The Full Convertibility of the Renminbi: Sequence and Impact

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The Full Convertibility of the Renminbi
Sequence and Impact

• Drafted by Shucheng Liu and Zhijun Zhao
• Hong Kong Institute for
  Monetary Research
• and
• Economic Institute, Chinese Academy of Social
  Sciences
• Research Project Group
• Yue Ma Associate Professor,
  Economics Department, Lingnan University
• Yak-yeow Kueh Chair Professor, Economics
  Department, Lingnan University
• Shu-ki Tsang Professor, Economics
  Department, Hong Kong Baptist University
• Matthew Yiu Manager, Hong Kong
  Institute for Monetary Research

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This paper was written while we were visiting
Research Fellows at the Hong Kong Institute for
Monetary Research. We wish to thank the HKIMR for
their hospitality and support. The views
presented in this paper are those of the authors
and do not necessarily reflect those of the
HKIMR.

• 1. Introduction
• This paper discusses the sequence of the
  Renminbis full convertibility and its possible
  impact on mainland Chinas economy and Hong
  Kongs economy.

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1. Introduction (Continued)

• Chinas entry into the World Trade Organization
  (WTO) will effectively speed up the full
  convertibility of the Renminbi.
• Foreign banks will be allowed to make
  corporate loans in
• local currency within two years of entry
  
• Foreign banks will be allowed to deal with
  individual Chinese
• customers within five years after entry.
• Some people thus point out that these measures
  mean the Renminbi will soon become a fully
  convertible currency. We think this viewpoint is
  incorrect.

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1. Introduction (Continued)

• It is because this viewpoint confuses the capital
  account convertibility with the Renminbis full
  convertibility. It also confuses removing
  restrictions on transactions with removing
  restrictions on exchange.
• The measures mentioned above are just important
  steps towards removing restrictions on capital
  account transactions. They are not yet equivalent
  to capital account convertibility and still far
  from the Renminbis full convertibility.

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1. Introduction (Continued)

• The paper is organized as follows.
• Section Two focuses on the sequence of the
  Renminbis full
• convertibility.
• Section Three develops a general
  equilibrium model for an
• open economy.
• Section Four analyses the possible effects
  of the Renminbis
• full convertibility on mainland Chinas
  economy and Hong
• Kongs economy.
• Section Five provides the conclusions.

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2. Sequence of the Renminbis Full
Convertibility A. A review of the
experience of developed industrial countries
B. Three stages in the Renminbis full
convertibility

• After World War ?, developed industrial countries
  stepped towards the capital account
  convertibility in a relatively cautious way.
• (See Table 1 and Table 2)

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Table 1 Currencys Convertibility in
Developed Industrial Countries
(In Order of the Time When Establishing Capital
Account Convertibility)
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Table 2 Currencys Convertibility in
Developed Industrial Countries
(In Order of the Interval Time between
Current Account
Convertibility and Capital Account
Convertibility)
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B. Three Stages in the Renminbis Full
Convertibility

• There does not exist a uniform or fixed sequence
  of the currencys full convertibility due to the
  differences across countries.
• At the same time, based on the common practice
  and basic sequence taken by most countries in the
  world, drawing on the experience and lessons from
  other countries practice and in view of the fact
  that China is a large developing country, we
  believe that a steady and carefully designed
  sequence is needed.

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B. Three Stages in the Renminbis Full
Convertibility (continued)

• The whole course of the Renminbis full
  convertibility, we think, should be broken down
  into three major stages in general.
• Stage One, Adopting current account
  liberalization. (It was established
• by 1996.)
• Stage Two, Adopting capital account
  liberalization. (Its currently going on.)
• Stage Three, Adopting the Renminbis full
  convertibility. (It will take place in
• the future.)
• As to the stage of current account liberalization
  and the stage of capital account liberalization,
  each should be further broken down into two
  successive steps.
• Step One, Removing restrictions on current
  account or capital account
• transactions.
• Step Two, Removing restrictions on current
  account or capital account
• exchange, namely adopting
  current account or capital account
• convertibility.
  (See Table 3)

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Table 3 Sequence of the Renminbis full
convertibility
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Stage One Current account liberalization
Step One Removing restrictions on
transactions

• Removing current account restrictions on
  transactions means removing restrictions on
  current international transactions themselves and
  still retaining current account restrictions on
  exchange, i.e. retaining the examination and
  approval system relating to current account
  exchange.

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Stage One Current account liberalization
Step Two Removing restrictions on
exchange

• On the basis of having removed some or most of
  current account restrictions on transactions, a
  country can further remove current account
  restrictions on exchange, namely adopting current
  account convertibility. It means removing the
  examination and approval system relating to
  current account exchange and only retaining audit
  on the authenticity of transactions.
• According to Article 8, Section 2(a) of the IMFs
  Articles of Agreement,current account
  convertibility means that no member shall,
  without the approval of the Fund, impose
  restrictions on the making of payments and
  transfers for current international transactions.
  

