STUDY ON THE STEPS TOWARDS RMB CONVERIBILITY

To study the convertibility of RMB, we have to clearly define RMB convertibility. Generally speaking, the meaning of RMB convertibility is three-folded. First, there is convertibility under current account plus control of capital accounts, i.e. partial convertibility; second is the convertibility of current accounts plus conditional convertibility on capital accounts, i.e. basic convertibility; third is the convertibility of current accounts and capital accounts, i.e. complete convertibility. This article briefly analyzes issues related to FX purchasing and selling under the partial convertibility of RMB, further discusses the possible effects resulting from basic convertibility of RMB conditions needed for complete RMB convertibility, and finally proposes steps promoting RMB convertibility. EøV EøV EøV EøV

Current situation of and issues related to RMB convertibility under current accounts

In recent years, China has made substantial progress in the reform of RMB convertibility. In 1994, China realized the unification system of RMB exchange rate and RMB conditional convertibility under current account; by the end of 1996, the country realized convertibility under current accounts three years ahead of the schedule; thereafter, it relaxed the restriction on resident's purchase of FX and the opening of foreign currency accounts by enterprises. EøV

From the perspective of commercial banks, RMB convertibility under current account is realized in the form of the purchases and sales between RMB and FX, referred to as the FX purchase and sale system. Currently, RMB exchange rate is formed through FX purchase and sale system. The RMB exchange rate formation is done by the People's Bank of China, whom publishes the daily quoted prices of US dollar, Euro, Japanese yen and HK dollars against the RMB's value. EøV These values are then quoted by the commercial banks to their quoted prices given by the commercial banks and ensures that the quoted prices of US dollar against RMB accords with that of the central bank; as for the quoted price of Euro, Japanese yen and HK dollar against RMB, the commercial banks will refer to the quoted prices of the central bank and the US dollar price against the Euro, Japanese yen and HK dollar on the international FX market released that day, and calculate the relevant quotations based on the quoted price of US dollar against RMB and prices on the international FX market. The quoted price given by the commercial bank will change on a daily basis. The specific transaction path starts with customers trading with commercial banks, who will then square the open position resulting from transactions with the customers through the China Foreign Exchange Trade System.

It can be assured that the practice of RMB convertibility under current account has been very successful. EøV However, things have to be done to improve the means of realizing RMB convertibility under current account.

First of all, there exists a "dual price system" for spot trading between RMB and non-US dollar currency. The direct reason has been problems with the "one price within a day" policy for the FX purchasing and sales system. For example, the customers convert foreign currencies other than US dollars into RMB at the commercial banks through two channels. First, the transaction may be done based on the quoted price of non-US dollar currencies against RMB published by the commercial banks daily (one price within a day). As there is no big difference in the exchange rate released by the commercial banks every day, it is believed that the price is relatively stable through this channel of transaction; or second, the customers convert the non-US dollar currencies into US dollars at the commercial banks. Then they convert US dollars into RMB, EøV so that they get the same result as through the previous channel. Through the latter channel, the non-US dollar currencies are indirectly converted into RMB, and the actual price will be determined by both the price of non-US dollar currencies against US dollar and the price of the US dollar against RMB. Due to the real-time change in the price of non-US dollar currencies against US dollars, the opportunity of risk free arbitrage will appear in the domestic FX market. The customers may be frequently engaged in arbitrage through FX purchase. As a result, the commercial banks may suffer a loss from some of their FX transactions. EøV

Certainly, there exists short-term arbitrage behavior in an effective FX market. However, as investors may soon discover the price difference of the same currency on any effective FX market, and sell high and buy low of the same currency, thus diminishing the price difference of the same currency. Consequently, the fair value of the currency may form instantly. On the contrary, since the conversion of non-US dollar currencies into RMB is subject to the policy regulation of "one price within a day", the commercial bank, as one of the trading parties, has to passively accept the fact that quotations fail on many cases. EøV In this way, the fair value of the currency can hardly be established. EøV EøV EøV EøV EøV

Second, ChinaÕE(Ns FX market is short of exchange rate hedging instruments, and the formation mechanism is imperfect. The hedging instruments generally include FX forward, swap, option and futures. The pricing for these hedging instruments is not only connected with the fluctuation of the exchange rate but also the interest rate of the money market for a certain period.

