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By Anthony Harrington

Having jealously guarded its currency and manipulated its exchange rate to give itself the best possible environment to grow its massive export surpluses, China, it seems, is at last contemplating loosening its capital controls. A number of moves in the direction of more flexibility have already been made and significant additional moves are planned.

Steps already taken include a limited amount of local settlement in Renminbi for Hong Kong’s exchange settlement system and the introduction of a handful of Renminbi denominated Exchange Traded Funds. Both these moves provide a way for some speculative plays on the anticipated relative strength or weakness of the Renminbi. In addition, according to a Reuters report at recent high level talks between Japan and China the two countries discussed the possibility of moving from settling trade between their two countries in US dollars, to settling in Renminbi.

The talks were conducted between Japan’s Finance Minister Jun Azumi and Chinese Vice Premier Wang Qishan, and Finance Minister Xie Xuren. According to China’s official Xinhau news agency, Wang Qishan told the Japanese Finance Minister that both countries needed to “proactively study” the possibility of local currency settlement for trade and investment between themselves.

That this is was more than a vague suggestion was made plain by the fact that the two countries also agreed to cooperate closely on the issue of providing additional finance to the IMF, which is seeking new funding from senior member countries worth some $600 billion. The funds are needed to help the IMF support struggling EU peripheral states and to participate in EU bailouts.

It seems that China and Japan, knowing that they would be expected to play a key role in the coming funding round as the world’s second and third largest economies, have decided not to get themselves trapped trying to outdo each other in the scale of their contributions. Instead, in the words of Japanese and Chinese officials, they are going to “coordinate” their response to the IMF, with matching funding from each.

Apparently making progress on the IMF issue gave the two top level delegations sufficient momentum to tackle the local settlement issue in a coherent fashion. A considerable amount of work remains to be done before agreement on local settlement will be reached. But the scale of trade between the two countries has reached the point where translating everything into dollars makes little sense – not least because dollar settlement comes at the price of exposure to fluctuations in the value of the dollar and involves an additional currency risk for both partners.

According to the Japanese Trade Organisation, trade between China and Japan increased by 14% through 2011 to set a new record of almost $345 billion. Moreover, Japan is not the only country to be seeking to push China in the direction of yuan settlement. It’s Asian trading partners would also prefer this, as would the EU and Britain.

The People’s Bank of China (PBOC) has finally acknowledged that some loosening will be necessary, given China’s massive and growing importance to the global economy. According to the Financial Times, the PBOC has drawn up a three stage plan for loosening capital controls over the course of the next decade. The Bank plans to act in a gradual, measured way, but there are enormous pressures already building up for faster liberalisation, and events may well speed things up in unforeseeable ways.

The entry of massive amounts of overseas investor money directly into China’s growing stock and bond markets would massively boost the Renminbi’s position on the international stage and could rapidly create a viable, alternative global currency to both the dollar and the troubled euro. A number of commentators have already begun pointing out that this could have fairly dire consequences for America’s ability to finance its massive deficit.

Ultimately, of course, anything that forces the US to take deficit reduction measures seriously will probably end up being a good thing but if that happens it will be a force for global contraction to set against the growth momentum building up from emerging markets. The road ahead just does not seem to be getting any less complicated!

Source: China Considers Opening Up The Renminbi