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The Chinese yuan, also known as the renminbi, is already convertible under the current account - the broadest measure of trade in goods and services. However, the capital account, which covers portfolio investment and borrowing, is still closely managed by Beijing because of worries about abrupt capital flows.

BusinessBanking & Finance

Shanghai official's vow on imminent freeing up of yuan a bone of contention

Response to Shanghai PBOC official's view that rules for capital account liberalisation in free port will be out within months highlights divisions

PUBLISHED : Tuesday, 18 March, 2014, 8:22am
UPDATED : Wednesday, 19 March, 2014, 5:19pm

When will China fully liberalise the red-hot yuan?

Even the central bank of the world's second-biggest economy may not really have a clue, with its senior officials locked in a debate over when the mainland's foreign exchange controls should be lifted.

Some officials even argue there should not be a clear timetable for yuan liberalisation.

The debate over when Beijing will start the next round of foreign exchange reform became more heated recently after a senior central bank official promised the yuan would soon be freely convertible on the capital account in Shanghai's trail-blazing free-trade zone, launched late last year and primarily modelled on Hong Kong's free port system.

In a television interview with Shanghai media on March 7 during the annual meetings of the National People's Congress and Chinese People's Political Consultative Conference, Zhang Xin, deputy director of the People's Bank of China's Shanghai head office and a CPPCC delegate, surprised many when he promised that new rules to liberalise the yuan on the capital account in the zone would "definitely come out in the first half of 2014, or even faster, we hope".

The PBOC's Shanghai head office is the central bank's most important nerve centre after its main headquarters in Beijing, and Zhang is the top official appointed by Beijing to oversee financial reforms in the free-trade zone.

[Advocates for yuan reform may] win praise from top leaders like Premier Li

Zhang's comments immediately attracted the attention of market participants, because liberalising the yuan on the capital account would be the last step to officially making the currency fully convertible.

In other words, if it was fully convertible on the capital account, the yuan - already the seventh-most used currency for payments worldwide, according to a recent ranking by industry group Swift - would be as freely convertible as other major currencies, such as the US dollar and the euro.

The yuan is already convertible for trade - on the current account - but the central government still imposes restrictions on its convertibility for investments - on the capital account - mainly because of concerns that excessive money inflows and outflows could threaten the growth of the economy.

If the yuan can be liberalised on the capital account in the free-trade zone in the next three months, as Zhang expects, it would suggest the currency could also be quickly liberalised across the mainland.

Premier Li Keqiang has repeatedly said he wants advances in Shanghai's free-trade zone to be implemented elsewhere. Meanwhile, more than a dozen cities and provinces, including Guangdong and Tianjin, have applied to the central government for approval to set up somewhat similar free-trade zones, and they all want financial reforms, too.

Zhang's promise was greeted by a chorus of negative reactions from inside the central bank and from some influential government researchers and leaders. Even some senior Shanghai government officials described full convertibility of the yuan in the city's free-trade zone in the next three months as a "mission impossible".

"Basically, we haven't formally submitted any plan to further liberalise the yuan in the free-trade zone to any ministry in Beijing," said one senior Shanghai official who declined to be named owing to the sensitive nature of the matter.

"Even after we submit all our proposals to related ministries, the evaluation process could easily take three to four months, so how can free convertibility of the yuan on the capital account happen in the first half of this year?

"There are some people at the PBOC who really want to push the yuan reform forward as soon as they can, because they would consider any significant progress in yuan reform as an achievement - you could call it 'political capital' - that would help in job promotions and maybe even win praise from top leaders like Premier Li."

Yu Yongding, an economist who sat on the PBOC's monetary policy committee from 2004 to 2006, is one influential figure who has spoken out publicly against liberalising the yuan too quickly.

Yu, who is also a CPPCC delegate, said in a closed-door meeting during the annual sessions of the NPC and CPPCC that he was opposed to anybody setting a specific timetable for yuan liberalisation.

"There should not be a timetable for the full convertibility of the yuan," a person at the meeting quoted Yu as saying.

"Yu's tone was very decisive and even a bit angry", signalling growing tensions between the pro-liberalisation camp and others who are considered more conservative.

Suan Teck Kin, a senior economist at Singapore's United Overseas Bank, said Beijing's recent decision to expand the yuan's daily trading band from 1 per cent on either side of a reference rate to 2 per cent signalled that the central bank was still adopting a conservative approach to foreign exchange reform.

That "suggests that the authorities are still approaching market reform and the restructuring process in a measured and cautious manner, despite the distorting effects the current system is having on pricing and capital flows", Suan said.

Former PBOC deputy governor Wu Xiaoling, now deputy director of the NPC's finance and economy committee, has also opposed rapid liberalisation of the yuan, according to sources, even if only for a trial in the Shanghai free-trade zone.

"Strong opposition from Yu and Wu soon made Zhang's promise to make the yuan fully convertible in Shanghai in the coming months look like a bounced cheque," one of the sources said.