The existing formation mechanism of RMB exchange rate is based on the bank FX purchase and sale system. Under such a mandatory FX purchase and sale system, the market players, especially, domestic enterprises and commercial banks, have to sell the FX they hold on the market. They cannot choose the time and quantity of the sales according to their future need and predication on the future rate movement. The exchange rate formed on the basis of mandatory sales is not the real market price. Although the forward purchase and sale system of FX are offered on the FX market, the maturity of these products is fixed to only 14 types, far from meeting all possible demands of the customers. EøV

Third, there is no sufficient reference to the pricing of the forward RMB. Theoretically, RMB forward exchange rate should be determined according to the interest rate parity theory in combination with the predication on the future exchange rate movement. It requires that RMB and FX have reasonable benchmark interest rates that can reflect the fund situation on the market. While the foreign currency rate is based on LIBOR with different maturities, the similar benchmark accepted by the market is not available for RMB interest rate. For example, in the domestic interbank borrowing market, the maximum maturity of CHIBOR is only four months, the majority of transactions are concentrated on the maturity of within two weeks and the trading volume for transactions with long maturity is rather small. Therefore, the existing market price lacking the backup of trading volume can hardly reflect the actual fund situation in the market, and a proper benchmark can hardly be established. Other interest rates such as relending interest rate can hardly represent the market fund cost due to its policy-related background. Owing to the lack of market-based benchmark interest rates of local currencies, the pricing for forward RMB is more often than not subjective.

Under the present market, the participants carry out the forward purchase or sale of FX for two purposes: exchange rate risk hedging and interest rate arbitrage. To carry out the purchase and sale of non-US dollar currencies with bigger fluctuation, e.g. Euro and Japanese yen, the customers aim to hedge against the exchange rate risk, locking up the trading cost or benefit. As for the US dollar, the interest rate of the US dollar is lower than that of RMB, there is USD forward premium. In the recent five years, the exchange rate of US dollar against RMB has been basically stable and is expected to remain so for a certain period. As a result, the risk free arbitrage opportunity may come. EøV Customers then usually do not carry out the forward sales of the US dollar at unnecessary costs for fending off the exchange rate risk, but rather sell the FX for arbitrage. EøV

Analysis on the effect of RMB basic convertibility

Several years after the realization of RMB convertibility under current account, China's economic strength has increased along with opening up reforms. In order to fulfill WTO commitments, it is pressing to relax the restriction on some mature capital accounts and realize the basic convertibility of RMB. Based on the measures likely to be issued by Chinese FX administration recently, loosening of the restriction on cross-boundary capital transactions in a selective manner is the focus of the current reform on the FX administration system. The basic convertibility of RMB will have great economic consequence in improving and developing China's market economic system and raising the economic construction to a new level of development.

First, such measures can ease the deflation pressure and promote the position of the RMB in the international market. So far, the developing countries have not found out an effective solution to macro-economic problems caused by large amounts of capital inflow. The problems resulting from the continuous dual favorable balance and high-level capital inflow are important external reasons causing deflation in China. We must comprehensively deal with the problems through integrated measures of local currency convertibility reform, while releasing pressure on RMB appreciation though proper deregulation of FX demand and two-way capital flows so as to bolster the foothold of the RMB in international markets. EøV EøV

Second, convertibility promotes the deep-level reform of Chinese economic system and encourages system innovation. The socialist market economy is bound to be an open economy. To accommodate to requirements after WTO entry, we must quicken the development of operating mechanism and regulation systems of the open economy. EøV EøV To accelerate RMB convertibility reform is favorable to eliminating market distortion and allowing the market mechanism to play the basic role in regulating the operation of the open economy. RMB convertibility reform is one of the key tasks in the deep-level reform of our country. Powered by the reform, we are bound to speed up the improvement of socialist market economic system. EøV

Third, step up the implementation of "going global" strategies and encouraging the needs for setting up Chinese multinationals. Capital control is the major barrier to transnational operation of enterprises. At present, our practices in absorbing foreign venture investment to develop new technological industries and attracting regional headquarters and operation centers of multinationals are all limited by unfree RMB conversion. For China to become an important manufacturing and R&D center worldwide, it is also restricted by the FX administration system and long-term appreciation of the RMB effective exchange rates. To cater for the need after China's WTO accession, more effectively utilize external resources, capital, technology and markets, and to expand room for economic development, we must quicken RMB convertibility reforms and create conditions for developing our own multinationals.

