Reforming the yuan: no easy answers

China Daily, March 2, 2012

China's careful, incremental steps in opening its capital markets and making the yuan a more global currency have been the subject of debate for some time.

Some analysts say the nation is moving too slowly. Others urge caution so that risks inherent in a fully convertible currency are kept to a minimum.

The process began in 2007, when China launched the first yuan-denominated bonds in Hong Kong. After that, settlement of certain cross-border trading was allowed in yuan, and the yuan was allowed to appreciate. Step by step, the door opens a little wider.

The following opinion pieces, gleaned from translations of talks delivered at the February 18 Shanghai Financial Forum and from economists' research reports, reflect an array of approaches China could follow as it tries to tune its capital account to the nation's burgeoning economic clout and global market presence.

China needs an aggressive approach

Ma Jun

Chief economist at Deutsche Bank

I think the biggest bottleneck for internationalization is the closed capital market, which forbids foreigners from holding yuan and yuan-denominated assets through channels other than trade.

With expectations for yuan-appreciation decreasing, the trade surplus narrowing and outbound investment rising, the next few years would be a prime time for opening capital accounts, rather than after 2017, as many have expected.

China may export only 2 trillion yuan (US$317 billion) or 3 trillion yuan through investment and trade in the next five years, and that amount of liquidity is merely a drop in the ocean compared with the global market. If China wants its yuan to become a truly international currency, there should be several tens of trillions of yuan held in hands of non-residents.

China's overseas direct investment is approaching US$100 billion, among the largest in the world. Nearly 10 percent of trade volume is settled in yuan, and the proportion of local currency settlement is also high compared with other countries.

However, only 1 percent of the market value of yuan-denominated A-shares is held by non-residents, lower than the average 2.6 percent for major emerging countries.

The openness of China's bond market is also around 1 percent, compared with the emerging countries' average of 13 percent. The openness of China's capital markets is mismatched with the nation's economic power and market size.

I have always been supportive of accelerating the opening of capital markets. Nominal controls cannot really control capital flows. Even if capital projects are ostensibly closed to foreigners, multinational companies can still make deals within the network of the numerous branches they have across the globe. Interbank transactions also have enabled cross-border capital flows.

The development of the offshore yuan market may force reforms in the onshore market. Compared with other developing countries in terms of similar stages of economic maturity, China ranks lowest in the flexibility of its foreign exchange and highest in the tightness of its capital controls.

In one or two years, the yuan market should be open to foreign companies to raise funds. Panda bonds, or yuan-denominated debt issued in China by foreign governments or companies, have been in hibernation for many years.

We should encourage companies to convert the proceeds from panda bond issuance into other currencies in Hong Kong. I hope that China in the next three to five years will evolve openness in its capital markets comparable with what now exists in Malaysia.

Relaxation with Chinese characteristics

Eswar Prasad

Senior fellow of the Brookings Institute and former head of the International Monetary Fund's China division

The fact that China doesn't have an open capital account will not hinder the currency's internationalization, but may prevent the yuan from becoming a reserve currency. Many people, including me, have said that China should follow the traditional path, which we refer to as "capital account liberalization with Chinese characteristics."

The government's medium-term objective, which we believe will be achieved in the next five years, is an open capital account but with numerous "soft" controls. This will allow the currency to play an increasingly significant role in global trade and finance but in a manner that allows the government to retain some control over capital flows.

When a country opens its capital account, its control over these matters is loosened. That will bring many risks to China. We have witnessed other countries that have experienced many difficulties when liberalizing bank accounts, but as Chinese policies makers are doing it carefully, China will have fewer problems.

Every country has some restrictions on capital accounts, and China has made great progress in opening up. Cross-border capital flows through trade, financial institutions and other settlement channels are becoming wider and more convenient.

Although China's rapid growth will help promote the international use of its currency, its low level of financial market development is a major constraint on the likelihood of the yuan attaining reserve currency status.

However, I don't think that China intends to challenge the status of the US dollar. The accumulating debt of the US government is harmful to the US and to the global financial stability, but if you are seeking safe capital, the US is still the market with most liquidity.

That said, more still should be done, such as making Shanghai an international financial center. Hong Kong is a great place for experimentation, but we have to develop an onshore market here. We must open up the market further and also sustain economic development. New measures also are needed to expand China's bond market, in terms of both government and corporate debt, to give foreign traders more safe and high-liquidity options.

Putting yuan internationalization aside, I think the opening up of the capital market is essential to balance China's domestic economic development. China is now allowing more freedom in the inflow of capital in order to better regulate its financial markets, including the stock market. My home country India has taken similar steps.

China has its own way of doing things. I believe that China is taking a correct approach to balancing domestic needs against the goal of internationalization.

A two-prong way to rev up financial overhaul

Cao Yuanzheng

Chief economist at Bank of China

It is possible that China will have an open capital market but not a fully convertible currency. The development of the offshore yuan market reveals the prospect of this dichotomy.

First, China has allowed yuan-denominated foreign direct investment via Hong Kong. Second, though the country doesn't allow Chinese residents to hold foreign-currency debt, Chinese companies have issued more than 70 billion yuan in bond overseas. Third, China's capital market can be opened to the local currency because yuan funds raised offshore have been allowed to be invested in China's bond and stock markets. But the markets can be kept relatively closed to foreign currencies.

We note that along with the globalization of financial markets, capital projects in developing countries must open up. But these countries face the problem that by allowing their currencies to become convertible, they become vulnerable to short-term speculative flows of money. After the Asian financial crisis in 1998, many countries said they were considering controls on foreign exchange.

Therefore, by separating the capital market from the currency issue, we can accelerate the pace of financial reform and reduce its risks.

Corporate expansion overseas as a crucial step

Pan Yingli

Professor at the Antai College of Economics and Management, Shanghai Jiao Tong University

To nurture and enhance the overseas presence of Chinese companies is an important premise of the internationalization of the yuan.

Chinese companies and financial institutions must gain a decisive position in cross-border commercial and financial deals. Without such presence, the yuan will not contribute to the real economic development globally, and the huge amount of yuan accumulated overseas will be easily used by hedge funds to attack China's domestic market.

To realize the goal, we should encourage domestic companies to expand overseas, accelerate our economic reforms and urge reform of international exchange rates. With control on capital accounts still in position, the Chinese central government should encourage private companies to go abroad by easing controls over the foreign exchange that they require for overseas investment.

No rush for full convertibility

Qiao Yide

Secretary-general of the Shanghai Development Research Foundation

We should gradually nurture overseas demand for the yuan before completely opening the domestic financial market.

Besides increasing channels for offshore yuan to flow back, we also need to take measures to encourage its flow offshore. We have seen Hong Kong and London engaged in talks to participate in the trading of yuan-denominated debt.

I don't agree that the yuan should be full convertible. Rather, I think it should be managed against a basket of currencies and its link to the US dollar should be severed. This could avoid trade friction with the US and encourage private capital to go abroad. We should encourage Chinese companies to acquire or invest in corporate assets instead of buying property.