Don't assume that offshore development of the yuan market is a sign that the currency is becoming internationalised, warns John Greenwood (pictured), the architect of Hong Kong's fixed exchange rate system.
'The key point about achieving convertibility is that domestic money and credit market liberalisation must precede convertibility,' Greenwood said yesterday. 'It would be a mistake to try to achieve convertibility only through creating an offshore yuan market.
'Domestic liberalisation comes first, but at the moment, I don't see that there is any urgency for domestic liberalisation. That's why all the experiments in the offshore arena will probably remain experimental,' said Greenwood, who is chief economist at Invesco Asset Management in London.
But Greenwood said that Beijing was retaining control over the domestic financial system through the use of rigid interest rate and credit quotas, rather than allowing the market to determine credit conditions.
His comments are also at odds with the upbeat reaction to HSBC's decision to issue the first offshore yuan bond in London, and the Chinese central bank's endorsement of London to position itself as a offshore yuan centre.
Greenwood also poured cold water on predictions that the yuan was on a fast track to full convertibility, arguing that yuan sourcing for the offshore market came from trade and foreign direct investments, rather than purely financial transactions such as share trading.
To be sure, all hot money inflows have to be approved by the State Administration of Foreign Exchange (SAFE), as Beijing seeks to maintain financial stability through controlling the capital account.
'The right thing to do will be to liberalise domestically first, and then gradually to permit non-resident foreigners to hold bank accounts in China, and to allow Chinese residents to hold bank accounts abroad, and only then to lift exchange controls,' Greenwood said.
On the subject of emerging markets, he said the global economic uncertainties, particularly Europe's sovereign debt crisis, was still casting a pall over their growth outlook.
The European Central Bank's liquidity injection to stabilise the region's banking system had not resolved the underlying problem of the lack of competitiveness of some euro-zone countries, he said.
For instance, labour costs in Spain, Italy, Portugal and Greece have risen more than 25 per cent in the last decade compared with Germany. An overhaul of Europe's labour system in the short run is unlikely, given the strength of the trade union groups in the public and private sectors.
As devaluation of the euro is highly improbable, Europe would likely undergo a long, painful period of deflation, which would eventually reduce wages and production costs, thereby restoring their economic competitiveness, said Greenwood.
The process had already started, he said, as euro-zone economies were now experiencing a pullback in lending. The devaluation process would cause more job losses and economic instability that could further brake economic growth.
In Hong Kong's experience, it regained economic vigor after six years of internal deflation between 1998 and 2004 in the wake of an Asian financial crisis. Due to its currency peg to the US dollar, the city was unable to devalue its currency to be competitive, Greenwood said.