Yuan policy game changer

Published 06 October 2011 05:01, Updated 13 October 2011 05:15

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The economic outlook for China in the next few years is, in essence, built on a more stable foundation (with 8 per cent real domestic gross domestic product growth on average) than is widely predicted by increasing proponents of a double-dip global recession.

There has been yet another quickly evolving development recently that in our view is a truly important potential ‘game change’ for the still necessary opening up and reform processes that have largely been stalled in China since the global financial crisis hit in mid-2008.

It will also open up myriad ongoing potential commercial opportunities for Australian based companies large and small across many sectors.

As importantly though, it will also continue to force policy and political decisions and adaptations, much as the World Trade Organisation agreement signed in 2001 had been forcing moves towards reform on China’s leadership until the GFC hit.

It is perhaps the most important development in the capital market for decades.

When they unveiled the 12th Five Year Plan in March this year, Beijing authorities said China aimed to expand the use of the yuan in international markets and “gradually make the currency convertible on the capital account”.

In a significant three-day visit to Hong Kong in late August, Chinese Vice Premier Li Keqiang announced a series of steps to boost the territory as a place where the yuan can trade with far fewer constraints placed upon it than was previously the case.

The measures, which include allowing foreign investors to buy up to 20 billion yuan of mainland Chinese shares and bonds, will encourage foreign demand for yuan by giving investors more places to invest the currency.

By encouraging the free trade of yuan in Hong Kong and creating new channels for that money to flow in and out of the mainland, Beijing is clearly refining a template that could prove valuable once it decides to further liberalise the currency more widely.

Its latest actions, including other measures announced to allow merchants across China to settle overseas accounts in yuan, clearly shows Beijing is now acting on its evolving yuan ambitions.

Unquestionably, the shock drop in Standard and Poor’s’ US debt rating from “AAA” last month made the task more urgent, as China keeps an estimated 70 per cent of its $3.2 trillion of foreign exchange reserves (and growing) in dollar assets.

But there is clearly a longer term strategy in all of this.

Enabling China’s customers to use yuan to pay for imports is obviously more attractive, for if an American company pays for a shipment in yuan, that transaction would not lead to more dollars being added to China’s foreign reserves and also saves both parties bank exchange fees.

To get to the point where the yuan can become a truly international currency, China clearly wants to use affluent Hong Kong (and likely Singapore and London as well) to create a deep and liquid offshore yuan market where investors can trade in the currency freely and get decent returns with little exchange risk, while also using Hong Kong as a test bed for nurturing global yuan demand and easing and evolving the capital controls.

Building on what is clearly an extended experiment of opening up the yuan, with the aim of eventually making it convertible, would also offer China’s leaders a gradual exit from mercantilism – another of the stated intentions of the 12th Five Year Plan.

The yuan is already fully convertible in Hong Kong, where the pool of yuan deposits is widely expected to hit 2-3 trillion yuan by 2016, thus paving the way for the yuan’s full convertibility and setting a benchmark for further China reforms to make its onshore yuan rate far more market driven.

China is clearly building this process step by step and it is an important trend moving far more quickly than most close observers had expected at the start of 2011.

True, risks abound.

These range from a rise in speculative inflows, the further opening up of China’s domestic financial markets to increasing cross-border capital inflows and the posing of a potential challenge to China’s financial stability. But China clearly appears to be willing and ready to try out its agenda.

Watch this space.

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