The people's forex liberation army
By Wu Zhong, China Editor 

HONG KONG - On Monday morning, the yuan-dollar exchange rate dropped below the key psychological benchmark of 8 to the US dollar, with the Chinese currency trading at 7.9980 to the dollar at 11:43am in Shanghai. With the yuan at new record highs almost daily, more attention than ever is being focused on China's foreign-exchange policies going forward.

Thus it is highly noteworthy that Beijing has recently taken a spate of measures to relax its foreign exchange controls further. These are expected not only to accelerate the liberalization of the yuan into a fully convertible currency, but also to speed up its revaluation.

Many observers are optimistic that the yuan could become a fully



convertible currency as quickly as three years from now, which will inevitably shake up the regional and global financial markets.

Hong Kong, for instance, is now becoming even more concerned that its status as an international financial hub will be seriously challenged, if not immediately replaced, by Shanghai once the yuan becomes a hard currency. No doubt a fully convertible yuan would become a major world currency given China's strong economy and the nation's huge savings.

At a forum in Beijing on March 18, Wu Xiaoling, vice governor of the central People's Bank of China (PBoC), heralded the principal change in the foreign-exchange policy. She said China should readjust its foreign-exchange policy to curb the sharp increase of its foreign-exchange reserves. Wu said China would change its current policy of "storing foreign exchange in the state coffers" into one of "storing foreign exchange among [the] people". In other words, the government would ease its tight grip on virtually all foreign exchange in the country and let its citizens and enterprises alike hold more foreign currency.

At the same function, Li Lianzhong, a senior official with the Policy Research Office of the Communist Party's Central Committee, said China should make better use of its huge foreign-exchange reserves, encouraging Chinese enterprises to "go abroad" to cultivate overseas markets.

Foreign exchange management seen as key issue
In fact, the question of how to manage the country's huge yet steadily growing foreign-exchange reserves efficiently has increasingly become a headache for Beijing. According to PBoC data, China's foreign-exchange reserves totaled US$818.87 billion by end of last year, jumped to $875.07 billion by the end of March, and are expected to exceed $1 trillion by the end of this year if the government does not take any action.

Beijing's think-tanks have made various proposals on the disposal of the foreign-exchange reserve. Some Chinese financial experts have suggested that Beijing increase its gold reserves. Since last year, periodic market rumors that "China is increasing its gold reserves" have triggered climbs in the price of the precious metal.

However, PBoC data show that from December 2002 to March of this year, China's gold reserves have remained unchanged at a level of 19.29 million ounces, which are only worth some $14 billion given the current gold price of about $700 per ounce. So even if China doubles its gold reserves at current prices, it only has to spend a small fraction of its foreign-exchange reserves.

Recently, a study by the State Development and Reform Commission's Academy of Macroeconomy suggested that the government spend a proportion of its foreign-exchange reserves to buy oil on the international market. The research describes this as "turning some foreign-exchange reserves into oil reserves". Again, if Beijing wants to do it, only a tiny proportion of its foreign-exchange reserves will be disposed.

'Storing foreign exchange among the people'
Wu's and Li's remarks suggest Beijing has found a more satisfactory solution. Less than a month after they made their remarks, China began to announce a spate of concrete measures to implement the new policy principle of "storing foreign exchange among [the] people".

On April 12, Wu Dingfu, chairman of the China Insurance Regulatory Commission (CIRC), said in Beijing that the State Council, China's cabinet, had given the green light for Chinese insurers to invest in overseas securities markets. This signaled that China was ready to launch a qualified domestic institutional investor (QDII) scheme that would allow Chinese investors to trade in foreign stocks even while the yuan remained not fully convertible.

Two days later, the PBoC lifted its restrictions on institutions opening foreign-exchange current accounts with commercial banks, so that a company no longer had to sell any foreign exchange it earned to the government but could keep it for its own disposal.

At the same time, it also announced that individuals would be allowed to buy and hold foreign exchange freely. A person would be allowed to purchase foreign currency equivalent to a maximum of $20,000 per year. Such measures will surely boost daily trading in foreign exchange.

On April 17, the PBoC, the China Banking Regulatory Commission (CBRC) and the State Administration of Foreign Exchange (SAFE) jointly issued a circular giving the green light to Chinese commercial banks to trade in overseas securities on behalf of their clients, formally including the lenders into the QDII scheme.

