China appears increasingly determined to have an international currency to match its clout as the world’s second-largest economy. Last month the country’s highest governing body, the State Council committed to publishing an “operational plan” for capital-account liberalization — a seismic event for international asset markets as well as China’s economy. But there are also various pitfalls on the road to currency convertibility. What’s more, China’s leaders have made similar pledges before, only to retreat.
To get a better idea of what to expect as the RMB steps out on the international stage we sat down with Joyce Poon, Asia Research Director at GaveKal Economics in Hong Kong.
These recent government announcements have put the RMB firmly back in the spotlight. Is China now really committed to removing capital controls?
We believe China is serious but before opening up the capital account it must press ahead with reforming its domestic market and improving the robustness of its financial system. After capital controls are lifted the risks of shocks will be that much greater – allowing depositors to go outside China’s borders introduces potentially huge currency volatility. China needs to introduce much greater transparency to its banking system, which has considerable non-performing loans. There will also need to be deposit insurance introduced, as well as more market-orientated interest rates. Real interest rate liberalization is likely to mean deposit rates rising so that savers get rates higher than inflation.
And what about timing?
Before removing capital controls, first China needs to move ahead with its wider reform program. This will cover everything from the fiscal system, the financial system to state-owned enterprises. We also expect reform to be accompanied by a period of slower growth, which again dictates timing. This means reform will precede the opening up of the capital account, because expectations of slower growth risks encouraging money outflows.
The value of the RMB is always a contentious issue. This year its continued to appreciate steadily against not just the dollar but also a basket of currencies. Given the importance of exports to China, will authorities be under pressure to weaken the currency?
I do not see a lot of risk that the RMB will depreciate. The currency direction is a lot more top-down driven, rather than based on fund flows. And there are several reasons why it is not in China’s interests to weaken the RMB. Firstly, China’s economy is now much less dependent on exports. In the boom years between 2002-2007, exports contributed an average 4.5 percent a year to real GDP growth. This figure is now around 1.5 percent. Exports are not going away as a driver of growth, but they are already playing a reduced role. The most important reason is that if China is serious about rebalancing its economy it needs a stronger currency.
Right now consumption is only just 35 percent of GDP. China’s undervalued currency penalizes consumers who can afford to buy less foreign-made goods. There are also other policy considerations such as China’s mandate to develop the Dim Sum bond market. To create a credible international currency and RMB bond market, it is important to let the currency go up – RMB appreciation is key.
Under our base scenario China can keep a steady annual appreciation of 2% against the dollar. This reflects the relative productivity growth of the two countries. China’s policy goals have moved past a focus on exports. The internationalizing of the RMB helps China meet its policy goals both at home and abroad. We believe this will serve the same purpose as WTO entry did a decade before in the manufacturing sector – speeding up domestic reform through external stimulus.
That being said, how much of a problem for China is Japan’s move to aggressively weaken the yen? Some Chinese economists have complained Japan is engaging in a destabilizing currency war.
We believe the direct impact of Japan’s behavior is actually quite minimal. There may be some capital inflows but China does not compete directly with Japanese exporters. In fact, China can actually benefit as it makes imports of Japanese machinery cheaper. It is a good opportunity for China to upgrade its factories. We do not believe it is in China’s interest to engage in currency wars.
When China finally does throw open the doors of its capital account, what impact do you expect on global asset markets?
We think there will be a relatively contained reaction. Here’s why. For China to go ahead with its planned capital account opening, this means there is confidence that the system is healthy. Under this assumption, we do not expect there will be a huge capital outflow.
But there will be some diversification of assets. We also expect there will be a two-way capital flow with money entering China’s domestic bond market. One reason China is pushing ahead with opening up its bond market to the world is to get more countries, particularly in Asia, using the RMB in trade settlement. This lowers the dependency on the US dollar in Asia.
China wants to avoid a repeat of the situation in 2008 when there was a freeze in trade finance following a squeeze in the supply of US dollars. Using the RMB should also help countries trading with China to lower transaction costs.
Looking further out, do you think it is realistic for the RMB to be a reserve currency?
Already some central banks are buying RMB. I doubt whether it can be a competitor to the US dollar but it could be on a par with the yen, which is 9% of central bank deposits. Maybe in the next decade the RMB could be one of the reserve currencies, although first China would need to open its capital account. That said, at the moment there is no need for the RMB to become a reserve currency, as there is not surplus RMB. Maybe when China starts running a trade deficit it would then make sense.
China has closely managed its economy for decades – could this opening up still go wrong?
China has to be careful. Just about all the Asian financial crises have started with the capital account opening – this has been the seed. The risk then has been capital inflows creating a bubble. The difference with China is arguably it has had its bubble already. But I would say it has had a credit bubble and not an asset bubble. It still needs to fix that problem before opening up.
And overall what is your house view about the Chinese economy?
While we see policy challenges ahead, a “hard landing” scenario is very unlikely. If you look at the current debt to GDP ratio it is not unsustainable, particularly with a closed- capital account.