Opening the capital account will further internationalise the Yuan and monetary policy

This report is the second of two looking into capital account liberalisation in China. This report looks at the international implications of this reform. Part one is here.

In mid-June, Pan Gongsheng, vice-governor of the People’s Bank of China (PBoC), suggested that China is ‘not too far away’ from full Yuan convertibility, while announcing the opening of a new channel for capital flows. Although we argue that the capital account is still some way from full convertibility, the liberalisation process has gone hand in hand with the internationalisation of the Yuan – with China’s government seeking a greater role for its currency in the global economy.

Capital account convertibility goes hand in hand with the process of internationalising the Yuan – a process that has been accelerating in recent times. While it is possible to have limited international use of the Yuan without full capital account convertibility, growing demand for the currency requires a greater level of convertibility to ensure sufficient Yuan liquidity in global markets.

Later this year, the International Monetary Fund (IMF) will conclude its five yearly review of the composition of the Special Drawing Rights (SDR) basket. At present, the SDR basket comprises of four currencies – the US dollar, the Euro, the Japanese Yen and the British Pound. As a part of this year’s review, the IMF is considering whether to include the Yuan in the SDR basket from January 2016 – a decision that is contributing to the Chinese government’s current urgency to liberalised its capital account.

Public statements from the IMF indicate that the Yuan’s inclusion in the SDR basket is a matter of when, not if. Officials have highlighted that the five year review is a requirement, but more frequent reviews are permitted – leaving the possibility that a rejection in 2015 does not mean waiting until 2020 for the Yuan to be included.

Over the medium term, there is a general consensus that opening the capital account would lead to a net outflow – as Chinese investors diversify their portfolios.

An open capital account would pose significant challenges for China’s financial regulators, since it is only possible to maintain two of the three of: a stable exchange rate; free flow of capital; and, independent monetary policy. It is the latter which is most likely to come under pressure, with the PBoC’s monetary policy decisions likely to be more globally influenced under such a scenario.

For the full report, please see the attached document. 

China Economic Update – 7 July 2015 (PDF, 126KB)