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Analysts say moving too fast on yuan convertibility will be risky

Analysts say moving too fast on yuan convertibility will be risky

Beijing is stepping up moves towards yuan reform, but analysts say the process is fraught with danger because of weak export demand


Beijing is stepping up its efforts to make the yuan a convertible currency for use in international trade and investment, but analysts say the central bank should tread carefully given the challenges posed by rapid capital inflows and weak export demand.

The State Council announced recently that an operational plan on achieving yuan convertibility would be put forward this year, indicating that progress toward a market-based exchange rate system and liberalisation of the capital account may be accelerated.

It's understandable that the new leadership in Beijing has chosen currency reform as a more straightforward task to start with before it gains the confidence and support to tackle much tougher problems, such as an overhaul of income distribution or land ownership.

However, many observers think the conditions and timing may not be right for swift action. They worry that drastic changes may induce a high level of volatility in financial markets and dampen the mainland's slowing, still export-reliant economy.

Interest rate and exchange rate liberalisation could accelerate rapidly
Barclays Capital Economists

"The government appears to be determined to achieve basic convertibility of the capital account by 2015 and full convertibility by 2020," Barclays Capital economists, including Huang Yiping , wrote in a research note, setting out a road map that is in line with Beijing's 12th five-year plan, which runs until 2015, and remarks made by various government officials.

"This means the process of interest rate and exchange rate liberalisation could accelerate rapidly in the next year or two," they said.

Currency reform, along with a plan by the State Council to allow individuals to invest directly in overseas capital markets, is set to bring more volatility to the yuan's exchange rate, the investment bank said.

As to the actions that Beijing may take in the near term, Barclays Capital expects the central bank to raise the ceiling for bank deposit rates, allowing them to float to at most 20 per cent higher than benchmark rates, from the current 10 per cent. Beijing is also likely to widen the daily yuan trading band to 1.5 per cent or 2 per cent either way of the fixed rate, from the current 1 per cent.

In recent months, despite the strength of the US dollar, the yuan has on several occasions hit its highest level since the government unified official and market exchange rates at the end of 1993.

Analysts say this shows the central bank may become more tolerant of yuan appreciation as it seeks to gain more independence in monetary policy. At the same time, fast capital inflows due to easing policies in developed nations have also pushed the yuan upwards.

Morgan Stanley economist Helen Qiao said the timing of the announcement was "somewhat surprising" although the move towards yuan reform was largely expected. "Continued currency appreciation against a very strong dollar could add more cyclical headwind against the fragile growth recovery in China, especially during a soft patch in global growth," she said.

China's economic growth eased to 7.7 per cent year-on-year in the first quarter from 7.9 per cent in the previous three months, hurt by overcapacity problems in domestic industries and faltering external demand.

In the January-April period, the customs bureau reported a 17 per cent year-on-year increase in exports. But some analysts estimate that real growth might be just half of that, with the figure inflated by suspected overinvoicing by exporters looking to send more foreign exchange funds to the mainland to bet on yuan appreciation.

In remarks underscoring concern about export weakness, Shen Danyang , a spokesman for the Ministry of Commerce, warned last week that a stronger yuan had squeezed exporters' profitability and also made trading firms reluctant to sign long-term orders for fear of losses due to exchange-rate fluctuations.

While China faces yuan appreciation pressures caused by fast capital inflows, Bocom International Holdings chief China strategist Hong Hao says there is also a risk of capital flight, if Beijing eases limits on funds leaving the mainland for more sophisticated capital markets.

Hong Kong is expected to be the primary destination for the long-delayed trial, which may be conducted on a small scale initially, Hong said. Any large outflow of funds, prompted by the possibility of better returns for mainland investors abroad, may hurt the domestic real estate and securities markets, he said.

Beijing is more likely to liberalise interest rates first, instead of overhaul exchange rates, as opening the capital account too soon may prove a "significant blow" to the mainland's financial markets, he said.

Hong expects the yuan may become a globalised currency by 2018 at the earliest. "That would be the most aggressive estimate I could make", he said.

It took Beijing seven years from July 2005, when it removed the yuan's peg to the US dollar, to widen the currency's daily trading band against the US currency to 1 per cent in April last year.

The path of yuan reform has been full of twists and turns since 2005. The 2008-2009 global financial crisis forced the People's Bank of China to return to what was effectively a peg system, until it removed the anchor again in June 2010 when the world's second-largest economy pulled itself out of a downturn with the help of a massive stimulus programme.

However, calls are mounting to make the yuan a convertible currency. The country now holds a record US$3.4 trillion in foreign exchange reserves - the world's largest - making it increasingly difficult for the central bank to intervene in the money market to maintain yuan stability.

International pressures persist for Beijing to make the yuan's exchange rate better reflect supply and demand. China's major trade partners have continued to complain about Beijing's forex market intervention as evidence that it is keeping the yuan artificially undervalued.

US Treasury undersecretary for international affairs Lael Brainard last week urged China to "take additional measures to increase the flexibility of its exchange rate regime". While the yuan band was widened modestly last year, intervention subsequently had risen, she noted.

Central bank deputy governor Yi Gang pledged in Washington last month that Beijing would widen the yuan trading band "in the near future".

Standard Chartered Bank sees a 33 per cent chance of a widening ahead of the Sino-US strategic and economic dialogue in mid-July, with a better-than-even chance of a move before the end of the third quarter.

Apart from that, Beijing is expected to increase the use of yuan in trade settlement and direct investment, further develop offshore yuan centres and sign more currency swap agreements with other countries.

Programmes such as the qualified foreign institutional investor (QFII) scheme or the renminbi qualified foreign institutional investor (RQFII) scheme are likely to expand, HSBC said.

The QFII scheme is a programme that permits licensed foreign investors to use US dollars to buy the domestically traded A shares of mainland companies on the Shanghai and Shenzhen stock markets, subject to a quota. The RQFII scheme allows licensed foreign investors to use offshore yuan to buy A shares.

Chinese bond markets would deepen too to serve the growing need for funding for local infrastructure projects, HSBC said.

"After putting its domestic financial house in order, China's onshore markets will be ready to become more open to foreign investors. In turn this will pave the way for the [yuan] to gradually achieve capital account convertibility," HSBC said, giving a five-year timetable for the currency to become fully convertible.

This article appeared in the South China Morning Post print edition as: Setting the stage for a convertible currency