB international index (RII) to measure the extent of 2 Copyright 2012 SMU Economics Intelligence Club

internationalization of RMB. The index increased from 0.02 to 0.45 in a span of two years, validating its phenomenal growth (Figure 1). In contrast, the USD international index remained high and unchanged at 54.18 (Figure 2). The report suggested that by 2030-2040, the RII will grow to 20+ and the international monetary system will then be dominated by three major currencies the U.S dollar, the Euro and the RMB. The view of Renmin seems to concur with the adopted view of the Chinese government at the moment. Figure 1: Renmin University - RMB Internationalization index (RII) from 2010 Q Year RII 2010-1Q 0.02 2010-2Q 0.02 2010-3Q 0.10 2010-4Q 0.23 2011-1Q 0.26 2011-2Q 0.40 2011-3Q 0.43 2011-4Q 0.45

Figure 2: Renmin University - Major Currencies Internationalization Index 2011 Internationalization 2011-1Q 2011-2Q 2011-3Q 2011-4Q Index USD 51.81 53 53.76 54.18 Euro 27.27 26.27 24.86 24.86 Yen 3.86 4.03 4.58 4.56 Sterling 4.73 4.21 4.34 3.87 There are various proponents arguing for and against RMB internationalization. Proponents claim the increasing size of the Chinese economy in the world, unstable USD, and benefits such as seignorage and geopolitical power projection provide the incentives for RMB internationalization. Detractors argue that Chinas weak financial systems, underdeveloped bond market and multiple capital market interest rates render China vulnerable and unable to buffer against capital flows should RMB be allowed to internationalize. All these factors will be examined in closer detail below. 1. Diversification away from the dependency on the Dollar Even though the US has confirmed its role as a safe haven despite the financial crisis in 2008, concerns about the booming US debt due to huge federal spending and trade deficit has been growing. The US national debt for 2012 currently stands at an astounding $16 trillion. Some have alluded this to the paradox of the Triffin Dilemma1, which states that a country has to run current account deficit in order for its currency to function as reserve currency status. Worries about potential USD devaluation due to continual Quantitative Easing2, the debt ceiling impasse in 2011 and a potential replay next month has caused reserve managers to be 3 Copyright 2012 SMU Economics Intelligence Club

wary of the systemic risk associated with holding USD. Consequently, IMF data in Figure 3 shows that reserves held by foreign central banks have been rapidly increasing, but shares of reserves in USD has fallen to about 60.7% in recent years. Figure 3: Decreasing Percentage of Total FX Reserves in USD

Hence, another credible reserve currency to reduce the reliance of the greenback is in the interest of international financial stability, and the likely replacement is the RMB. 2. Size Of Chinese Market Economy and Share In Exports For RMB to be an international currency, it has to fulfil several requirements. It must first satisfy the requirement of a large economy with huge trade volume. By the end of 2012, Chinas GDP will be around USD 8.4 trillion or 11% of the worlds total. Figure 4: Countries Share of World GDP 2006 2007 2008 2009 5.43 6.16 7.14 8 26.83 25.05 23.44 22.06 21.89 22.37 22.39 19.4 4.91 5.05 4.37 3.4 8.94 7.99 8.1 7.85

China US Eurozone UK Japan

2010 9.27 23.6 21.3 3.64 8.7

China is also the biggest exporter with 11.6% of the worlds market share and second bigggest importer. It is projected that at the end of 2016, China will overtake the United States to become the worlds largest trading country. 3. Tremendous benefits of RMB as Global Reserve Currency

