Opening Up: RMB Liberalization and the Future of China’s FTZs

Opening Up: RMB Liberalization and the Future of China’s FTZs

By Jonathan DeHart

The prospect of a freely flowing RMB — moving with ease through China’s borders and into the world — could be a game changer. The newly launched Shanghai Free Trade Zone is the main testing ground where such liberalized finance policy is gradually being rolled out. Could the experiment in Pudong be a sign of things to come?

China’s monumental role in shaping the world’s economic destiny in the 21st Century is beyond dispute. The explosion of the nation’s economy in the past few decades has been staggering. But a major piece of the economic puzzle has been left out of the picture until the past few years: liberalization of the RMB.

Simply put, the time has come for the unfettering of China’s currency, which has steadily grown in importance in recent years. As the Bank for International Settlements pointed out in September 2013, China’s stratospheric economic rise has given then RMB a place among the world’s top 10 most traded currencies — although only partially convertible.

In particular, The Diplomat said this is “thanks to high GDP growth, consecutive currency and capital account surpluses and an aggressive People’s Bank of China (PBoC) policy since 2009, a time when China found itself in the dollar trap.”

Not only does the prospect of liberalizing the RMB allow China to escape the dollar trap, it also gives multinational corporations (MNCs) setting up shop in the country easier access to financial services than ever before.

The China (Shanghai) Pilot Free Trade Zone, or Shanghai FTZ for short, is the first testing ground in China’s modern history where MNCs will have access to liberalized financial services onshore. Until the launch of the Shanghai FTZ, borrowing, lending and putting capital to use has been a perennial obstacle for MNCs operating in the People’s Republic.

Although the plan has polarized critics who say it lacks teeth, it is gradually moving forward nonetheless. Should the liberalization trickle down from the Shanghai FTZ and into China’s other fresh batch of FTZs, from the Zhuhai Delta to Tianjin, it could be just a matter of time — though how much is up for debate — until the RMB is freely flowing nationwide.

The sum result of this gradual liberalization, as Australian Treasurer Wayne Swan put it in 2012 during high level talks in Beijing, “represents China’s move toward a freely traded currency and toward a fully integrated economy that will very soon lead the world.”

No wonder this new crop of FTZs has China watchers on the edge of their seats.

The Long Road to Liberalization

Liberalizing China’s currency is the next step in a massive decades-long undertaking. Ever since China’s trade was freed by Deng Xiaoping in Shenzhen 35 years ago, the country’s economic protectionism has gradually been dismantled piece by piece.

Amid successive waves of economic liberalization, the prospect of freeing up the RMB has increasingly loomed on many China watchers’ minds over the past decade. But the time had not yet come until recently.

Technically, the RMB has been partially convertible on the current account since December 1996, but the economic crisis that swept through Asia in 1997 put a damper on plans to make the currency fully convertible by 2000, as Beijing had hoped to do, Forbes notes.

Indeed, the RMB is still not fully convertible and its capital account has not yet been completely opened. This lingering layer of protection is intended to serve as a buffer between the nation’s economy and the potential for financial unrest in the global market. But for China to fully emerge as the economic leader it is becoming, its capital account must gradually be fully opened and the RMB must become an international currency of choice.

Chatham House notes that the push to popularize the RMB overseas — with the aim of weaning the country from over dependence on the USD — is based on a dual-track approach: boosting the use of RMB for global trade and setting up RMB markets offshore.

Towards this end, first, the Bank of China Hong Kong was given the mandate to act as a clearing house for the RMB in 2004. London followed Hong Kong’s lead in 2009, with Singapore — via the Industrial and Commercial Bank of China — joining the growing list of RMB clearing centers in 2013.

The Asian Development Bank added the RMB to its Trade Finance Program in support of burgeoning intra-regional trade and Iran opted to take RMB as payment for oil exports, among other similar developments in recent years.

But the biggest move towards the elusive full convertibility of the RMB was yet to come. And it was to take place onshore, in Shanghai.

Shanghai FTZ Brings Liberalization Onshore

Beyond the glimmering skyline in a less flashy part of Shanghai known as Pudong New Area, an experiment with liberalization unlike anything done to date in China is underway.

Stretching across 28.78 square kilometers and strewn with groups of industrial buildings, the China (Shanghai) Pilot Free Trade Zone, or Shanghai FTZ for short, was officially launched on September 29, 2013. The zone comprises the four customs supervisory zones of Waigaoqiao Bonded Zone, Waigaoqiao Bonded Logistics Park, Yangshan Bonded Port and Pudong Airport Comprehensive Bonded Zone, each with its own specialty.

