Proper Sequencing Of Financial Reforms Is Key

The author is UBS global economics research team

Since the global financial crisis, China has actively promoted greater use of the RMB in international trade and investment. With RMB internationalization as an informal long term policy objective, China has moved to develop the offshore RMB market and relaxed controls on interest rates, non-bank financing and cross-border financial movements.

China started to allow RMB settlement in 2009. In 2012, total RMB trade settlement reached 2.94 trillion, 41% higher than in 2011, and multiple times more than in 2010. In the first half of 2013, around 11% of China’s overall foreign trade of goods was settled in RMB.

Starting in January 2011, domestic companies have been allowed to make outbound direct investment in RMB. This was expanded in October that year to foreign direct investment. In 2012, RMB settlement for cross-border investment totaled 284 billion, more than doubled from 2011.

The People’s Bank of China has also set up 20 RMB swap lines with foreign central banks to provide RMB liquidity. Capital controls on portfolio investment were eased in the form of an expansion of Qualified Foreign Institutional Investor (QFII) and an introduction of RMB QFII. The total asset of QFII investment in China was reportedly at around 45 billion U.S. dollars by June 2013, and total RQFII investment reached RMB122 billion by July 2013.

To facilitate RMB internationalization, China needs to allow for a more flexible exchange rate, further develop domestic financial markets, improve bank and corporate governance, enhance financial supervision and crisis-resolution mechanisms, adjust its monetary framework, and finally, open up the capital account.

The upcoming third plenum of the Party Congress is expected to announce more financial market deregulation and capital account opening measures. Such reforms and RMB internationalization can help increase the efficiency of capital allocation, though experiences in other countries suggest that proper sequencing of reforms is important.

RMB internationalization could bring more business opportunities for the financial services industry, though banks will have to adjust to a world of increased competition and an open capital account.

The manufacturing sector could benefit from increased access to alternative financing but may have to face higher interest rates and the challenge of currency appreciation.

(The article has been edited for clarity)