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It is no doubt that the US derives many advantages when the Dollar is used as the reserve currency. Governments that print reserve currencies benefit from seignorage, a term coined to represent the revenue differential between the cost of printing and the face value of goods purchased. They also stand to gain exorbitant privilege, meaning that they will never face a Balance of Payment crisis since they can always pay for imports in their own currency. By internationalizing the RMB, China can also gain other benefits including cheap financing, greater power status recognition and accelerating the reforms needed for its weak financial system a step necessary for its thriving businesses and enterprises. Despite such advantages that stand to be reaped, there are obstacles that will hamper the pace of RMB internationalization. These obstacles will be further discussed in our next issue Triffin Dilemma is a theory that when a national currency also serves as an international currency, there will be a trade deficit due to the countrys willingness to supply the world with an extra supply of currency to fulfill world demand. 2 Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities such as mortgages from the market. It increases the money supply by flooding financial institutions with capital, in an effort to promote lending and spending. 3 Shadow banks are unregulated non-financial intermediaries that provide similar services to traditional banks.

Sources:
1. Renmin University International Currency Research Institute, Beijing - Report on the Internationalization of Renminbi 2012 2. Economist.com - Climbing Greenback Mountain 3. BIS Papers No 11 - The development of bond markets in emerging economies 4. Zhou Xiaochuan - Chinas corporate bond market development: Lessons Learnt 5. Alsosprachanlyst.com - Interest Rates for Underground Credit in Wenzhou Surge 6. Foxbusiness.com - China Plans to Tighten Banks Corporate Bond Underwriting Rules 7. Standard Chartered - Singapore is worlds second largest offshore RMB centre 8. Business Times, 8th Jan - Move to boost yuan business of HK banks

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The Stalled Growth Dynamic and the Way Forward

By Kenneth Ho, Singapore Management University
After the 2008 great recession, many drew from their past experiences of previous recessions and were expecting a quick V shaped economic recovery. Three years on however, the recovery has been elusive and painfully slow. Unemployment in the United States only recently fell below 8% while Europe continues to be mired by structural issues because of the Euro currency and its debt crisis. Compounding this, larger emerging markets like China are also showing signs of slowing down. Against this backdrop, we ponder why the growth dynamics are so different this time around. Two key questions come to mind - (1) why has the recovery been so slow? and (2) what is the way forward? (1) Why has the recovery been so slow? A. Lack of policy options to support growth in the developed world One major reason for the slow recovery in the developed world is the lack of available tools to stimulate growth in these nations compared to the past. The fact is that developed nations have run out of tools to stimulate growth to fuel the recovery! From a monetary policy standpoint, interest rates are already at the zero-bound in the US, UK, Japan and Europe and there has been little room to stimulate demand by lowering interest rates. Policymakers have turned to unconventional and unproven monetary methods such as Quantitative Easing to try and stimulate growth but there have had little visible impact. In fact, if history is any guide, Quantitative Easing might not be as useful as policy makers hope. Japan was the first country to turn to Quantitative Easing back in 2001 and after their repeated attempts to stimulate the economy has fallen flat. Japan has been in a deflationary spiral1 since the early 1990s and growth has been anaemic despite their unconventional methods. The same could be said of fiscal policy. The government sectors of these developed nations are burdened by significant amounts of debt thus making expansionary fiscal policies unlikely. Conversely in fact, these developed nations will soon have to deal with fiscal tightening to try and reduce their budget deficits and slowdown their public debt accumulation. One of the biggest talking points today is the US fiscal cliff, a reduction of government spending scheduled for the end of 2012 that is predicted to lower growth significantly if the political stalemate between Democrats and Republicans is not resolved. B. Emerging markets trading off growth for lower inflation In the larger emerging markets, priorities of policy makers have been changing. After a decade of blistering growth, policy makers are prioritising inflation management over growth. In China for example, much of the slowdown has been self-imposed. In a bid to cool inflation and prevent a property bubble, the government raised the Reserve Ratio Requirement2 four times in 2011 and allowed the RMB to appreciate against the US dollar.

