The announcement last month that China’s State Council has called for a plan to achieve full convertibility for the yuan marks the start of profound and beneficial changes that will resonate inside and outside China for years.
Chinese Premier Li Keqiang’s (李克強) commitment to full convertibility under the capital account will free up two-way investment flows, and together with related interest rate and exchange rate reform, this is the start of a new economic chapter.
This is the emergence of the yuan as a viable new investment option tied to the world’s most dynamic economy, and eventually an alternative reserve currency. The internationalization of the yuan will in the long term fundamentally change the global microeconomic equation of how traders and financial houses structure their foreign exchange exposure, and the macroeconomic equation of how central banks and governments formulate fiscal and monetary policy.
Yet in the near term, the most profound changes will be felt within China itself.
As Li implied, in order to achieve capital account convertibility, China’s interest and exchange rates will have to be substantially set by market forces to maintain balance in capital flows in and out of the country and instill confidence among international investors.
Exchange rate reform is relatively straightforward. Though the yuan now floats within a managed band against the US dollar, analysts believe it is at, or very close to, its market rate. Chinese exporters have learned to live with a cheaper dollar and are unlikely to be affected by a new regulatory regime.
Interest rate reform is more thorny. China’s low deposit rates have provided a cheap source of investment capital and wide interest margins have given China’s banks latitude in lending and made it much less costly for the government to sterilize inflows to curb inflationary pressure.
Yet the country will reap huge benefits from interest rate reform: Chinese savers will get a better return, a more competitive market will promote more efficient allocation of capital and encourage retail savers to return to the formal banking sector rather than using the less-regulated shadow banking system.
The worries expressed by some international analysts that Chinese banks will be unable to cope with narrower interest rate margins — the source of the bulk of their income — are exaggerated. Though banks still play a much greater role in the Chinese economy than they do in the developed world, years of internal reform and regulatory improvements have produced competitive players. Banking profits grew 20 percent last year, even after interest margins were cut in June, and return on capital is still well above Western levels.
The current policy of combining steady domestic reforms with encouragement for the offshore market will gradually encourage convergence while avoiding systemic shock. Establishing and expanding the Qualified Foreign Institutional Investor and Renminbi Qualified Foreign Investor schemes are templates for future reforms, well-measured in conception and in execution.
The offshore yuan clearing centers in Hong Kong, Taipei and Singapore, along with international banks like HSBC, will have a key role integrating the yuan into global financial markets.
The offshore market today is relatively small, but growing fast. Now about 12 percent of China’s trade is settled in yuan, but this is expected to grow to more than 30 percent by 2015. As more international clients settle in yuan, the offshore liquidity pool will grow, as the euro market did in the 1960s and 1970s.