A Roadmap to Financial Internationalization in China: The Freeing Up of Capital Resources and Prospects on the Chinese Yuan Exchange Rate Market

ABSTRACT

Discussions on the exchange rate system have started up again in the wake of the Asian currency crisis. The crisis is partly attributable to the fact that the currencies of the affected countries were in effect pegged to the U.S. dollar. Ideally, the exchange rate system should be adjusted flexibly. The number of countries in the world that have adopted the floating exchange rate system is increasing.

The countries that have adopted the floating exchange rate system in East Asia are Japan, Thailand, the Philippines, Indonesia, and South Korea. On the other hand, Hong Kong, China, Malaysia, and Singapore have adopted the fixed exchange rate system, or de facto fixed rate system. China has adopted the managed floating system for the RMB, but the RMB is essentially pegged to the U.S. dollar.

The current exchange rate system for the RMB is rigidly controlled by the State Administration of Foreign Exchange, the People's Bank of China. The reason the exchange rates of the RMB do not fluctuate wildly is because capital transactions are not liberalized by China and there is a unique system of exchange transactions. Under this system, the daily fluctuation of the RMB exchange rates is limited to 0.3% in the interbank market, and prior approval is required for transactions.

Under the current foreign exchange control system, the liberalization of exchange transactions in the current account and the strict control of capital transactions are based on actual demand to stabilize the exchange rate. However, the liberalization of capital transactions is inevitable because it is needed to reduce the cost of capital transaction control and internationalize China's financial industry after entering the WTO.

Before opening its financial market and easing foreign exchange control, China will need to reform its domestic financial system and improve the efficiency of its financial system. The objectives of a 1994 financial system reform were the reform of state-owned banks, the lowering of entry barriers for new banks, and the promotion of competition among banks. Although interest rates were partially liberalized, rigid interest rate regulations were generally still in force. Interest rates are expected to be liberalized in the following order: 1) interest rates for foreign currency deposits, 2) interest rates for foreign currency lendings, 3) interest rates for large RMB deposits, 4) interest rates for small RMB deposits, and 5) interest rates for RMB lendings.

Because China will formally enter the WTO in the near future, preparations for the internationalization of its financial industry are urgently needed. For the time being, it is not likely that the foreign exchange control system will be significantly changed. However, preparations for the liberalization of exchange transactions have already been made, as have proposals for revisions to the foreign exchange control system. The following measures are of the utmost importance: 1) foreign exchange control should be relaxed by easing before-the-fact control and strengthening after-the-fact control; 2) the current foreign exchange control system, under which domestic and foreign companies are treated differently, should be revised; 3) the liberalization of interest rates should be further promoted; and 4) the scope of operations of foreign banks should be enlarged.

To restore the convertibility of the RMB, China must overcome many obstacles, such as 1) improving its financial market, 2) reforming state-owned banks, and 3) reforming its foreign exchange control system. At the same time, it must improve the supervising capability of financial supervisory authorities.

Improvements in China's international competitiveness will strengthen the RMB in the medium or long terms. In the short term, however, many unfavorable factors may be generated, for example, the balance of trade may worsen due to capital flight or a slowdown in the growth rate of exports. A deep concern is that the credibility of the Chinese economy among international markets is still low. A delay in political reform may be seen as a factor that will weaken the RMB.