China's free trade zone plans herald quicker FX reforms

Reuters

By Saikat Chatterjee and Pete Sweeney

SHANGHAI/HONG KONG, Dec 4 (Reuters) - China plans to rollout financial sector reforms in the Shanghai special economiczone in the next three months and most will be implemented in ayear, suggesting authorities are accelerating the pace ofdismantling capital account controls.

A People's Bank of China (PBOC) statement on Wednesday forthe first time gave a timeline for launching deep reforms in thezone, adding they could then be duplicated in other similarzones around the country.

The statement came after the PBOC provided additional detailfor its plans for financial liberalisation in the Shanghai freetrade zone (FTZ) in a separate document published on Monday.

However, cross referencing the two statements does notprovide a specific deadline for any one reform. It also is notclear if major reforms, such as allowing the yuan to tradefreely, would be included as part of "most" of the reforms.

Still, analysts suggested the statements point to moresignificant action than seen in the past, especially as theyfollow a meeting of the Communist Party leaders in November thatset a bold agenda for nationwide reform in the years to come.

"Financial reform in the pilot zone is not in the pasttense, nor the future tense, but the present tense," PBOCShanghai chief Zhang Xin said in a statement posted on thebank's Shanghai branch website.

The announcements have boosted investor optimism - at leasttemporarily - that Beijing is serious about reforms in the FTZ.

Expectations had eased off the back of a lack of detailedannouncements and timelines after the zone was launched inSeptember. The absence of major leaders at the opening eventalso prompted speculation the zone lacked top-level support andhad become the focus of a bureaucratic turf war, and in factstate media had repeatedly warned that implementation would taketime.

This caused many foreign banks and other multinationals tohold off on plans to establish subsidiaries in the zone as theyawaited more details.

Chinese domestic investor enthusiasm had also waned and theyhave steadily sold off shares in zone-related stocks in recentweeks - some of which had risen up to 300 percent. ButWednesday's announcement saw tickers like Shanghai WaigaoqiaoFree Trade Zone Development rise by the maximumdaily amount of 10 percent.

Because the zone risks setting off waves of arbitrage anddestabilising cross-border capital flows if it is not properlyfirewalled, many expected China to begin with other, less riskyreform areas, like easing controls on trade in services,developing commodities futures, and reducing bureaucratic redtape.

Tracy Tian, China strategist at Bank of America MerrillLynch, said that she was surprised regulators committed to a 12month timetable, which she said would be "challenging."

"Our observation is that when PBOC officials comment on(capital account opening) in speeches or articles, they tend totarget 2015-2020 for national rollout."

To address concerns about arbitrage - onshore companiesfinding ways to use the freedom of the zone to move fundsoffshore and vice versa - the central bank said it will usespecially tagged bank accounts for companies and individuals inthe zone. But how a company or individual will be defined ashaving a "presence" in the zone has yet to be published.

Dariusz Kowalcyzk, economist at Credit Agricole CIB in HongKong, said he was startled not only at how quickly the FTZ plansto implement reforms but also at the extent of the reforms.

He pointed out that plans to allow Chinese individualsemployed by companies in the zone to freely invest in overseasassets, while at the same time opening the Chinese securitiesmarket to foreign investors in the zone, would qualify asdramatic changes impacting capital flows.

"If these are implemented in the first three months thatwould be shocking," he said.

Many Chinese economists have publicly warned against openingthe capital account before distortions to the domestic economy -especially interest rate controls - are eliminated.

Even many executives at foreign multinationals have saidthat opening the capital account is not a major priority fortheir companies at present, although Western governments havecalled for Beijing to allow the free movement of capital foryears.

"Capital account reform ... is not on my priority list,"said Michelle Liu, chief financial officer at German chemicalmaker Lanxess AG, speaking at a conference in Shanghaion Nov 27.

"In terms of yuan internationalisation, I would wish thegeneral rules be clarified; I mostly want rules to be moretransparent and stable."

Ryan Hershberger, Asia Pacific treasurer for Ford Motor Co, speaking at the same conference, said his priority wasdomestic capital market liberalisation to reduce dependence onbank lending.

YUAN GLOBALISATION

The apparent tempo of reform in the FTZ is consistent withother moves by China to promote the use of its currency inglobal trade, including seeding offshore yuan centres in London,Paris and Singapore and allowing banks and companies to freelymove the yuan across its borders for trade-related services.

While this may not be a priority for foreign treasurers, itserves other policy goals, in particular reducing foreignexchange risk for Chinese exporters and decreasing the need forChina to add to its already massive foreign exchange reserves.

China's yuan overtook the euro in October to become thesecond-most used currency in trade finance, data from globaltransaction services organisation SWIFT showed on Tuesday.

China's share in various markets has also increased,particularly in Asia. For example, China now takes a quarter ofNew Zealand's entire volume of merchandise exports, compared toa 5 percent five years ago and it is the biggest foreign directinvestor in Sri Lanka.

"The size of the Chinese buying also means that the abilityof the buyers to demand that payment be accepted in the yuanrather than U.S. dollars is increasing, and the product sellerhas needed to accommodate that change and put in place localcurrency facilities for product payment," said Sean Keane, adirector of Triple T Consulting and formerly a markets trader atCredit Suisse.

China now conducts nearly a fifth of its trade with theworld in its own currency compared with about 1 percent at thestart of 2009. That share is expected to rise to as much as athird in the next couple of years, various estimates suggest.

It has also whetted demand for Chinese assets, with theChinese currency flirting with a record high, yuan deposits atHong Kong banks swelling and signs of growing foreign demand foroffshore assets, particularly Chinese stocks listed in HongKong.

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