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China still need to accumulate much more Gold to add to its smallish 1,054.1 tonnes Gold reserve.
My guess below assumes that China's capital control is still intact.
If China's capital account is completely relaxed, then the present interest rate differential will also mean massive capital inflow into China.
Perhaps both massive capital outflow and massive capital inflow will occur at the same time.
The resulting effect on the yuan's exchange rate and China's interest rate, inflation rate and the like, will depend on whether there is a net capital inflow or outflow, and to what extent.
Arguably the dominance of the US dollar owes much more to oil than to gold.
The US dollar is also called the oil dollar.
International transaction of oil is mostly denominated in US dollar.
Gold is one way to diversify China's foreign asset reserves.
Diversification may be the only free lunch under the sun.
Money is credit, it's widespread use is ultimately based on people's confidence in it.
In turn the confidence is determined by a lot of factors other than the amount of gold owned by the country.
Similarly the stability of Hong Kong's linked exchange rate system is ultimately based on Hong Kong people's confidence in the Hong Kong dollar.
If for some reason all Hong Kong people (or the few tycoons combined) 'jump into the angry sea' and exchange en masse their Hong Kong dollars into US dollar or other currencies, the dam of the 7.8 linked rate will burst at once.
The Hong Kong government may need to impose exchange control to stem any further capital flight.
Bank models show that the free float of the Yuan would lead to massive money outflows as people try to diversify and protect their wealth. This would collapse the currency and there will of course be many investors who see this coming and will hedge against the currency.
What will happen next year (or later this year) ?
The even-more-overvalued yuan means that more severe internal devaluation or deflation (or disinflation) has to occur to restore China’s external equilibrium,
in the form of falling CPI, PPI, PMI manufacturing figure,
perhaps fall in real wage rate, rising unemployment,
stop-to-rise-or-start-to-drop property sector in the first-tier cities, rising bad loans of the banks, falling or refusing-to-rise stock market both in China and in Hong Kong,
more defaults of trust products in the shadow banking sector, more defaults of foreign loans,
less import of raw materials and energy products, further drop in exchange rates of those raw-material-exporting countries,
further fall in China’s GDP growth rate,
and growing discontent by China’s vested interests toward the present reforms (read, Xi and Li)
--- if (and this is a big if) there is no corresponding expansionary monetary or fiscal policy (hukou system reform) enacted by the Chinese government.
Of course, in economics, ceteris isn’t paribus in practice.
Let’s do the following mental experiment (mental only --- don’t try it at home):
Suppose the PBOC officials really think that the yuan exchange rate has now more or less attained the equilibrium level, and confidently let go her control of the exchange rate, which henceforth will be free to float and determined by the free market forces.
No doubt the mistaken free market, witnessing China’s positive trade surpluses, the inflow of hot money into China, and the country’s effort at internationalizing the yuan, will keep on pushing the yuan higher and higher against the US$, say to 5 yuan per US$ or beyond, at the end of the year.
What will happen this year?
It’s business as usual then.
The positive interest rate differential, together with the yuan’s continued revaluation, means that the yuan remains a one-way bet --- the free lunch is still there for everyone to grab.
More and more hot money will be attracted into the country, in the form of carry trades (disguised as export invoices or whatever), foreign loans, and RQFII dim-sum bonds (a derogatory term for the small size of the loans).
These money inflow helps sustain China’s Ponzi-scheme-like shadow banking and property markets.
In fact, the recent economic data show that the yuan is now (perhaps severely) overvalued. China’s wage inflation in the past few years helped increase China’s real exchange rate.
Now, under China’s current managed and more-or-less-fixed exchange rate against the US$,
the yuan’s overvaluation can be corrected either by artificial yuan devaluation (to a much higher degree than has been realized up till today),
or internal devaluation in the country,
or both, to go back to equilibrium.
As is said by the author of the above article, ‘the internationalization of the yuan is best deferred until conditions in the world economy improve’.
Let me say one more time (hopefully the last time) the following (I’m really fed up with this repetition):
China’s current account surplus (with the United States) does NOT indicate that the yuan is undervalued.
Rather the trade imbalance reflects a big surplus of saving over investment in China, and a big saving deficiency in the United States.
Continued revaluation of the yuan vis-a-vis the US$ CAN'T reduce China’s trade surplus to zero,
it only attracts more hot money into China (in addition to the interest rate differential) in the form of carry trades.
The size of China's trade surplus is determined much more by the external demand for her exports.
The declining and smaller (trade surplus/GDP) ratio in China in recent years does NOT mean that the yuan has more or less achieved the equilibrium level.
It reflects much more the still-weak American and European economies in the past few years.
Today I come across a newspaper article which I would like to share with you,
because that author really knows what he’s talking about,
and his argument is correct and to the point --- unlike those third-rate “experts” from all sources who pretend to know but don’t actually know, and who fill the newspaper columns in the morning post and elsewhere with such stupid explanations of what’s really going on about China’s economy.
‘The Exchange Rate Conundrum’
by Ronald McKinnon, a professor of International Economics at Stanford University.


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