But the real reason all eyes are on Shanghai’s new FTZ is that it has been given the distinction of being the testing ground for a trial run with making the RMB a fully convertible currency — with liberalized financial services to boot. And business is buzzing. According to a study by Ernst & Young, published in 2014, there were already 628 Wholly Foreign Owned Entities in the Shanghai Free Trade Zone (FTZ) eligible for cross-border pooling of the RMB.

While the project has come to be closely associated with Shanghai, the seeds were planted by Beijing. Speaking at the Summer Davos Forum in 2013, just prior to the unveiling the zone, Premier Li Keying touted the Shanghai FTZ as a key pillar in the process to unfettering the yuan.   Li’s sentiment has been echoed widely. “The FTZ will act as a stress test. We are going  to explore to what extent China can open its capital account,” a source close to the  process told People’s Daily around the same time that Li stressed the importance of  the groundbreaking project in Shanghai.  The timing to launch the Shanghai FTZ was determined by a number of factors, both at home and abroad. Domestically, China’s economic growth was beginning to taper off, which meant that it could no longer rely solely on exports to fuel its economic engine.  Internationally, pressure mounted as the US pushed for the Trans-Pacific Partnership.  

Meanwhile, the US and EU were ironing out the details of the proposed Transatlantic  Trade and Investment Partnership, the largest bilateral trade agreement the world has  ever known.  Facing such tectonic shifts in the realm of global trade, the time had come to act. And so, in September 2013, the General Plan for the Shanghai FTZ laid out China’s strategy for how to go about the momentous task of liberalizing its currency. In simple terms, the plan sought to adjust a few key areas: finance and foreign exchange, tax policies and investment management, among others. 

From full convertibility of the RMB to liberalizing trade and interest rates, and establishing foreign and joint venture banks, the ambitious plan for the Shanghai FTZ has the city firmly on track to reach its goal of becoming a world-class financial hub by 2020. This creates synergy with the overseas RMB centers that have grown in clout in recent years, including Hong Kong, London and Singapore.  “China can now encourage RMB use in several key markets,” The Diplomat notes.  “First, London provides an important bridge to European markets. Similarly, Singapore connects the emerging Southeast Asian economies to RMB funds and trade   settlements. Given Hong Kong’s highly internationalized financial sector, it plays a particularly important role in connecting China to the rest of the world.”  

Crucially, the report adds, “This is a role that will be shared by Shanghai, with its Pending emergence as an international financial center.”

Beyond Shanghai: RMB Outflows and the Other FTZs

The Shanghai FTZ does not exist in a vacuum. It is one of four new FTZs recently launched in China, announced by Premier Li in December 2014. Modeled on the Shanghai experiment, the additional zones will take shape in Tianjin, Guangdong province and Fujian province.

These other FTZs will have their own distinguishing traits and focuses. The Guangdong FTZ will be massive in size at 931.385 square km and will devote most of its resources to customs clearance and the finance industry. The Fujian zone — with its strong cross-strait links with Taiwan — will take a more technical focus, specializing in electronics, petrochemicals and mechanics. As northern China’s biggest port and the world’s fourth busiest — sandwiched between Beijing and the Pacific — Tianjin will take on a strong maritime role. The northern FTZ will also dedicate significant resources to petrochemicals, as well as mobile phone and aerospace manufacturing.

It is worth noting that the other FTZs are not being treated as currency laboratories in the same way as Shanghai. But chatter from the media and officialdom is in agreement that the findings in Shanghai will inevitably trickle down, via the other FTZs, nationwide.  

Wang Xinkui, an economist involved in drafting the FTZ plan, said: "Experiences learnt in the FTZ will be shared nationwide.”

Chief China economist at UBS Wang Tao added: “It's difficult to segregate the Shanghai FTZ from the rest of China. There will be money flows underground. It can be said that the FTZ experiment opens a hole in China's capital account wall.”

Undoubtedly, this is part of the plan. If the Chinese government hopes to make the yuan a global reserve currency, with Shanghai situated as a major RMB trading hub, the effort to first liberalize the currency in the Shanghai FTZ is “merely part of an overarching RMB strategy,” The Diplomat argues.

Although the suggestion may be controversial, it is worth adding that there will inevitably also be an unofficial liberalization at play across the FTZs. While Shanghai may be the primary testing ground for liberalizing the RMB, make no mistake: the effect will also spread via “subterfuge”. An article in Forbes puts this in perspective, noting that “once banks in the Shanghai zone have the right to convert currency; businesses outside the zone will find ways to deal with those banks to convert currency and freely move cash in and out of the country, more or less at will.”