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Stage Two Capital account liberalization
Step One Removing restrictions on
transactions

• Removing capital account restrictions on
  transactions means removing restrictions on
  capital international transactions themselves and
  still retaining capital account restrictions on
  exchange, namely retaining the examination and
  approval system relating to capital account
  exchange.
• China has been generally on the process of
  removing capital account restrictions on
  transactions. In 1979, it began to reform and
  open to the outside world. In 1996, it
  established current account liberalization.

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Stage Two Capital account liberalization
Step One Removing restrictions on
transactions (continued)

• Note that the measures mentioned above are just
  important steps towards removing restrictions on
  capital account transactions. They are not yet
  equivalent to capital account convertibility and
  still far from the Renminbis full
  convertibility.
• For instance, by that time, resident individuals
  may be able to deposit Renminbi in foreign banks
  residing in China, but what they can draw from
  the banks is still Renminbi and not foreign
  currency. If resident individuals want to draw
  out foreign currency to pay for capital
  international transactions, they still need, in
  accordance with the Chinas relevant regulations,
  to go through the procedures relating to exchange.

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Stage Two Capital account liberalization
Step Two Removing restrictions on
exchange

• On the basis of having removed some or most of
  capital account restrictions on transactions, a
  country can further remove capital account
  restrictions on exchange, namely adopting capital
  account convertibility.
• It means removing the examination and approval
  system relating to capital account exchange and
  only retaining audit on the authenticity of
  transactions.
• Until now, there still exist strict capital
  account exchange restrictions that need to be
  lifted up step by step in due course.

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Stage Two Capital account liberalization
Step Two Removing restrictions on
exchange (continued)

• (1) Direct investment
• Regarding foreign direct investment, some
  exchange restrictions have been lifted up
  already.
• The remaining restrictions are the prohibitions
  against the remittance of foreign exchanges into
  China as an investment by overseas legal persons
  or natural persons. These foreign exchanges could
  only be settled with the approval of the State
  Administration of Foreign Exchange (Regulations
  on the Administration of Settlement, Sales and
  Payment of Foreign Exchange).

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Stage Two Capital account liberalization
Step Two Removing restrictions on
exchange (continued)

• (1) Direct investment
• Concerning Chinas direct investment abroad,
  current exchange restrictions are also very
  strict.
• Under the existing rules, when making an
  investment abroad, institutions residing in China
  shall receive an audit on the source of their
  exchange capital by foreign exchange
  administrative agency.
• (Rules on Foreign Exchange Administration of the
  Peoples Republic of China)

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Stage Two Capital account liberalization
Step Two Removing restrictions on
exchange (continued)

• (2) Portfolio investment
• With regard to issuing securities to foreigners
  and opening domestic securities market, exchange
  restrictions are still very strict. Under the
  existing rules, foreign exchange received from
  issuing foreign currency stocks and bonds could
  not be settled without the approval of State
  Administration of Foreign Exchange (Regulations
  on the Administration of Settlement, Sales and
  Payment of Foreign Exchange).

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Stage Two Capital account liberalization
Step Two Removing restrictions on
exchange (continued)

• (2) Portfolio investment
• With respect to purchasing foreign securities,
  exchange restrictions are also very strict. Under
  the existing rules, institutions and individuals
  residing in China are forbidden to buy foreign
  exchange for the purpose of purchasing foreign
  currency stocks issued abroad.
• (Circular on Relevant Issues Regarding
  Perfecting Foreign Exchange Administration
  Relating to Capital Account.)
• (Provisional Measures on Foreign Exchange
  Administration Relating to Individuals Residing
  in China.)

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Stage Two Capital account liberalization
Step Two Removing restrictions on
exchange (continued)

• (3) Loans
• For loans, restrictions on exchange are also
  extremely strict currently.
• Under the existing rules, without the approval of
  State Administration of Foreign Exchange,
  institutions residing in China could not deposit
  abroad the raised international commercial loans,
  use them for overseas direct payment or convert
  them into Renminbi (Measures on the
  Administration of Raising International
  Commercial Loans by Institutions Residing in
  China).

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Stage Two Capital account liberalization
Step Two Removing restrictions on
exchange (continued)

• We can see from the above analysis that on the
  whole, there is still a lot to do in the removal
  of various restrictions on capital account
  transactions and exchange. The removal of
  restrictions cannot be accomplished in a single
  action.