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In fact, unlike the developed world, China retains many policy tools that can spur growth. It simply chooses not to utilise them right now. Chinas one year lending rate is now 6.0% and the RMB can be depreciated to improve competitiveness and boost exports. Furthermore, the Chinese government is flush with cash to implement expansionary fiscal policies if needed. While inflation has cooled since 2011 and the Chinese government has relaxed some policies, it is unlikely to target higher growth just yet. They seem to be aiming for the Goldilocks point where growth and inflation are at sustainable long term levels. Its growth target for this year is only 7.5% versus historical double digit growth. C. Ageing population and other structural changes are additional headwinds Longer term, ageing population issues and other structural changes3 in many economies are likely to be additional headwinds to the economic recovery. Globally, and especially in the developed world, populations are ageing as the baby boomers age and enter retirement. This is likely to have a profound slowing effect on global growth since the baby boomers are expected to consume less and invest less as they age. Studies have shown that the baby boomers were the key driver of economic growth in the 1980s and 1990s. The reversal of this key demographic trend is likely to be accompanied by structural slower growth globally. Additionally, there are many structural challenges in many countries that need to be sorted out before we can turn more optimistic. Europe for example, will have to sort out its debt crisis. The most likely solution to this problem is a structural shift to deeper fiscal integration among nations. However, agreement on this issue will take many years given the extremely political nature of the problem. Accordingly, these issues are likely to pose longer term headwinds to the economic recovery. (2) The way forward The Next 11 While the growth outlook in the developed world and larger emerging markets remains bleak, there is some hope in the next wave of emerging nations that could drive global growth over the coming decades just as the BRICs nations did in the 2000s. Jim ONeill, the chairman of Goldman Sachs Asset Management, has identified the N11 (Next 11) nations that is the BRICs equivalent of this decade. To identify these nations, Jim ONeill screened out nations that had large, young and growing populations. In fact, this is the same methodology to identify the BRICs nations back in 2001! The Next 11 nations consist of Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, Turkey, South Korea, and Vietnam. These nations exhibit macroeconomic stability, political maturity, openness of trade and investment policies, and good quality of education. Accordingly, they are poised to become the worlds largest economies in the coming decades. These nations have large, young and growing populations. Their developing economic architecture will likely help grow and develop a rising middle class. The twin drivers of 7 Copyright 2012 SMU Economics Intelligence Club

population growth and increasing GDP per capita are likely to boost the GDP of these nations to rival even the G7. It is clear that the N11 nations will be an important source of growth and opportunity in the coming decades. (3) Conclusion In summary, the growth dynamics since the 2008 great recession have been markedly different from the past. While recoveries used to be swift and V shaped, this recovery has been agonizingly slow and intermittent. Much of this can be attributed to the changing global landscape. In the developed world, there is a lack of policy options to support growth since policy makers have exhausted traditional monetary and fiscal policy tools. In the emerging markets, priorities have changed and leaders are trading off lower growth for lower inflation. Finally, longer term, ageing population issues will likely be a headwind to economic recovery as the baby boomers retire and spend less money. Amidst this gloomy economic outlook however, the Next 11 emerging markets provide some hope. With their large, young and growing populations with a rising middle class, they may come to rival the G7 in the coming decades and be a source of opportunity and growth for the world.
1A

deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. 2 The reserve ratio requirement is a central bank regulation that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves. 3 A structural change refers to a long-term, macro level shift in the fundamental structure of an economic system.

Sources:
1. Dominic Wilson and Anna Stupnytska, The Goldman Sachs Group. The N-11: More Than an Acronym 2. Raghuram G. Rajan. Fault Lines: How Hidden Fractures Still Threaten the World Economy

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A commentary on Basel III and Asia

By Leslie Tay, University of Hong Kong
Basel III in a nutshell Following the global financial crisis, the Basel Committee of Banking Supervision (BCBS) sought to improve the supervision of banks and actively shaped policies to reduce systemic risks1 within the financial sector. The result was a set of guidelines released in December 2010, known as Basel III, and was set to be implemented in 2013. Basel III was a follow-up from Basel 2.5 but comprised stricter standards and innovative counter-risk measures, with the goal of achieving financial stability using the lessons learnt from the financial crisis. Basel III includes the following key features: Enhanced quantity and quality of capital with higher capital ratios and additional capital buffers (Figure 1) Enhanced risk coverage by imposing higher capital requirements for securitized positions, derivatives and trading accounts Reduction of systemic risks through counter-cyclical capital buffers and higher capital and liquidity requirements for SIFIs (Systematically Important Financial Institutions) Enhanced leverage and liquidity requirements Enhanced monitoring of the shadow banking sector 2 and derivatives markets