The article notes that parallels have been drawn between the Shanghai FTZ and Deng Xiaoping’s grand experiment of 1980 with the Shenzhen Special Economic Zone. “It’s instructive to see how the laobaixing—ordinary folks—handled Deng’s rules. We credit Deng with the startling transformation of the Chinese economy because he permitted individual initiative.”

It might muddy the picture, but the messy reality was that individual initiative was the key to Shenzhen’s success, according to Forbes. “You can expect disobedience this decade as well. Even if Premier Li locks down the Shanghai zone, money will come swooshing through the area on its way to and from the rest of China. And if despite everything Li strictly controls every cent—actually, every fen—coming and going in Shanghai, he will not be able to keep his eye on all the other zones.”

Risky Business

While most would agree that liberalization is good and necessary in the longer term, it doesn’t mean that it won’t come with some short-term pain. In an effort to ease the transition and avoid undue economic stress, Beijing is not in a rush to remove all controls on the RMB.

This has riled some critics who have suggested that currency reforms are too slow to gain traction, or worse, that they could lead to more dire consequences down the road if handled improperly. A study by Chatham House sums up this double edged sword, noting that despite the huge potential for success inherent in the plan, “the lack of progress in implementing meaningful steps to make the FTZ an ideal business hub for international investors, and the absence of a transparent and consistent regulatory framework, raise considerable concerns about whether the policy measures made in the Shanghai FTZ are replicable to the entire onshore market.”

Chatham House is hardly alone. The International Monetary Fund (IMF) has also voiced concerns about unintended consequences that may be triggered by pushing through currency liberalization, including the potential for a mass outflow of money from China.

“According to IMF calculations, a speedy liberalization of cross-border capital movements could produce over several years net outflows from China equal to as much as 15% of the country’s GDP, roughly $1.35 trillion,” the Financial Times notes.“Of that sum, the Chinese would send as much as $2.25 trillion overseas, while foreigners would invest $900 billion in China.” Such an “exodus” of cash could cause the valuation of the RMB to fluctuate in unforeseen ways, the report said.

Meanwhile, some have suggested that currency controls will never be fully lifted, but that the RMB will instead enter a gray zone between fully controlled and free. Speaking with the Financial Times, Paul Lambert, head of currency at Insight Investment Management, said a “quasi-float along the lines of the Singapore dollar” may be more realistic than a fully liberalized RMB. Lambert also voiced concerns over corporate governance standards in the FTZs as another obstacle.

Some critics have even taken the actual power of the RMB itself to task. Jonathan Anderson of Emerging Advisors Group went as far as saying that the RMB was roughly “on a par with the Philippine peso and just a bit higher than Peru’s nuevo sol” — a far cry from the supposed “eye-popping” impact depicted by numbers showing the RMB’s globalization on an isolated chart, he added. When Beijing’s tight control over the economy to date is coupled with the reality of how little things have changed regarding currency policy in the past decade, Anderson suggested that the RMB is unlikely to account for a significant share of global portfolios in the near future. 

Other critics agree that liberalizing the RMB will be a long slog, but give the plan better odds of longer term success. Jan Dehn, head of research at Ashmore, has forecast total convertibility of the RMB within 12 years, but only under strict state control. In Dehn’s view, “the process will be gradual, based on the signing of bilateral agreements with different countries around the world, and will be a function of China’s dismantling of capital controls.” 

The Case for (Cautious) Optimism

While all of the above criticisms are valid to a point, the plan continues to forge ahead, one pronouncement at a time. And there are just as many cheerleaders as critics. According to those who see more pros than cons, a shift in perception overseas — rather than the nuts and bolts of Beijing’s strategy — could be the biggest determining factor in whether the effort to free up the RMB succeeds.

RMB use overseas is also gradually rising, says Patrick Zweifel, chief economist at Pictet Asset Management. Zweifel said he believes the RMB will be an international investment currency within three to five years, listing Mongolia and South Korea as being among countries where the yuan is being used outside China today. “The volume of trade settled in RMB four years ago was zero, today it is 14 percent of Chinese trade,” he says. “This is only the beginning of a trend that all major trading nations have experienced.”

No pain, no gain.


With a liberal dose of optimism — and assuming a lg enough time frame — there is little doubt that the RMB will eventually become an international currency that stands with the likes of the dollar, euro, yen and pound as China’s economic clout grows.”

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