Necessary conditions for full convertibility of RMB

Generally speaking, by convertibility under capital account we mean lifting off the conversion limitations on FX revenue and expenditure arising from the short-term financial capital, direct investment and securities investment and allowing the capital to freely flow in and out of the country. IMF has not rendered a strict definition on convertibility under capital account. In practice, some international reserve currencies are still subject to certain necessary restrictions on conversion under capital account in the internationalized process. EøV

After plenty of empirical research, economists concluded that the full convertibility of currencies should be based on the following conditions:

Proper exchange rate levels. The only standard for determining whether the exchange rate level is proper is the impact of the exchange rate on domestic economy. Based on the current operation, RMB exchange rate and Chinese macro economic condition is sustainable and play a proactive role in the economic development and stability of China and Asia at large.

Proper international reserve levels. The proper international reserve level is essential to handle all sorts of interference in the balance of payments. The stock of FX reserve should be adequate to facilitate the international trade with another country and dissolve the interim impact on the balance of payments. Based on the study on several countries already subject to the currency convertibility and the theory on the demand of international reserve, sufficient FX reserve means the volume of the FX reserve accounts for no less than 20% of the annual import volume, usually 30% to 40%. EøV EøV

Prudent macro economic policy-making and strong support from national strength. Prudent macro economic policy should eliminate such policies as excessive currency expansion, deficit budgeting causing inflation and monetary and credit policy that conflict with convertibility and stable exchange rates. If the inflation rate of a country is well over that of its trade partner, it can hardly maintain the balance of payments without depreciation or strict control on import and payment. The more powerful a country and the more diversified its economic and product mix, the stronger the country is to weather the risk caused by currency convertibility and the smaller the possibility is of the ill effect from the free currency conversion. Full currency convertibility must be backed up by powerful national strength.

Effective market environment. Effective market environment means that the product and element market is very flexible, so that the domestic cost price structure may vary with the changed economic condition and reflect the existing relative price on the international market, and that all economic entities have the initiative and ability to respond to the market price. The complete and effective financial market includes FX market and short-term money market and long-term capital market as well.

The robust development of the capital market is an essential factor for supporting the long-term stability of RMB value, while a sound capital market can bring long-term and stable benefit to investors and become a stabilizer for the currency. Otherwise, the capital market, having systematic risk, may result in capital withdrawal and outward investment. Although countries like the US call for RMB appreciation out of consideration for trade issues, many problems still exist in the development of the capital market and the banking system in China. With the great systematic risk, the RMB can hardly appreciate for a long period of time. Rather, a freely converted RMB is bound to depreciate. The practices of currency liberalization in many developing countries prove the point. With the considerable systematic risk in the capital market, the currency is most likely to depreciate. After liberalization, Brazilian cruzado depreciated from 1.2 to 4; South African rand depreciated from 2.5 in the early 1990s to 13.76 and recently appreciate to 6.5; and rouble deprecated to around 3 percent that of the 1993 level. In light of a long-term RMB stability, we must step up efforts to promote the further development of the capital market from now on, and strive to resolve the mentioned problems in the years to come. To settle the problems concerning the robust development of the capital market is to tackle the in-depth problem of the FX market in China. A robust capital market is a stabilizer, which allows the investors to favor the RMB. EøV

Selected steps of promoting RMB convertibility

Based on the practices of countries all over the world, the starting point and condition for promoting the convertibility of the local currency varies from country to country, and there is no universal mode to follow. According to the important experience drawn from the practices of the international world, the key to maintain the continuous process of local currency convertibility is that currency convertibility under capital account cannot proceed in an isolated way. The compliance and coordination of macro-economic policy, financial and exchange rate policy with the capital account liberalization should be taken as an important component part of the reform package. We can secure the success only when we promote auxiliary reform.

After ten years of hard work, we have made substantial process in RMB convertibility. Currently, except the control on the flow of short-term capital, many limitations on capital account are actually quantitative rather than prohibitive. For example, Chinese enterprises can issue bonds and get listed overseas, and the investment income of foreign-funded enterprises can be freely remitted out of the country. The prudential management of capital account and progressive reform are not only a must for promoting the sustainable, stable and healthy development of the Chinese economy, but are also in the interests of foreign investors.