Figure 1: Basel III Capital Ratios

Source: Moodys Analytics

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Asia takes the lead Asia has taken the lead with a number of countries (Singapore, Hong Kong SAR, India, China and Japan) starting to implement Basel III early this year. Asian banks, being better capitalized (many Asian banks already have capital ratios higher than Basel III requirements) and less leveraged than their European or American peers, will clearly see a smoother transition to Basel III. Monetary authorities and bank regulators in Asia generally agree that the benefits of early implementation outweigh the costs. With robust economic conditions, the consolidation of financial capital should not impose a huge burden to financial institutions. As financial markets in Asia mature and as trades in more complex financial instruments increase, the implementation of Basel III is highly timely by improving the soundness and sustainability of the financial sector. Nonetheless, there are key issues with regards to Basel III that regulatory bodies and banks should continue working on. Simply implementing Basel III without further considerations is not a sufficient condition for financial stability in Asia. Issues concerning Basel III on Asia a. Liquidity Under Basel III, two new liquidity rules will be introduced. The first ratio, the Net Stable Funding Ratio (NSFR) ensures that banks have funding requirements over a one year period of extended stress. The second ratio is the Liquidity Coverage Ratio (LCR) requires banks to hold sufficient high quality liquid assets (HQLA) to cover net cash outflows stemming from 30 days of severe stress. One implication of liquidity rules is that banks may be less willing to lend out and this may act as a brake to the growth of Asian economies. Small and medium enterprises, an essential source of growth for developing Asian economies, will need to compete for loans or seek alternative methods of financing. The 30 day assumption of the LCR also fails to reflect the underlying scenario in Asia where bank runs, rather than wholesale funding shortage, is the main source of liquidity problems. Bank runs are much shorter and more volatile in nature. As such, the 30 day time framework may be too long for Asian banks. The probability of bank runs may increase over time as banks seek to attract deposits which are a source of stable funding to maintain liquidity and capital ratios, making traditional Asian deposits less sticky than before as savers simply shop for the bank that offers the best interest rate. On this note, regulators should ensure that liquidity rules are implemented in stages to ensure that there will be sufficient stable funding in the economy for banks to meet those rules. A final concern with the new liquidity rules is the definition of what qualifies as a HQLA. Prior to January 2013, only cash and government bonds qualify as Level 1 assets while government bonds and corporate bonds rated AA- or higher qualify as Level 2 assets (Figure 2). The Basel committee has since relaxed the Level 2 requirements to accept corporate debt with BBBrating and above. High quality mortgage-backed securities will also be counted. Nonetheless, the key concern for most Asian regulators lies in Level 1 assets due to a shortage in domestic government debt. Monetary authorities would thus need to consider how to adapt the rules to 10 Copyright 2012 SMU Economics Intelligence Club

local scenarios. The Hong Kong Monetary Authority (HKMA), for example, is considering to only implement liquidity rules on core financial institutions and to allow banks to hold some US dollar liquid assets to counter the shortages of Hong Kong dollar assets since the HKD is pegged to the USD. This measure will however contain foreign exchange risks. With regards to Level 2 assets, one concern may be the lack of a transparent rating system of corporate bonds in safe Asian markets (e.g. Singapore) which are often assumed to possess a high rating by default. Regulators need to improve the transparency within the bond markets and provide incentives for companies to rate their bonds.
Figure 2: Definition of Level 1 and 2 Assets for LCR

