'More or less' policy on freeing up yuan means more for HK
When someone says 'more or less', you always know he means less rather than more.
Yi Gang illustrated the point over the weekend. Speaking in Washington about Beijing's currency policy, the deputy governor of the People's Bank of China declared that: 'It's time to let the market more or less decide the exchange rate.'
What he actually meant was: 'We're going to pretend that supply and demand set the yuan's value, but behind the scenes we're going to make damn sure that the exchange rate goes only where we want it to.'
Yi's equivocation is understandable. For years, analysts have wondered what would happen if Beijing suddenly stepped back from the currency and let market forces set the yuan's exchange rate.
Most have concluded that the yuan would shoot upwards in value. The reasoning behind this view has always been straightforward. China has traditionally attracted heavy inward investment at the same time as it has run a massive trade surplus. As a result, there has been heavy demand for the yuan, demand which has only been met by enormous sales of the currency by the central bank.
If those sales were to stop, runs the argument, market forces would immediately drive the yuan sharply higher in value.
Not everyone has bought into this line of reasoning, however. A minority of analysts have argued that if the authorities let market forces have free play, far from strengthening, the yuan would drop like a stone against other currencies.
These contrarians point out that demand for the yuan is skewed by China's capital controls. These allow investment flows into the country, but limit outflows. While foreigners have some freedom to buy yuan-denominated assets in the onshore market, ordinary Chinese investors are forbidden from converting their yuan into foreign currencies to buy assets in overseas markets.
If these restrictions were relaxed, say the contrarians, millions of Chinese savers would rush to buy foreign currencies. Sick of earning deposit rates lower than China's rate of inflation, and deterred by high volatility and falling prices from investing in local stock and property markets, onshore investors would quickly diversify into foreign assets, with the resulting capital outflows driving the yuan steeply lower.
Both scenarios are plausible, and either could have a positive feedback effect. A rapidly strengthening yuan would attract more capital inflows while deterring outward investment, which would lead to even faster appreciation, fuelling domestic asset prices and hurting the export sector.
On the other hand, a weakening currency would only encourage more local investors to buy foreign currency assets, accelerating the decline and potentially forcing the authorities to raise interest rates to punishing levels.
Both scenarios are equally unwelcome as far as Beijing is concerned. As a result, no matter what Yi might have said in Washington, we can be sure that the central bank will go on restricting the free flow of capital across China's borders, while continuing to intervene in the currency market to set China's exchange rate.
Beijing's reforms - both towards letting the market determine the exchange rate, and towards allowing freer capital flows - will be extremely gradual. But over time their impact will be enormous. As Yi said in Washington, with US$3.3 trillion in official reserves, it doesn't make sense for the central bank to continue to build up foreign assets. But in order to slow its pace of reserve accumulation, Beijing will have to allow more Chinese capital to be recycled abroad.
That means an accelerating rate of both outward direct investment and outward portfolio investment. According to researchers at the Hong Kong Monetary Authority, between now and 2020, the stock of China's outward direct investment is likely to balloon from US$400 billion to more than US$5 trillion.
Over the same time period, China's overseas portfolio investments will grow even more rapidly, from a little over US$300 billion last year to almost US$5.5 trillion (see the charts below).
Meanwhile, China will continue to attract both foreign direct investment and inward portfolio investment. According to the HKMA's projections, the stock of foreign direct investment in China will more than triple by the end of the decade to US$7 trillion, and foreign portfolio investment will increase ten-fold to US$3.9 trillion.
If Hong Kong manages to intermediate even a small part of those flows, the growth in the volume of business transacted in the city's financial centre will be huge.
So even if Yi's pledge to allow market forces to work turns out to be rather less than more, for Hong Kong, less will still mean more.