Comments from senior Chinese officials are rarely, if ever, made without an intention to signal a message of some sort. So, it is perhaps surprising that Ms WuÆs comments on November 19 at a Beijing seminar have not been more widely discussed.
Two days before Wu made her comments, Jin Liqun, the supervisory board chairman of the mainland's $200 billion sovereign wealth fund, said that Beijing would demand a more significant role in the global financial system if it was to inject additional capital into the International Monetary Fund (IMF).
According to some analysts, these comments are significant. There is a clear consensus among policymakers that full convertibility is necessary û even urgent û and is a key to the eventual development of the renminbi as an alternative reserve currency, says Yiping Huang, Asia-Pacific economist at Citi. China needs an alternative to holding its vast foreign exchange reserves in US dollars and needs to encourage foreign investors to hold more renminbi-denominated assets.
China has about $1.9 trillion of foreign reserves and has overtaken Japan to become the largest holder of United States Treasury securities, holding $585 billion compared with Japan's $573.2 billion. So, China has good reason to be worried about the volatility of the US dollar amid the current financial crisis.
Wu, who was a deputy governor of the PeopleÆs Bank of China (PBOC) until earlier this year, said that the renminbi should become an international reserve currency in tandem with its full convertibility, reflecting a renewed interest in loosening control of the currency as the country becomes more deeply integrated in the world financial system. She said it was difficult to find an alternative reserve currency but added that the renminbi was ready to become an international currency to replace the dollar.
Currently, China has a managed foreign exchange mechanism under which the renminbi is partially convertible. However, it still needs to liberalise the capital account, so it is a huge leap, possibly unrealistic and certainly hazardous, to move towards full convertibility soon û let alone reserve currency status, which can hardly be decreed anyway. Besides, a managed mechanism may have helped China to stave off the worst of the global financial crisis.
For trade in goods and services, controls are mainly to verify that foreign exchange is being used for valid and legal underlying transactions. Restrictions on capital transactions, on the other hand, are in place in order to maintain an independent monetary policy and a stable exchange rate, to limit vulnerability to capital flow reversals, and to protect some domestic industries. Currency controls are interwoven with regulations on other economic activities, including foreign trade, establishment of firms, and banking operations.
For example, foreign direct investment (FDI) is strongly encouraged, but tightly regulated. Most sectors are open to FDI, with incentives to potential investors. Each investment involves conditions that seek to maximise equity injections, exports, local content, technology transfer, employment, and (where applicable) control by a local partner in a joint venture, while minimising the outflow of royalty payments and foreign exchange. Also, portfolio investment in China is strictly segregated between residents and non-residents, and there are limits on overseas borrowings by Chinese enterprises, often subject to quotas.
Benefits and risks of full convertibility
Clearly, restrictions on capital account transactions are good for stability and for curbing outflows in the current turbulent environment. However, recent statements by Chinese officials, such as WuÆs, suggest that they are keeping the objective firmly on the agenda. This ôis significant because opinion against financial liberalisation has been gathering strength since the beginning of the financial crisisö, says CitiÆs Huang.
In theory, capital account liberalisation helps create a more efficient global allocation of savings, thus increasing economic growth and welfare. From an individual country viewpoint, the benefits come from increases in both the available pool of savings for investment, and greater access to foreign capital markets for domestic residents. From an international perspective, open capital accounts support the multilateral trading system by broadening the channels to finance trade and investment.
In the real world this translates into more FDI, access to cheaper financing, new financial technologies, more diversified and less risky portfolios, higher investment and growth. Another practical point is that capital controls tend to become less efficient over time, as financial markets become more sophisticated and better at evading the controls.
However there are risks. Capital account liberalisation can cause overheating of the economy from large capital inflows, and can create incentives for financial firms and other companies to borrow excessively. Both can lead to sudden reversals of capital flows, possibly triggering financial crises leading to major output losses and economic and social hardship. Also, initial shocks to an economic and financial system can spread more easily to other countries through systemic linkages and contagion.
The Chinese authorities seem well aware of these drawbacks û from lessons learned in the Asian crisis 10 years ago and, of course, the malaise afflicting the worldwide financial system today.
But, "convertibility is a must for a country that is already a major player in the global economy and markets," says CitiÆs Huang. He points out, though, that two conditions are necessary before full convertibility can be introduced: confidence in the domestic financial system and market-based interest rates. The Chinese authorities must move cautiously, he says.
Even the IMF recognises that successful liberalisation depends on careful sequencing of reforms, with important changes in certain areas required before opening up to free capital mobility. These include implementing sustainable macroeconomic policies and forming a strong and well-supervised financial sector û although the IMF also concedes that most market reforms are interdependent and need to be pursued in tandem to some degree.
ChinaÆs current macroeconomic situation is (still) strong, with rapid growth, low inflation and a robust external position. But to ensure continued stability in the future, the key issues are stable and sustainable public finances û which might be damaged by the recent fiscal stimulus packages û and the choice of an appropriate exchange rate regime.
As China moves towards a more open capital account, a flexible exchange rate will become increasingly important in order to preserve scope for an independent monetary policy and to help absorb shocks to the capital account.
Safety first
In the short-term, argues Ting Lu, China economist at Merrill Lynch, there wonÆt be full convertibility of the renminbi because the government is concerned about financial stability in China. Full convertibility could lead to capital outflows, which could pose risks to China's currency and financial health.
Instead, the focus is on maintaining a stable exchange rate against the US dollar. Before the escalation of the worldwide financial crisis at the beginning of October, the Chinese authorities focused on a trade-weighted basket of currencies, but since the rapid US dollar appreciation they have just watched the dollar rate, says Lu. CitiÆs Huang agrees that at times of crisis, the authorities prefer to maintain a stable dollar/renminbi exchange rate.
Nor is there likely to be a competitive devaluation. ôThere is little emphasis by policymakers on using the foreign exchange rate to help exporters gain an edge over rivals within the region, so there is unlikely to be any competitive devaluation against other Asian currencies,ö says Lu.
Although many officials are concerned about the renminbiÆs strength against the euro and other currencies and the effect on exports, they recognise that there is a general worldwide weakening in demand, and that maintaining financial stability is a priority, says Huang. Although he adds that ôa temporary depreciation of the renminbi against the US dollar by the PBoC cannot be ruled outö.
But Lu is more emphatic: ôThere will be no renminbi devaluation; the authorities will maintain the US dollar exchange rate at around Rmb6.82-6.83,ö which it has done since July, pausing the renminbiÆs steady appreciation.
He argues that the authorities are particularly concerned about capital outflows as investors and exporters try to take advantage of a stronger dollar. If that is their main concern, then full convertibility is unlikely to be imminent, while elevation of the renminbi to reserve currency status is a long way off.
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