China's Yuan: Chance of Full Liberalisation Rises

by Alaistair Chan, Moody's Analytics, 26 September 2011

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Risk Management

tags:
currency controls managed monetary system renminbi liberalisation

China is piling up foreign reserves as its foreign trade and domestic financial assets grow.
The country’s managed monetary system is becoming more costly.
Yuan liberalisation would allow the central bank to pursue normal monetary policy.

China’s financial markets are deepening as the economy develops, pushing policymakers to move toward a more liberal treatment of the yuan. Indeed, as China’s growth fans speculation that its economy will one day exceed the size of the U.S., some expect the Chinese currency to join the ranks of international reserve currencies, alongside the U.S. dollar, U.K. pound, euro and Swiss franc.

China’s leaders have long talked of freeing the currency and capital account from their current controls, and have set a goal of full liberalisation by 2020. Yet whatever prospects the yuan may have to eventually be counted as a reserve currency, there is significant uncertainty about their plans for the near term.

Before the yuan can become an international currency, China would have to allow freer movement of capital, while moving away from its tight management of the exchange rate. Chinese policymakers are approaching yuan liberalisation with caution, concerned that missteps could lead to financial volatility, asset price bubbles, and a possible financial crisis similar to those seen in Japan in the late 1980s or Southeast Asia in the mid-1990s.

Powerful trends

At the same time, two powerful trends favor yuan liberalisation: The growth of China’s overseas trade and the growth of its citizens’ wealth.

China’s rapid economic development has been driven by exports and investment in export-facing industrial sectors. Now firmly integrated into the global economy, China accounts for around 10% of world exports. From a mere US$60.9 billion in 1990, the value of China’s exports rose to US$1.58 trillion in 2010, a 26-fold increase.

Imports have risen even faster, but from a smaller base, so that China continues to run a sizeable trade surplus.

Click to enlarge

China’s trade accounts are largely settled in US dollars, even as it diversifies its markets beyond the US. From 2001 to 2006, 21% of China’s exports went to the US. In the first five months of 2011, that proportion fell to 16.5%.

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