The start of 2016 has seen a tumultuous start for the global financial system. Oil prices have descended below $30 a barrel and economic developments in China have brought episodes of volatility - trading in the Shanghai Composite Index was halted twice in the first week of the year due to sharp selling.
While the slowdown in China has understandably made the markets nervous, it’s worth pointing out that with an estimated $4 trillion in foreign exchange reserves, the opening up of the Chinese financial system and the internationalisation of the renminbi (RMB) are likely to have a significant impact on the global economy.
Of course this impact may not all be for the best. Leaders in Davos will be well aware that China’s liberalisation is likely to produce further financial market volatility. Without proper management, this process is risky given foreign capital flows will introduce new competition for less profitable banks and non-financial corporations.
This however needs to be viewed in context. The increases in trade and investment after full RMB internationalisation could in fact offset the global trade and investment slowdown. Meanwhile, rebalancing China’s economy could also see a decline in US dollar dependence for developing countries, as transactional RMB usage rises.
These influences are important for emerging and oil-dependent developing economies. The latter two stand to counterbalance the trend of rising US interest rates, a stronger US dollar, and lower oil and commodity prices.
Risks need to be managed when pursuing China’s objective of taking a full part in a globalised economy. At 10%, its share of world trade is still relatively small. However, it has increased by five-fold since the mid-1990s, according to the OECD.
At this pace of growth, the Chinese contribution to world trade and investment could help mitigate emerging and developing economies’ ‘triple crises’ of higher US interest rates, lower oil and commodity prices and China’s growth transition.
Increased outbound foreign direct investment (OFDI) would be a boon for sub-Saharan Africa. Its oil-exporting countries derive more than 50 percent of government revenues from oil related activities and gross oil exports alone account for nearly 25 percent of their GDP, according to the International Monetary Fund.
Institutionally, the internationalisation of the RMB has only just begun. Currently, China’s offshore financial centres comprise only a fraction of China’s domestic deposit balance of CNY999.3 trillion. Increased RMB bond issuance, greater inclusion in trade and greater OFDI will boost global liquidity, trade and investment.
China is the world’s second largest economy, but its financial system is no where near as open as its developed country counterparts. Intermittent fear in financial markets comes from the historical experience of liberalisations – more often than not, generating currency crises.
Moving beyond the ‘impossible trinity’ of a fixed exchange rate, an independent monetary policy and opening an economy is difficult to manage, as witnessed in some of the Southeast Asian economies during the Asian financial crisis of 1997. Liberalising the RMB needs to be managed amid volatility in global capital flows. It is therefore expected that China’s policymakers will reform at a slow and steady pace.
As it took over the G20 leadership, China’s presidency highlighted the need for better global economic governance. One way of meeting this need would be to bolster its contribution to the BRICS’ shock facility, drawing in part from its significant reserves. This would be game-changing in the light of the current global financial risks.
Phyllis Papadavid is Team Leader in International Macroeconomics at the Overseas Development Institute