b. Compliance and Risk Management Basel III has seen a great deal more regulations and supervision efforts. It is important that both banks and regulators continue to improve quantitative risk analysis. Banks need to fully understand the technicalities within Basel III and keep abreast with regulatory developments. Banks should continue to take ownership of risk management and not simply seek to comply with market regulations. Risk and performance management need to be aligned. Asian banks should also seek to improve data management as data serves as the seeds to effective compliance and risk management. This should be done by embracing new technology and data management system. c. Derivatives Markets Basel III has sought to move the clearing of over-the-counter (OTC) derivative3 contracts to centralized exchanges or trading platforms and penalize non-centrally cleared contracts by posing higher capital requirements for those contracts. A key concern in this area is the lack of trading volume, hence liquidity, of derivative contracts in Asia as compared to Europe or US (Figure 3), which will hinder the effective functioning of central counterparties (CCPs) with the eventual result of higher margin and collateral requirements. The cost of trading derivatives may increase, reducing the net benefits of hedging in the first place. In this light, regulators in Asia should seek to cooperate and agree to have a common set of standards for derivatives, with the possibility of consolidating the Asian OTC clearing space in one or two CCPs, such as Singapore and Japan which have already taken the lead in clearing houses. 11 Copyright 2012 SMU Economics Intelligence Club

Figure 3: Asia lags behind in volume of OTC derivatives to begin with

Source: Celent
1 Risk

inherent to the entire market. In finance, systemic risks are also known as un-diversifiable

risks. 2 Financial intermediaries involved in facilitating the creation of credit but are not subjected to regulatory oversight. An example of a shadow banking institution is hedge funds. 3 Over-the-counter derivatives: Derivative contracts that are traded between two parties, without any supervision of an exchange. Over-the-counter derivatives, as compared to centrally cleared derivatives, contain higher degree of credit or counter-party risk when either side defaults. Sources: 1. Wee, Ling Phua (May 2011), Basel III & Beyond: A View from Asia, University of Cambridge Judge Business School 2. Watanagase, Tarisa (Oct 2012), Impact of Changes in the Global Financial Regulatory Landscape on Asian Emerging Markets, ADBI Working Paper Series 3. Hong Kong Banking Survey 2012, KPMG 4. Chan, Albert et al (2011), Beyond Basel III: The future of high performance in Chinese banks, Accenture

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The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large- cap common stocks actively traded in the United States. It has been widely regarded as a gauge for the large cap US equities market The MSCI Asia ex Japan Index is a free float-adjusted market capitalization index consisting of 10 developed and emerging market country indices: China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. The STOXX Europe 600 Index is regarded as a benchmark for European equity markets. It represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, I reland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

Correspondents Vera Soh (Vice President, Publication) Vera.soh.2011@economics.smu.edu.sg Singapore Management University Singapore Samuel Ong (Publications Director/ Editor) samuel.ong.2010@business.smu.edu.sg Singapore Management University Singapore Yingyu Zeng (Liaison Officer) Yingyu.zeng.2010@economics.smu.edu.sg Singapore Management University Singapore Kenneth Ho Undergraduate Lee Kong Chian School of Business Singapore Management University kenneth.ho.2009@business.smu.edu.sg Tong Kah Haw (Writer) Graduate Lee Kong Chian School of Business Singapore Management University kahhaw.tong.2009@business.smu.edu.sg Ng Jia Wei (Vice President, Operations) Jiawei.ng.2012@economics.smu.edu.sg Singapore Management University Singapore Shreya Chatterjee(Marketing Director) shreyac.2010@economics.smu.edu.sg Singapore Management University Singapore Darren Goh Xian Yong (Editor) Darren.goh.2010@business.smu.edu.sg Singapore Management University Singapore Henry Chan Hing Lee (Writer) PHD in Business (General Management) Lee Kong Chian School of Business Singapore Management University henry.chan.2012@phdgm.smu.edu.sg Leslie Tay Master of Economics Candidate School of Economics and Finance The University of Hong Kong taynxl@hku.hk

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