The road to convertibility is paved with repression
Despite new talk of a five-year timeframe for full yuan convertibility, state firms' inefficiency makes it unlikely that Beijing will loosen its grip
Great excitement followed Beijing's announcement on Monday that it will draw up an "operational plan" this year for deregulating domestic interest rates and making the yuan fully convertible.
A whole legion of analysts reacted by predicting the liberalisation of China's exchange rate during the next couple of years, and full convertibility within five years.
Forgive me if I contain my jubilation. It's that five-year time horizon, you see. Back in 2000 a very senior mainland official told me how Beijing would free China's interest rates and make the yuan fully convertible within five years.
He gave good reasons for this timetable. China's obligations under its World Trade Organisation accession agreement would force Beijing to open its domestic financial sector to foreign competition within five years. Regulated interest rates and controls on capital flows would be untenable after that, he explained. It was in China's interest to press ahead with reform.
Today - 13 years later - he's even more senior, and I gather he's still telling people that full convertibility is five years away.
Clearly there's a problem here. Beijing likes the idea of internationalising the yuan, because that would allow China to pay for its imports with government IOUs, much as the United States does today.
But although an international currency is an attractive proposition for Beijing, the reason currency liberalisation always seems to be five years in the future is that allowing full convertibility would also pose enormous risks.
Today, of course, the Communist Party is only communist in name. In reality, it is the arch-practitioner of state capitalism.
The party-state relies on its control of China's financial system to allocate cheap capital to favoured state-owned enterprises. The senior party officials who control these corporations then use this privileged business position to reward their supporters by dispensing patronage on a massive scale.
The model has successfully ensured the economic - and hence the political - primacy of the Communist Party for years, despite the enormous changes that have swept China.
But there is a price. Because their function is political rather than commercial, China's state companies are grossly inefficient. According to the World Bank, their returns on equity are 10 percentage points lower than in the private sector.
This systemic inefficiency means Beijing must maintain its tight control over the financial system, holding interest rates artificially low and directing lending decisions to ensure capital flows where political, rather than commercial, imperatives dictate.
But if lending rates are kept low, then deposit rates must be kept even lower. As a result, China's ordinary savers, who are currently sitting on 45 trillion yuan in household deposit accounts, earn a derisory return on their hard-earned cash.
As the chart below shows, on average over the past 10 years, the interest rate on a three-month time deposit has been 0.85 percentage point below China's rate of consumer inflation, which means savers have been losing money in real terms.
In effect, Beijing is seizing trillions of yuan a year from China's households and handing the money to state-owned companies.
Economists call this financial repression, and it is the foundation of the Communist Party's economic power base.
But in order for its model to work, the party has both to keep interest rates low and to prevent households taking their savings elsewhere for a better return, which means it can neither deregulate interest rates nor relax capital controls.
Granted, in the future, Beijing could find another mechanism of financial repression. It could, for example, adopt the Singapore model, requiring all workers to pay 30 per cent of their gross remuneration into a state pension fund. This fund could then pay a negative real rate of return to its contributors, which would allow it to provide artificially cheap capital to the politically important state sector.
Then with its funding pool held captive and its source of cheap capital for state-owned enterprises guaranteed, Beijing would have more room to internationalise the yuan.
But setting up such a new system and ensuring it works will take a long time, which is why no one should too be surprised if in another five years, officials are still talking about a five-year time horizon for full yuan convertibility.