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The Full Convertibility of the Renminbi: Sequence and Impact

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Title: The Full Convertibility of the Renminbi: Sequence and Impact


1
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

2
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.

3
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.

4
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.

5
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.

6
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)

7
Table 1 Currencys Convertibility in
Developed Industrial Countries
(In Order of the Time When Establishing Capital
Account Convertibility)
8
Table 2 Currencys Convertibility in
Developed Industrial Countries
(In Order of the Interval Time between
Current Account
Convertibility and Capital Account
Convertibility)
9
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.

10
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)

11
Table 3 Sequence of the Renminbis full
convertibility
12
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.

13
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.

14
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.

15
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16
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17
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18
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.

19
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.

20
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).

21
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)

22
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).

23
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.)

24
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).

25
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.

26
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.

27
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.

28
The Behavior of a Representative Consumer
29
The Behavior of a Representative Firm
30
Solution
31
Solution
32
4. The Impact of the Renminbis Full
Convertibility on Mainland Chinas Economy and
Hong Kongs Economy A. The Impact on Mainland
Chinas Economy
33
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.

34
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.

36
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.

39
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.

40
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.

41
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.

43
Figure 1 Effect of Massive Inflow of Foreign
Investment
44
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.

45
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

46
B. The Impact on Hong Kongs Economy (continued)
47
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.

48
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.

49
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.

50
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.

51
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.

52
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.

53
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.

54
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.

55
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.

56
5. Conclusion
57
5. Conclusion (continued)
58
5. Conclusion (continued)
59
5. Conclusion (continued)
60
5. Conclusion (continued)
61
5. Conclusion (continued)
62
Thank you very much.
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