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Stage Three The Renminbis full
convertibility

• The Renminbis full convertibility means removing
  in all respects exchange controls relating to the
  Renminbi, removing audit on the authenticity of
  current account and capital account transactions
  and allowing the Renminbis convertibility
  without the occurrence of any real transactions.
• This clearly could not be established within five
  years after Chinas entry into WTO.

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3. A General Equilibrium Model for an Open
Economy

• Adopting the Renminbis full convertibility will
  involve a very broad range of areas, including
  macro-economy and micro-economy, real economic
  activity and financial activities, internal and
  external economic balances, price, interest rates
  and exchange rates, etc.
• In order to analyze the possible effects of the
  Renminbis full convertibility on mainland
  Chinas economy and to analyze the interaction
  between the Chinese economy and its foreign
  counterpart such as Hong Kong, we will develop an
  open macroeconomic general equilibrium model with
  micro foundations. Each economy in the model is
  assumed to be composed of a representative
  consumer and a firm.

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The Behavior of a Representative Consumer
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The Behavior of a Representative Firm
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Solution
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Solution
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4. The Impact of the Renminbis Full
Convertibility on Mainland Chinas Economy and
Hong Kongs Economy A. The Impact on Mainland
Chinas Economy
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A. The Impact on Mainland Chinas Economy

• The process of the Renminbis full convertibility
  will have an extensive effect on mainland Chinas
  economy.
• As suggested by the experience of most countries
  in the world, the most noticeable accompaniment
  of capital account liberalization will be the
  massive inflow of foreign investment.

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A. The Impact on Mainland Chinas Economy
(continued)
35
A. The Impact on Mainland Chinas Economy
(continued)

• With respect to the effect of massive inflow of
  foreign investment, we can make an analysis from
  two angles, namely the effect on real economic
  activities and the effect on financial
  activities.
• We begin our analysis with the effect on real
  economic activities.

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A. The Impact on Mainland Chinas Economy
(continued)
37
A. The Impact on Mainland Chinas Economy
(continued)
38
A. The Impact on Mainland Chinas Economy
(continued)

• In the above chain-reaction, the most important
  links are equation (42) and equation (34). The
  massive inflow of foreign investment will not
  necessarily increase the real productive capacity
  of capital and lead to an increase in domestic
  output.
• If the large-scale inflow of foreign investment
  is just in pursuit of profits in the securities
  market or real estate market, rather than
  ultimately entering the sphere of real
  production, bubble economy will result.

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A. The Impact on Mainland Chinas Economy
(continued)

• As a consequence, certain preconditions,
  including (1) accelerating reform of domestic
  enterprises with the liberalization of capital
  account, (2) enhancing the efficiency of domestic
  enterprises in utilizing foreign investment, and
  (3) promoting the healthy development of domestic
  securities market so as to hold the bubble in
  check effectively, are needed for the conversion
  of massive inflow of foreign investment into real
  production capacity which will raise domestic
  output.
• Without these preconditions, massive inflow of
  foreign investment may cause some trouble.

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A. The Impact on Mainland Chinas Economy
(continued)

• We will make an analysis of the effect from the
  other angle below, namely the effect on financial
  activities.
• Massive inflow of foreign investment will lead to
  an increase in domestic foreign exchange reserve,
  which will, under the fixed exchange rate regime,
  result in an increase in the corresponding
  issuance of the Renminbi. A large increase in
  domestic money supply will cause inflation and
  affect real exchange rate.

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A. The Impact on Mainland Chinas Economy
(continued)
42
A. The Impact on Mainland Chinas Economy
(continued)

• The trend of rising imports and falling exports
  will cause China to run a current account trade
  deficit, which will cause a real devaluation of
  the Renminbi.
• A severe real devaluation of domestic currency
  may lead to the massive flight of foreign
  investment and even to the outbreak of financial
  crisis. Consequently, in the course of capital
  account liberalization, the Chinese government
  should adopt a more flexible exchange rate regime
  in order to avoid the occurrence of these
  problems.
• The whole chain-reaction discussed above is shown
  at Figure 1.

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Figure 1 Effect of Massive Inflow of Foreign
Investment
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A. The Impact on Mainland Chinas Economy
(continued)

• In addition, in the course of capital account
  liberalization, there also exist some other
  issues, such as persistently deepening financial
  system reform, enhancing the competitiveness of
  domestic commercial banks, pursuing
  market-oriented interest rate, and strengthening
  financial supervision.
• Here in this paper, we do not intend to discuss
  these issues in detail.

