Talk of yuan convertibility in five years is just pie in the sky

PUBLISHED : Tuesday, 22 November, 2011, 12:00am
UPDATED : Tuesday, 22 November, 2011, 12:00am


Several times in the past couple of weeks, readers have asked me when I think Beijing is going to scrap its remaining exchange controls to make the yuan freely convertible.

The reply most people expect to hear is 'within the next five years'. So they tend to be disappointed with the answer they actually get, which is 'not in the foreseeable future'.

To see why Beijing is not going to relax its capital controls any time soon, we only need to imagine what would happen if the yuan were made fully convertible tomorrow.

With the whole world suddenly to choose from, millions among China's legions of savers would ask themselves whether they could make a better return on their investments elsewhere.

Considering that Shanghai stock prices have fallen 16 per cent in the past 12 months, that the mainland property market is now sinking, and that deposit rates are 2 percentage points below the rate of inflation, which means that savings accounts yield a negative return in real terms, many would conclude that they would indeed be better off investing their savings abroad.

Some have already come to that conclusion. In October, household savings deposits in mainland banks fell by 727 billion yuan, while declines in China's foreign reserves and foreign exchange purchases indicate that money is now flowing out of the economy despite Beijing's capital controls.

If those controls were lifted, the trickle would become a torrent. To stem the outflow, the People's Bank of China would be forced either to appreciate the yuan at a much faster pace or to raise deposit rates to at least a couple of percentage points above the rate of inflation, say to 7.5 per cent.

There are powerful reasons why the authorities would be reluctant to pursue either option.

With exports of key items such as televisions, digital cameras and video games down in volume terms over the year to date, China's exporters and the Commerce Ministry would be sure to fiercely resist faster currency appreciation. With millions of export jobs at stake, the State Council's decision-makers would be bound to listen.

At the same time, from Beijing's perspective, an increase in deposit rates would be just as unattractive. That is because China's economic growth is powered overwhelmingly by investment. Last year, fixed asset investment equalled 57 per cent of gross domestic product. Over the first nine months of 2011 the figure was an astonishing 66 per cent.

According to official data, most of that investment comes from government bodies and state-owned enterprises, and much of it is dependent on cheap financing from the country's state-controlled banking system.

If the central bank were to raise deposit rates to discourage capital outflows, it would naturally have to raise lending rates as well, to ensure China's banks could still make a profitable spread on their loans.

Right now they make a generous 3 percentage point spread. If that were reduced to 2 percentage points, then raising deposit rates to a real 2 per cent would mean lifting the benchmark lending rate to a nominal 9.5 per cent.

At that level many government-backed infrastructure projects and state-owned companies would no longer be able to generate sufficient cash flow to service their bank loans. The result would be a sharp increase in non-performing loans, with a very high probability of a full-blown banking crisis.

In other words, as long as China remains dependent on investment to power its growth, and that investment relies on cheap loans from state banks, then there is zero chance that Beijing will relax its capital controls. The consequences if it did would be catastrophic.

It is conceivable that China's new leaders, due to be anointed early in 2013, could introduce bold economic reforms aimed at switching the engine of growth from investment to consumer demand, allowing them to relax capital controls within five years. But to do that they would have to defeat powerful interests in China's political system, and there are few signs they are spoiling for the fight.

As a result, in this context 'five years' sounds akin to the Spanish ma?ana or the Arabic boukra inshalla: best interpreted as 'don't get your hopes up.'