Perfect Timing

China will gradually relax controls over the capital account and boost the yuan as a global currency By Hu Yue

Perfect Timing

China will gradually relax controls over the capital account and boost the yuan as a global currency By Hu Yue

China has been presented with a strategic opportunity to open its capital account a little wider and accelerate the internationalization of the yuan, said the People’s Bank of China, the central bank, in a recent report.

“Liberalizing the capital account will be a needed boon to widening the channels for the yuan funds to fl ow in and out of the country,and bolster the status of the Chinese currency in international trade and investments,” said Sheng Songcheng, director of the central bank’s statistics department and chief compiler of the report.

Under a more liberalized capital account,Chinese firms will be more able to acquire overseas resources, technologies and market shares, said the report. Moreover, Chinese households will obtain easier access to overseas capital markets and facilitate wealth management.

The capital account and the current account are two primary components of a country’s balance of payments. It reflects a country’s net change of public and private international investments. China’s capital account is partially convertible. Major obstacles on inward and outward direct investments were removed, but policymakers have been cautious to loose the grip over fi nancial derivatives, debt fi nancing and securities markets.

“There may never be a better time to push for reform, if the country continues to wait until conditions mature for the interest rate and exchange rate to be decided by the market and the yuan to become a global currency,”said Sheng.

This short window of opportunity may pass China by if it stalls until market conditions mature, said the report.

“Possible dangers stemming from the reform may not be as acute as expected,” said Sheng, citing the controllable risks facing real estate and capital markets, and the country’s limited short-term external debts.

By the end of September 2011, China’s outstanding short-term external debts had totaled $507.6 billion, accounting for only 15.9 percent of the country’s foreign exchange reserves.

“Moreover, China’s foreign exchange reserves are mostly parked in the bond portfolio, and their principal and interest payments are less vulnerable to fluctuations in foreign exchange rates,” he added.

Still, Sheng pointed out China must optimize the sequence of the opening up by fi rst promoting reforms with the highest prospective returns and later taking more risky moves.

Reform in the pipeline

This is not the fi rst time that Chinese policymakers have sent out a signal for capital account reform. In a recent interview with theNew Century Weekly, central bank governor Zhou Xiaochuan said China is not far from convertibility under the capital account.

By the end of 2010, inside the 40 speci fi c items under capital account transactions classified by the IMF, five items had been fully opened, with eight items basically convertible,17 items partially opened and 10 items tightly restricted.

“While it tries to move toward greater fi nancial freedom, China will retain necessary regulations to ensure fi nancial stability,” said Zhou. “The IMF in 2010 mandated that regulatory controls over short-term volatile capital fl ows are legitimate and temporary solutions.”

“For China, it is necessary to keep a vigilant eye on cross-border fi nancial transactions to prevent speculation and money laundering,” he said.

“Another cause for concern is that many Chinese enterprises and residents have weak awareness about the risks of investing abroad,” said Zhou. “So a pressing task of the government is to strengthen risk education.”

Although internationalization of a currency is not tantamount to capital account liberalization, many economists believe the degree of globalization is conditional on capital account liberalization.

Timetable for the Yuan

Internationalization

● In one to three years, lifting restrictions on Chinese enterprises’ direct outbound investment

● In three to five years, loosening controls over commercial credit for crossborder trade

● In fi ve to 10 years, strengthening fi nancial market construction and opening up the real estate, stocks and bond markets to foreign investors

(Source: People’s Bank of China report)

“Internationalization of the yuan can be achieved without opening up the capital account, and that is likely to be a complicated process given simmering fi nancial risks,” said Li Xunlei, chief economist at the Shanghaibased Haitong Securities Co. Ltd.

“Partial convertibility under the capital account means China’s currency could only ful fi ll 10 percent of its potential international role, and the growth momentum of overseas yuan accumulation for trade use would dry out in two to three years,” said Ma Jun, chief economist at Deutsche Bank Greater China.

He suggested China further loosen the quota limit for qualified foreign institutional investors to invest in the domestic capital market, and allow domestic non-residents to raise yuan funds through borrowing, bond issuance, stock listing and transfer the capital out of China in foreign currencies.

Zhang Yongjun, a researcher with the China Center for International Economic Exchanges,said China should take a gradual approach to capital account liberalization. “With a solid economy and deep foreign exchange reserves,China is able to withstand external shocks,” he said. “But the challenges would be daunting due to fledgling financial markets, limited depth of bond markets and slow progress in marketization of interest rates.”

Going global

In a bid to widen the global presence of the yuan, China has spared no effort. In its latest move, the country in December 2011 initiated a pilot program, allowing Hong Kong subsidiaries of quali fi ed fund management companies and securities firms to use yuan funds raised in Hong Kong to invest in mainland securities within a permitted quota.

Prior to this, in July 2009 the government started a trial scheme of yuan settlement in crossborder trade in five cities, and in August 2011 expanded the scheme to cover the whole country.

In 2011, 2.08 trillion yuan ($330.16 billion) worth of cross-border trade was settled in the yuan, accounting for more than 10 percent of the country’s total foreign trade, according to data from the State Administration of Foreign Exchange.

Meanwhile, China’s experiment with Hong Kong as a test bed for internationalizing the yuan has proved successful. More than 80 Chinese and overseas institutions have issued yuandenominated bonds in Hong Kong, including the World Bank, German automaker Volkswagen and Chinese steelmaker Baosteel. Data from the Hong Kong Monetary Authority showed yuan deposits in the city’s banking system surged 87 percent from a year ago to 588.5 billion yuan($93.4 billion) at the end of 2011.

“China’s growing weight in world trade,the size of its economy and its role as the world’s largest creditor will make the internationalization of the yuan inevitable,” said the World Bank, in its latest report.

“The fi nancial crisis has compromised the U.S. dollar and the euro as safe-haven stores of value, and the world urgently needs a greater role for alternative currencies,” said Guo Tianyong, Director of the Research Center of China’s Banking Industry at the Central University of Finance and Economics.

“Acceptance of the yuan as a major global reserve currency will depend on the pace and success of fi nancial sector reforms and opening of its external capital accounts,” said the World Bank. It suggested China press ahead with fi nancial reforms, including commercializing the banking system, gradually removing interest rate controls, deepening the capital market and further developing independent and strong regulatory bodies to support the eventual integration of China’s fi nancial sector within the global fi nancial system.

Ding Zhijie, a finance professor with the Beijing-based University of International Business and Economics, said the yuan is bound for a slick prospect of becoming an international currency.

“To achieve that, China needs to strike a balance between regulatory controls and capital account liberalization,” he said. “Moreover, the country must retain health of the fi nancial markets and safeguard against risks while it tries to liberalize interest rates and exchange rates.”