Capital account crack may yet be temporary

PUBLISHED : Sunday, 06 March, 2011, 12:00am
UPDATED : Sunday, 06 March, 2011, 12:00am

Hong Kong Exchanges and Clearing plans to introduce a 'yuan trading support facility' in an effort to ensure investors have enough currency to fuel expected demand for yuan denominated stocks in the city.

SCMP, March 3

From the way the talk on yuan trading goes, you get the impression that a crack has finally opened in China's closed capital account and it can only grow wider now until the dam has split wide open and the yuan is a freely exchangeable currency across the world.

Don't be too sure. What we really have here is a Hong Kong anomaly that may yet prove to be only a temporary one. The anomaly is that suddenly everyone in this town wants to hold yuan where previously it was a scorned currency that you held only for necessary cash transactions across the border.

There are two reasons for this change. The first is that yuan deposits actually pay you an interest rate. It's still well under 1 per cent, but you need a microscope to see Hong Kong dollar interest rates.

The second, and more important, reason is that the yuan is strengthening once more against the US dollar. The universal reasoning has it that there is only one way to go - stronger yet. And for once, the universal reasoning may just be right.

But how to get this yuan and generate a return that can protect your money against inflation, that's the question.

The answer is many importers across the border would like to pay in yuan for the goods they import from and through Hong Kong. They are now allowed to do so. We have our match of yuan inflows to satisfy yuan investment appetites.

Now we have to find how to invest this money. At the moment, it all goes back to users across the border through the single clearer, the Bank of China. What the exchange wants to do is encourage local companies with operations across the border to broaden the options by listing yuan-denominated securities.

The longer-term hope in Beijing is, of course, that other economies will soon follow Hong Kong's lead and that their central banks will be happy to hold yuan instruments, which would make the yuan a reserve currency. There might then not be such a desperate need to mop up all the US dollars flowing into China to pay for China's exports. The customers would increasingly pay with yuan.

It's a far-fetched dream and one that I think misunderstands how the balance of payments works. But let's leave that aside and look just at the Hong Kong equation.

What happens if yuan deposits should no longer offer those premium interest rates? It has happened in the past, quite often in fact, as the chart shows. More importantly, what happens if the yuan stops appreciating? Sooner or later that will have to happen. Even if Beijing just freezes the rate there will no longer be an exchange rate advantage to holding yuan. Will there still be such a great demand in Hong Kong for yuan then?

Almost certainly not. Hong Kong holders of yuan are fair-weather friends only.

And if that is the way things turn out then the whole game of cycling yuan through Hong Kong will slow down dramatically and mainland importers will be told to start paying their bills with US dollars again.

In other words, what we have here is no crack in the dam of China's capital account, but only the opening of one small diversion channel that can close at any time and do so independently of what the dam operator may like to see.

The dam remains firmly in place and intact. The problem for the leadership is that a full opening of the capital account will put an end to the central government's direction of capital flows within China. If any citizen can take money out of the country whenever he or she chooses then the authorities have lost control of the economy. The money will go where it gets the highest return and that may not be China at all.

I shall now waste words: This is not a welcome prospect in Beijing.