Shortly before the May 1 "Golden Week" holiday, China officially kicked off its QDII scheme. With the approval of the State Council, the National Social Security Fund became the first qualified institutional investor to put money into overseas stock markets, with the Hong Kong market its top priority. The news drove Hong Kong's Hang Seng Index to its highest levels since the former British colony reverted to Chinese rule in 1997.

This year, up to $6 billion is expected to flow out of China into overseas securities markets, which is likely to increase to up to $10 billion.

Outbound investment restrictions lifted
But Beijing's relaxation of its foreign-exchange controls does not stop there. On April 27, Li Dongrong, the deputy director of SAFE, revealed in Beijing that China was planning to lift restrictions on outbound capital investments by Chinese enterprises.

China began to open its outbound doors slightly in October 2001 for Chinese firms to make capital investment overseas. However, Beijing has since also imposed tough controls setting a strict quota on the amount of capital outflow - for a region and for a project.

Because of this, China's outbound capital investment remains very tiny. According to statistics from the Ministry of Commerce, the amount of outbound capital investment, as approved by the government, only totaled some $4 billion in the whole of last year. By comparison, China drew $53.13 billion in actual foreign direct investment in merely the first 11 months of 2005.

Li said the SAFE was considering a revision of the 2001 regulation governing outbound investment by Chinese enterprises to lift capital restrictions. Furthermore, multinationals in China would also be allowed to transfer their funds in foreign exchange out of China to support their overseas subsidiaries.

Speeding to full convertibility
The pace of Beijing's easing of foreign-exchange controls has risen so remarkably that some financial experts now are optimistic that this will significantly accelerate yuan liberalization. Charles Lee Yeh-kwong, a former chairman of the Hong Kong Stock Exchange, said he now expected the yuan could become a fully convertible currency within three years. Lee originally made these remarks in an exclusive interview with a Chinese-language newspaper in Hong Kong, the Ming Pao Daily, which was published on May 8.

"If you asked me two years ago when [the] yuan could become fully convertible, I would have said it would be in [the] remote future - in 15 or 20 years. But today if you ask the same question again, I'll say this could happen well within 10 years, or even likely three years later," said Lee, who is known as the "godfather" of Hong Kong's financial sector.

Lee, who is a member of the Executive Council, Hong Kong's cabinet, said the impact on Hong Kong of a fully convertible yuan would be profound. In his view, the peg of the Hong Kong dollar to the greenback would have to be reviewed. Hong Kong's financial industry would face direct competition from other Chinese cities, Shanghai in particular, and in the end there would likely appear more financial hubs in China than just one (Hong Kong).

A Chinese financial researcher in Beijing agreed that, in view of the accelerated pace of Beijing's relaxation of foreign-exchange controls, the process of yuan liberalization will be remarkably shortened. However, he stressed that there were also political concerns regarding yuan liberalization. Hence, in the end, when the yuan would be allowed to become fully convertible remained a political decision of the government.

Why the policy change?
From another angle, however, it could be said that Beijing has been obliged by market forces, in addition to foreign pressure particularly from the United States, to make drastic changes to its foreign-exchange policy.

Last July, China changed the yuan's peg to the US dollar to a basket of foreign currencies, simultaneously allowing the currency to appreciate by 2.1% from 8.28 to 8.11 to the dollar. Since then, the yuan has steadily appreciated against the greenback. For example, on March 17, the yuan was at 8.0286 to the dollar, a gain of 3% since July. On May 9, it was 8.0065 to the dollar - or the yuan revalued 1% more compared with March 17.

Historically, the Chinese government has held most of its foreign-exchange reserves in US dollars or dollar-denominated assets. The yuan's revaluation against the greenback means a book loss on the value of these foreign-exchange reserves. Therefore, to "store foreign exchange among people" would help the state to spread these risks.

But the change, which means the government will reduce its foreign-exchange holdings, will inevitably boost the appreciation of the yuan. This is because the central bank will no longer be obliged to buy up all the foreign exchange in the market and "store" it in state coffers. Furthermore, it now can sell certain foreign exchange in hand to retrieve yuan from the market. As a result, the amount of yuan circulating in the market will be reduced.

From this point of view, the change of "storing foreign exchange in the state coffers" to "storing foreign exchange among the people" is expected to take place gradually and in an orderly manner. Beijing cannot allow any sharp revaluation of the yuan to occur, as that would be disastrous to the economy. 

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