20 September 2018

Shanghai FTZ to push RMB convertibility? Forget it

There are high hopes that the Shanghai free trade zone (FTZ) will be a laboratory for China to experiment with full capital account and renminbi convertibility. Many market players are speculating that an announcement of details for implementing yuan convertibility in the zone will be made at the third plenum of the Communist Party’s Central Committee.

Don’t bank on it. The thunderous calls for convertibility are likely to result in just a few raindrops. This is because the zone has an inherent limitation that makes it an unlikely vehicle to push through bold reforms, such as full currency convertibility, in any meaningful way in the medium term. That limitation is Beijing’s requirement that the zone’s reforms be replicable.

The leadership’s aim is to roll out the experiment to the rest of the country after successful trials in the same way that special economic zones were introduced in the 1980s and 1990s. However, this emphasis on replication automatically constrains the depth and scope of reforms in the Shanghai FTZ and other potential free trade zones awaiting approval. It also limits the zone’s ability to deepen the national structural changes needed to make the capital account and the currency fully convertible.

Why so? Full RMB convertibility requires the support of an efficient and transparent framework. It will take many years for the Shanghai FTZ to build a legal and institutional framework based on the rule of law and in line with international norms for transparency and integrity. During the process, the rest of the city and the country will still struggle with moral hazard and rent-seeking problems. Thus, even when the FTZ does build such a framework, it will not be replicable in the rest of the country in the medium term. And if it isn’t deemed replicable, there will be no incentive to implement that reform in the FTZ.

Some reforms, such as interest rate liberalisation and RMB convertibility, are only meaningful when they are implemented nationally. These are the very reforms that the market is expecting the zone to catalyze for deep changes going forward. However, the FTZ is too small to be able to test these major changes, especially with the incentive incompatibility problems that plague the country’s economic system.

Crucially, if regulators fail to ring-fence the FTZ from the rest of the country, arbitrage activity will quickly overwhelm the zone’s financial systems and risk capital flight. However, if the regulators are able to segregate the FTZ, it will just be an isolated experimental area with a limited impact on the drive towards national structural reforms. The best way to think about this is Hong Kong, which has been a de facto free trade zone of China since 1997.

Hong Kong has already developed a world-class financial system that runs on the rule of law and has a high level of credibility and integrity. It has a fully convertible capital account and currency, and its economy is run on free-market principles. All these principles are exactly what the Shanghai free trade zone will try to emulate in the coming years. But Hong Kong is ring-fenced, quite successfully, from the rest of China, with no free flow of investment and capital.

Hong Kong has long been known as a financial laboratory for China’s financial liberalization, and Beijing wants the rest of the country to learn from it. Despite this “prestigious” status granted by Beijing, has it been able to advance China’s structural reforms? No. Many key Chinese financial institutions have had operations in Hong Kong and have learnt from the city and from the cross-border operating environment for some years. It is doubtful if the Shanghai zone will teach the key Chinese financial players anything significant that they do not already know or have not learnt from Hong Kong.

The irony is that the very need for reform replication that Beijing imposes on free trade zones will constrain their ability to promote structural changes nationally. The local authorities will be reluctant to pursue bold changes that have little chance of being rolled out across the country, even though they may be crucial for deepening the nation’s structural reforms and building a world-class financial system.

In the medium term, the benefits of the zones will be limited to within their boundaries, with no fungible investment and capital flows between them and other parts of the country. The situation is exactly like Hong Kong’s. As for the currency convertibility experiment, unless one expects the rest of the country to be able to implement full RMB convertibility in a few short years, there is little incentive for Shanghai to seriously experiment with it.

Chi Lo is senior strategist at BNP Paribas Investment Partners (Asia) Ltd. and the author of “The Renminbi Rises: Myths, Hypes & Realities of RMB Internationalisation and Reforms in the Post-Crisis World”, Palgrave Macmillan 2013. The opinions expressed here are the author’s and do not necessarily reflect those of BNP.


Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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