In fact, China has been advancing the reform of RMB convertibility in a progressive manner. At present, the reform is at a critical stage. We should choose the proper time to press ahead with the integrated reform package and make breakthrough in core issues. We should also gradually establish managed floating exchange rate system and promote the convertibility under capital account gradually. In this way, we can make great headway in the market-oriented reform of our foreign trade-oriented sectors and accommodate the need for China's integration into the global economy and development of the open economy.

We should improve the existing management system of FX purchasing and sales. During the process of promoting RMB convertibility under capital account, we should continuously improve the existing management system of FX purchasing and sales. Previous practice in FX management shows that although the system of FX purchase and sale is imperfect, it has played an important role in safeguarding the economic security of China, maintaining the stability of RMB exchange rate and enhancing the stable development of the economy. The SAFE should reinforce the supervision on the implementation of state FX policy and regulations by the designated FX banks, so as to ensure the authenticity and legality of most exchange activities.

Second, gradually enlarge the floating range of RMB against US dollar. To further develop the interbank FX market in China, and steadily press ahead with the reform of the operation mechanism of the FX market, the SAFE decided that from October 1, 2003, the interbank FX market allows the two-way transactions. Being a key measure to develop the FX market in China, the resolution is of great relevance to bring China's inerbank FX market in line with the international practice and improve the formation mechanism of the RMB exchange rate. The implementation of two-way transactions will open a way for the banks to hedge against risks, further vitalize the interbank FX market transactions and better feedback the market inclination. It can reflect the relation between supply and demand on the market and the trend of exchange rate movement and minimize the transaction cost of the banks on the FX market. In addition, it facilitates the exchange by enterprises through the banks and lays the foundation for expanding the floating range of the exchange rate of the RMB against US dollar. EøV EøV

Third, relax the limitation on the price of non-US dollar currencies against the RMB. After WTO entry, Chinese enterprises and financial departments need not only to maintain profitability amongst competition, but also need to develop sound financial awareness to manage corporate finances, including manage financial risks. And poor financial risk awareness is unfavorable to the prevention of financial risk. Therefore, it is suggested that the limitation on the price of non-US dollar currencies against RMB should be relaxed. The existing dual price system of non-US dollar currencies against RMB, i.e. "one price within a day" should be replaced by a system of "varied prices within a day". EøV Since the exchange rates on the international FX market change all the time, and the price of US dollars against RMB is relatively stable, it is reasonable that the price of non-US dollar currencies against RMB also continuously alter to form the fair value. In order to improve the FX market in China, it is necessary to bring the above-mentioned first-channel price closer to the second-channel one. Hence, the customers and commercial banks can trade the non-US dollar currencies with RMB at the price based on the fair value.

Fourth, improve the exchange rate formation mechanism. We should pace up the financial system reform, further improve the FX management system and keep the balance of payments equilibrium. Measures should be taken to gradually loosen the limitation on FX availability by enterprises and residents, and create conditions for the market to play a bigger role in forming the RMB exchange rate. We should further upgrade the existing formation mechanism of RMB exchange rate, improve the domestic FX market mechanism, enhance the enterprises' and residents' awareness of exchange rate risks and develop market instruments to fend off risks. We should also steadily press ahead with the market-oriented reform to interest rates, gradually establish a reasonable price mechanism, and encourage the financial institutions to advance the reform. Efforts should be made to build the modern corporate system, develop the complete internal control mechanism and upgrade the level of financial risk management. EøV

Fifth, gradually improve the supporting reform measures. We should vigorously encourage the effort to develop asset backed securitization (ABS), financial options and futures, effectively expand the channels of corporate financing and the means of market risk prevention, and support for the rapid and healthy development of the economic and financial sector with reforms and regulations. We should pay close attention to new changes in economic and financial operations at home and abroad and further develop new concept on monetary policy. Market-based regulatory methods should be applied to maintain the proper growth of the money credit. The inertial return to administrative control shall be prevented. We should simultaneously advance structural reforms to the price system, foreign trade system, state-owned enterprises and industrial reorganization, and upgrade the market-oriented level of the overall economic system.