BEIJING (Reuters) - China's plan to test yuan convertibility in a new services hub being built near Hong Kong fanned excitement Beijing may be dismantling its rigid capital controls sooner than expected.
A reality check paints a different picture and suggests that China's latest test bed carries risks that will make the country's policymakers move slowly.
The experimental zone of Qianhai - dubbed a $45 billion "mini Hong Kong" - will be a pioneer of the gradual opening up of China's capital account. While China controls capital moving in and out of the country, it will allow freer movements of the currency in and out of Qianhai in the southern city of Shenzhen.
That was the plan announced by officials at the weekend with much fanfare in a series of policy incentives to mark the 15th anniversary of Hong Kong's return to China.
But analysts point to potential risks and cite setbacks from similar experiments. Chinese officials, including the central bank chief, have also expressed caution suggesting Beijing is likely to roll out any changes in baby steps, which have characterized the country's economic liberalization.
The biggest challenge for authorities will be to prevent companies from exploiting the zone, from inside or outside the area, because of the easier terms on capital account transactions, said economist Zhao Qingming.
"Once you open a hole in the capital account in a certain area, it means the capital account is open for all of the people," Zhao, of China Construction Bank in Beijing, said.
BARREN
The 15-square-kilometre area zoned for the test bed is currently a barren stretch of reclaimed land. Under the plans, basic infrastructure will be put in place by 2015 and it will become a global services hub by 2020 with financial services identified as the top sector to develop.
Details on how the zone will operate are sketchy. Chinese officials have said firms located in Qianhai can experiment with cross-border yuan transactions. They will be allowed to borrow or issue yuan bonds in Hong Kong, opening up a market now only available to some state-owned banks and companies.
It is not clear either how Qianhai will proceed with capital-account convertibility - whether firms in the zone will be allowed to convert yuan freely into foreign currencies and vice versa.
China's yuan is convertible under the current account, the broadest measures of trade in services and goods. But it maintains tight restrictions on the capital account, particular on debt and portfolio investment, worried that freeing up the yuan too quickly could leave the economy vulnerable to rapid movements in capital in and out of the country.
This year Beijing agreed to allow all trade to be settled in yuan, following a series of regional experiments. It has set up a number of currency swap agreements with countries to support settlement in yuan.
It has also taken steps to relax its tight grip on currency trading, gradually widening the permitted daily trading range for the yuan. In April, Beijing doubled the band to 1 percent either side of a mid point.
Relaxing controls on the financial services industry and capital account convertibility presents a different test for authorities because much of the zone's activity will be paper-based, or electronic transactions, that will be much more difficult to monitor.
Firms in Qianhai could abuse their privileges to profit from dealings with firms outside the zone in China, giving the government a distorted view of how the zone is working.
"If they cannot effectively ring fence Qianhai, then it loses the pilot-testing status because you cannot create a fire wall to stop what's happening in Qianhai from affecting the onshore market," said Kelvin Lau, senior economist at Standard Chartered Bank in Hong Kong.
SETBACK
Pilot schemes to test economic reforms locally before rolling them out nationwide have been a hallmark of China's development in the past three decades, under former leader Deng Xiaoping's slogan: "cross the river by feeling the stone".
Indeed, Shenzhen was the location of China's first special economic zone in 1980, the start of the country's climb to a manufacturing powerhouse.
China tried an experiment similar to Qianhai in the northern port city of Tianjin. It won the cabinet's blessing in 2006 to test yuan convertibility in Binhai, a district in the city.
But official interest in the scheme faded as academics and officials highlighted concerns that greater yuan convertibility and overseas investment could lead to an influx of speculative funds.
"The approach of using special zones in financial reforms has been a failure because it's difficult to limit money flows," Andy Xie, an independent economist, told a forum in Shanghai last week.
China's central bank chief, Zhou Xiaochuan, has also rejected the idea of experimenting with interest rate or currency reforms.
"Some reforms must be pushed across-the-board. Reforms of interest rates and exchange rate cannot be carried out via trials in some places," Zhou was quoted as saying by state media last month.
Still, the Qianhai zone is being created after Hong Kong has developed into the biggest offshore yuan center as China settles more of its trade in the Chinese currency.
China has been steadily expanding the role played by Hong Kong in internationalizing the yuan, but this has been constrained in part by limitations on bringing yuan held offshore back onto the mainland.
Allowing Qianhai to tap Hong Kong would help channel some of the growing yuan pool back to the mainland. Yuan deposits in Hong Kong have grown to more than 550 billion yuan ($86 billion) in May 2012 from just 64 billion in January 2010.
"There could be some convenience (on convertibility). But there is no plan to conduct a trial on full yuan convertibility, the government has no such consideration," said He Fan, an economist at the Chinese Academy of Social Sciences - a top government think-tank - who helped to draft the Qianhai plan.
"It's a gift sent by the central government to Hong Kong, which hopes to use Qianhai as a spring board to enter the domestic market. But it will be a step by step approach."
CAPITAL ACCOUNT
Jun Ma, China economist at Deutsche Bank in Hong Kong, believes the time is right for China to ease curbs on capital inflows.
He contends that currency risks would be manageable because appreciation pressure on the yuan - which has been persistent since its landmark revaluation in 2005 - has weakened. The yuan fell against the dollar in the June quarter the most on record.
Overseas investors that hold yuan have been lobbying for further opening of China's financial markets, including raising the quotas for its qualified foreign investor programs.
"But China might need to be a little more careful on outflows," Ma said, given how vulnerable emerging markets are to global risk aversion. "The abolition of restrictions on outflows could lead to some risks of capital flight."
The central bank wants to achieve "basic" yuan convertibility by 2015. It says China has already made the yuan virtually or partially convertible on capital account transactions, but analysts say it still controls key areas, such as portfolio investment and borrowings.
Ma expects China to make the yuan convertible within five years but still retain some controls on short-term fund flows.
But caution remains the watchword for Chinese leaders, especially during the current global financial market turbulence.
"We should move cautiously in allowing free yuan convertibility and it needs a long period of planning," Liu Mingkang, China's former top banking regulator, said in remarks published in state media on Wednesday.
($1=6.36 yuan)
(Editing by Neil Fullick)
Source: http://news.yahoo.com/analysis-chinas-yuan-experiment-faces-risks-legacy-104605634--business.html
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