Big-Bang Reforms in China’s Financial Sector Sunanda Sen 1

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: 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 (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 RMB Calculations of CNH by author based on 1 Hk$=7.75 RMB 6

China’s net export earnings vis a vis net FX flows 7

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 China e)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