Getting the sequencing right

Apr 15th 2015 |

China’s liquidity crunch at the end of June 2013 served as a wake-up call for banks and corporations. Overnight interbank lending rates surged over 30% at one point. Discounting of bank drafts came to a halt. China’s central bank may have wanted to teach banks and other financial institutions a lesson, that they shouldn’t rely on the short-term interbank market to finance their ballooning books. However, some market observers believe the liquidity crunch highlighted the weakness of China’s domestic financial system, which may wreak havoc if China races towards capital account liberalisation.

“You need to carefully sequence domestic and external financial liberalisation reform,” warns Liu Ligang, Greater China chief economist of ANZ Bank. “If compounded with capital account liberalisation, risks will rise dramatically.” He refers to numerous incidents of heightened risks in financial history when a country, whether developed or developing, tries to carry out financial sector reform alongside capital account liberalisation.

His suggestions are for China to work on a series of internal reforms, such as interest rate liberalisation, a market-determined exchange rate, building deeper corporate and government bond markets before considering full capital account convertibility.

“Maybe China shouldn’t think about full capital account liberalisation,” adds Nicholas Lardy, senior fellow at the Peterson Institute for International Economics, “It’s better to retain some controls, especially to portfolio investment.”

“Shall we aim for full capital account convertibility soon and face the challenges of managing and supervising large amount of hot money flowing in and outside the country rapidly?” seconds Sun Lijian, professor of economics at Fudan University in Shanghai, “Or shall we rather focus on building a better clearing system, facilitating [the] increase in use of RMB to settle trade and ease the process?” He’s in favour of the latter option.

The July 2013 EuroFinance survey of 307 treasurers also indicates that the focus of RMB internationalisation should remain in the area of trade settlement. The survey shows that the usage of offshore RMB for trade settlement currently leads usage for financial transactions and is most embedded in Asia. It also highlights that the regulatory environment is one of the major challenges facing companies use of offshore RMB.

It’s hard to tell whether Beijing is firmly set on the 2015 timetable of capital account liberalisation, or it is satisfied with the wider use of RMB in international trade and funding. With the announcement allowing Shanghai to set up a free trade zone in July 2013, in which free movement of currency and transaction is a possibility, one thing is for sure: in the arena of RMB internationalisation, China will keep on piloting.