Big-Bang Reforms in China’s Financial Sector

Sunanda Sen1

China’s capital Account Regulation: Major Breaks

• 2005: End of fixed official dollar rate for RMB at 8.27 per USD• 2007:Private holdings of foreign currency allowed• 2011 (September) “two-way floating” of RMB in

market• 2012 (April): widening of daily trading limit of

currency rate from 0.5% to 1%.• 2013(November) : Proposed reforms include de-

regulated interest rates for China as a whole, Shanghai FTZ with RMB convertibility and relaxed banking regulations

2

Components of China’s Balance of Payments:

2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2

-2,000

-1,500

-1,000

-500

0

500

1,000

1,500

Components of China's Balance of Payments

investment income balancecapital & financial account balanceother investment balancetrade credits balanceloans balanceforeign exchange balanceSeries7

100m

illio

n US

dol

lar

3

Financial reforms and the built-in instabilities a) Drop in financial account, turning negative b) Due to reversal of ‘other investments’ due to expectations of RMB rate

change) with (i) drop in short term trade credits ( advanced and delayed),(ii) negative balance in loans advanced (iii)drop in foreign currency and deposits held by banks and (iv) negative flows of foreign exchange balance (with proportionate additions to stocks of reserves)

c) Rising net portfolio liabilities ( possibilities of bunching short term outflows)

d) A deteriorating BoP signaled by (i)movements in exchange rates with depreciations between April and

August 2012 from RMB 6.30 to 6.42 per dollar….caused by currency speculation with two-way floating & widening of band in 2011 and private holdings since 2007.

(ii) Drop in Financial and Capital Account (ii) Negative investment income flows ( with higher rates in China compared

to those abroad) e) China’s BoP no longer propped by ‘twin surpluses’. 4

Offshore centres, Shanghai FTZ and two-way convertibility of RMB

• Other offshore centres already had introduced currency convertibility which include: Hongkong , London and Singapore

• Possibilities of arbitrage along trade channels as well as capital flows opened up using the Hongkong market for the slightly higher rate of RMB in terms of USD.

• Bonds (‘Dimsum bonds’ ) issued in Hongkong in RMB opened up channels of investment by foreigners in China’s capital market

• Limits of minimum capital regulation to be removed in Shanhai….opens relocation of banks

• De-regulation of interest rates … may push up rates … may relocate deposits

5

Exchange rates of USD in RMBCalculations of CNH by author based on 1 Hk$=7.75 RMB

2008 2009 2010 2011 20125.9

6

6.1

6.2

6.3

6.4

6.5

6.6

6.7

6.8

6.9Exchange rates of USD in Mainland China and in Hongkong

CNYCNH

RMB

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China’s net export earnings vis a vis net FX flows

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Some issues concerning financial stability in China

• Indications of destabilizing financial flows :a) larger flows of portfolio capital , b) use of Wealth Fund by banks as alternate channels of

investments, especially in currency markets and in real estates,

c) channels of shadow banking with derivatives,d) Arbitrage opportunities across Hongkong and Mainland

Chinae) Speculation on currency rates• Are these a path to RMB internationalization? Is China and rest

of world ready to face that without risking instability?• Can China continue with its model of ‘guided finance’ in the

face of the de-stabilizing forces?8