China cautiously hastens capital account reform

China's latest call for an "operational plan" to achieve yuan convertibility under the capital account has raised the prospect of a specific reform timeline, although the government will likely conduct the reform step-by-step rather than all at once, analysts said.

The State Council, or China's Cabinet, said Monday that a plan to make the currency convertible under the capital account will be proposed this year, indicating that a blueprint for the long-discussed reform is in place.

"China should come up with a general target this year and gradually phase in specific measures," said Zong Liang, deputy head of the Institute of International Finance at the Bank of China.

He said he expects the convertibility goal to be achieved by 2020.

Currently, the yuan is convertible for trade purposes under the current account, while the capital account, which covers portfolio investment and borrowing, is still largely controlled by the state over concerns of abrupt capital flows moving in and out of the country.

The timing and speed for opening the capital account, as an important part of the country's intended financial reform and the yuan's internationalization, has resulted in divided views among market analysts, with some suggesting quicker steps and others describing such radical moves as disruptive to the financial market.

"Yuan convertibility under the capital account will hinge on the further liberalization of interest rates and exchange rates, as the distorted price of capital may misguide money flows," said Liu Dongliang, a senior analyst at China Merchants Bank.

Analysts largely believe the government will focus on expanding existing programs, including the Qualified Foreign Institutional Investors (QFII), RMB Qualified Institutional Investors (RQFII) and Qualified Domestic Institutional Investors (QDII) programs, to encourage inbound and outbound capital flows.

In recent years, China's securities regulator has been steadily boosting quotas for the QFII and RQFII programs, while the central bank, the People's Bank of China (PBOC), is preparing for trials of the QDII2 program that allows individual investors to invest outside the country.

Zong said restrictions on outbound investment by domestic individuals will be at the top of the reform agenda.

At Monday's meeting, the cabinet said it will create a comprehensive system for individual outbound investment this year.

It also pledged to steadily roll out reforms to liberalize interest rate and exchange rate regimes.

In mid-April 2012, the central bank moved to widen the yuan's daily trading limit against the U.S. dollar to 1 percent, up from the previous 0.5 percent.

Yi Gang, vice governor of the PBOC, said at a seminar on exchange rate arrangements for the International Monetary Fund held last month that the central bank is currently considering further expanding the yuan's fluctuation limit.

With a widening daily limit and more frequent capital flows in and out of the country, the yuan will be more volatile and market-based in the future, Zong said.