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Fully convertible RMB: the final frontier

China’s long journey to a fully convertible currency may be nearing an end, according to BCA research, as the timing for liberalization couldn’t be any better.

In 1992 – when Deng Xiaoping was making his southern tour of China to introduce a new, capitalist way of doing business in the hitherto closed economy – the Pudong district of Shanghai was nothing more than marshland. Today, the area is one of the most important economic hubs in the world.

You obviously know the drill...on the back of cheap labour and materials, China reinvented itself as the world’s market place, which started a trend for cross-border trade with the mainland. Since the 1990s, and the slow liberalization of the currency, the use of the redback has grown substantailly, spurred on by the introduction of the qualified foreign institutional investor (QFII) scheme in 2002 and dim sum bondsout of Hong Kong in 2010.

RMB deposits in Hong Kong reached a high of Rmb622 billion in 2011 – before taking a slight tumble – and in London deposits came to Rmb109 billion in January 2012. At the beginning of this year, Taiwan became the latest offshore clearing house for RMB, which will only encourage further international use of the currency.

As it stands, RMB transactions under current-account activity, mainly through the trade of goods and services, have been liberalized. But the pace of liberalization for capital-account transactions has been slightly more reserved.

However, according to BCA Research, this is poised for a change. It looks as if its transformation into a fully convertible, free floating currency is on the horizon, especially as the new administration has come in and revived the liberalization process, according to the research shop.

But why now? Because the stars have aligned for China, says BCA:


Policymakers believe removing capital account restrictions enables Chinese firms to acquire overseas assets and advanced technologies. Moreover, it facilitates domestic firms in some low value- added industries to relocate production to lower-cost countries. All of this should enhance productivity and competitiveness among Chinese firms over the long run.”  


“China’s remaining restrictions over cross-border capital flows are largely asymmetric: Capital flows into China much easier than out. This arrangement is increasingly against China’s best economic interests. In recent years, the net balance of capital and financial accounts has outpaced that of current account transactions, and has become the main source of China’s reserves accumulation. This has not only put strong upward pressure on the RMB, but has also to some extent fanned overly buoyant asset markets, particularly in the housing sector. Establishing a legitimate mechanism to allow freer capital outflows will help reduce liquidity pressures in the domestic system."  


It has become increasingly difficult for the Chinese authorities to maintain capital account controls, as the economy is increasingly open and the offshore RMB market is rapidly developing. Companies have become increasingly creative in exploiting loopholes and gray areas in regulations to get funding and arbitrage for higher-yield investments, as evidenced by the recent exaggerated trade numbers. If this phenomenon continues to spread, it will not only distort macro data, but also make cross-border capital flows even more difficult to monitor, and potentially more harmful to macro stability."  

And finally:

Chinese authorities believe the value of the RMB, after a 30% appreciation against the U.S. dollar since 2005, has approached “fair value” territory. This means that loosening controls over capital account transactions is unlikely to lead to a one-way bet on the RMB and one-way capital flows. This should leave the country’s external accounts roughly balanced.” 
BCA Research has been known for some cyclically-bearish EM calls in the past so this view is worthy of note.

Sorry, Michael Pettis.