In the past decade, China has stepped up efforts to open its capital markets through all means, including paving the way for the widespread international use of its currency, the RMB. Recently, there has been an increasing call from the global sphere for the Chinese government to faster globalization of the RMB, since stronger economic growth in China can also help pull the rest of the world out of its current financial slump. The next question comes to whether China is ready for the challenge in next five to ten years.
On April 16th, China has decided to loosen some of its currency controls permitting greater volatility in daily trade. Why is it flexible exchange rate necessary to achieve RMB globalization? The purpose of greater flexibility of exchange rate is to provide a mechanism for exchange rate to get closer to equilibrium, which is very important as a precondition for capital economic liberalization. In capital economic liberalization, without a flexible exchange rate, it is likely that by the time of opening the capital account, the exchange rate is still very different from equilibrium. If such situation happens, the opening of the capital account would be dangerous, because it might lead to a sudden increase of capital inflow or outflow. Therefore, the precondition of capital liberalization has to be more flexibility of exchange rate itself. This is one of the few steps towards more flexibility, and more increase in trading banks should appear in the coming years.
At present, China is ready to start capital account reform. The basic reform process will take three to four years. By around 2016, we will see basic opening of capital account. The basic opening is similar to a Taiwan model, which allows individuals to convert up to 5 million U.S. dollars, and a lot of companies to convert up to 50 million U.S. dollars.
Several steps reform China’s capital account towards opening up. The first step is to increase the quarter of individual currency conversion. For example, China can raise personal conversion rate to 200,000 U.S. dollars per person per year and raise corporates conversion rate to 2,000,000 U.S. dollars. This is something China can do right now without worrying about a major change in net flow, because the expectation of exchange rate is quiet stable right now. As China opening up its capital account step-by-step, individual and corporate conversion limit would still exist but go up. It is known that informal conversion is happening anyway, yet China still need to formalize this process and to make the process more transparent. The second step is to allow local capital markets be more open to foreign institution investors, for example, raising the quarter for foreign institution investors to enter Chinese inter-bank market. The third step is to allow foreign institutions to issue RMB bonds in Chinese bond market, and set up the international board of the Shanghai equity market for international insurance and also allowing foreign corporate to borrow from Chinese banking system. These actions will form the core of basic opening up of the capital accounts.
RMB globalization is allowing RMB to flow between China and the offshore market more freely for capital account purposes. So far the RMB flow for trade accounts is already open. What to do next is first to open the capital account transaction in RMB, and second to open the capital account, allowing conversion between RMB and hot currencies more freely. These two reforms are equivalent in nature. As in some aspects, when allowing investors to bring more U.S. dollars into the Asian bond market, it is equivalent to allowing foreign institutions from bringing CNY from Hong Kong market to the local market. Because from the investors’ perspective, they will convert U.S. dollars or other hot currency into CNY and RMB anyway. Therefore, the impact on the investors is the same. Also, the impact on monetary policy will be the same as well.
The biggest influence on China’s inbound and outbound direct investment should be on portfolio investments. Lifting the restrictions on investments on the Chinese local equity market and relaxing the quarter on international bank investment market will bring more foreign capital flow into Chinese domestic bound and equity markets. At the same time, ODI will be promoted by an easier approved process and less restrictions on the foreign currency conversion. It is most possible that, in the coming few years, we will see two-way flows getting stronger. One is portfolio inflow. The other is ODI outflow. On balance, we may not see a big change on the net flow in the next three to five years.
To conclude, in the next five to ten years, the impact of capital account open up would have a small impact on foreign currency reserve, and foreign currency reserve would going to be rather steady going forward.
Ma Jun is Chief Economist of Deutsche Bank.