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B. The Impact on Hong Kongs Economy

• The liberalization of Chinas capital account and
  the full convertibility of Renminbi will
  undoubtedly have a far-reaching effect on Hong
  Kongs economic development. The effect can be
  summarized as follows

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B. The Impact on Hong Kongs Economy (continued)
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B. The Impact on Hong Kongs Economy (continued)

• (2) Portfolio investment aspect
• When the mainland relaxes various restrictions on
  portfolio investment, there must be development
  in the listing of foreign-funded enterprises on
  the mainland stock market. In addition, more
  mainland residents could purchase stocks and
  other securities issued out of the territory.
  This will help Hong Kongs firms getting listed
  in the mainland and enlarge the size of Hong
  Kongs securities market.

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B. The Impact on Hong Kongs Economy (continued)

• Recently, that Hong Kong firms hope to get
  listed in the mainland has become a hot issue in
  Hong Kong.
• Chief executive of the Hong Kong Monetary
  Authority, Joseph Yam (2001), once stated his
  views about this issue on the web page of the
  Hong Kong Monetary Authority. He came up with
  some instructive proposals on how the mainland
  should gradually lift restrictions to enable Hong
  Kongs firms to get listed in the mainland.

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B. The Impact on Hong Kongs Economy (continued)

• He (Joseph Yam) also put forward some quite
  meaningful opinions on how to outline the
  sequence of financial liberalization.
• He holds that, on one hand, rules designed to
  restrict the free flow or use of money are to be
  broken or to be circumvented so that further
  steps of liberalization should be taken. On the
  other hand, decision-makers should be careful
  about the pace of financial liberalization. Only
  when the attendant risks have been clearly
  identified and a prudent risk management
  mechanism has been put in place should the
  relevant steps, however beneficial, be taken.

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B. The Impact on Hong Kongs Economy (continued)

• (3) Imports and exports aspect
• With the mainlands accession to WTO and its
  continuous opening of capital account, the scale
  of imports and exports of the mainland will be
  further enlarged. This will offer Hong Kong more
  commercial opportunities. Thus Hong Kongs role
  as a bridge in the field of trade will be
  enhanced.

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B. The Impact on Hong Kongs Economy (continued)

• (4) Financial service aspect
• Just like the co-development of Hong Kong and
  Singapore in the past few decades as
  international financial centers and like the
  co-functioning of London and Frankfurt, New York
  and Chicago, which jointly act as financial
  centers Shanghai and Hong Kong will join their
  hands together in playing the role of
  international financial centers.
• With the mainlands entry into WTO, its
  continuous opening-up of capital account and the
  future full convertibility of the Renminbi, the
  overall scale of mainlands capital inflow and
  outflow will dramatically be enlarged. This will
  not only favor the development of Shanghai as a
  newly rising international financial center, but
  also offer new and very large room for the
  further development of Hong Kong as a mature
  international financial center, due to the
  inadequacy of the mere reliance on Shanghai.

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B. The Impact on Hong Kongs Economy (continued)

• Influenced by the 1997 Asian Turmoil and the
  recent slowdown in economic growth in major
  countries such as the United States, the world
  financial market is in a phase of adjustment and
  commercial opportunities will thus diminish.
  These would drive some Hong Kong-based financial
  institutions to partly transfer to Shanghai to
  seek new commercial opportunities.
• Once the world economy regains its momentum,
  coupled with the new development of the
  mainlands economy, Hong Kongs financial
  industry will achieve new and greater development.

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B. The Impact on Hong Kongs Economy (continued)

• (5) New financial derivative instruments
  aspect
• The rapid globalization and intensified
  competition in global financial market are
  encouraging constant development of financial
  innovation. Hong Kong, as a well-grounded
  international financial center which bears a
  specific advantage, will play an important role
  in developing new financial derivative
  instruments.

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B. The Impact on Hong Kongs Economy (continued)

• (6) Interregional links aspect
• Hong Kong is backed by the vast market of the
  mainland, especially the very large market of
  some southern provinces adjacent to it like
  Guangdong that are very closely linked to it in
  aspects of economy, history, culture and life.
  These southern provinces, Guangdong in
  particular, have achieved great development since
  the mainlands opening-up and reform, and they
  are expected to gain further development with the
  mainlands accession to WTO and its opening of
  capital account. This will also offer very large
  room for Hong Kongs economic development.

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B. The Impact on Hong Kongs Economy (continued)

• (7) Qualified personnel aspect
• With the ever-expanding flow of fund, commodity
  and information, qualified personnel flow is also
  getting enlarged. In the presence of intensified
  competition in financial market, commodity market
  and service market, qualified personnel will
  surely play a more important role.
• In order to retain the favorable position and
  bring it into full play, Hong Kong should, in the
  long term, make greater effort in the cultivation
  of qualified personnel.

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5. Conclusion
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5. Conclusion (continued)
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5. Conclusion (continued)
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5. Conclusion (continued)
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5. Conclusion (continued)
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5. Conclusion (continued)
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Thank you very much.