Shanghai FTZ tests China's currency liberalization

Among a cluster of warehouses located on the outskirts of Shanghai, China is set to experiment one of its most significant reforms since Shenzhen freed the country's trade 33 years ago -- how China should liberalize its currency.

The world's second largest economy announced it would build a free trade zone (FTZ) on the shore of the East China Sea. The zone will be a test bed for pushing forward full convertibility of the Chinese yuan and the opening of financial services.

As China's economy has showed signs of stabilizing during the last two months, economic transitions and reforms are again becoming the focus of attention.

Chinese Premier Li Keqiang said at Summer Davos Forum on Wednesday that China's modernization will not be accomplished without reform, nor will it be achieved without opening-up, citing Shanghai FTZ as one of the new ways to open the country wider to the outside world.

"The FTZ will act as a stress test. We are going to explore to what extent can China open its capital account," said a person with direct knowledge of the issue.

According to Shanghai Securities News, a financial newspaper owned by Xinhua, the general plan of the zone will possibly be published by the end of this week.

"It's a landmark event in China's drive of deepening economic reforms," said Citi Bank senior economist Ding Shuang. "The Shanghai FTZ demonstrates China's commitment to reforms before key reform packages are to be discussed in the third plenary session of 18th CPC central committee."

TEAR DOWN THE WALL

Among all the reform measures, opening the capital account is the most debated.

China re-started to free its currency exchange rate in 2005, and since then the Chinese yuan has appreciated over 30 percent against the U.S. dollar. But to buffer China from international financial turmoil, the country's capital account remains closed, a rule in existence for decades.

Exchanges between the Chinese yuan and foreign currencies are regulated with strict quota allocation and transactions are scrutinized. Every Chinese person is only allowed to buy up to 50,000 U.S. dollars each year.

The regulators, however, now believe tearing down the currency wall will do more good than harm. Opening the capital account will improve financial transparency and efficiency as well as spur China's drive of building Shanghai into a world financial hub.

China's cabinet pledged in May to map out "operational" plans to make the Chinese yuan convertible under the capital account. Shanghai FTZ is considered the first place to carry out the plan.

"It's difficult to segregate the Shanghai FTZ from the rest of China. There will be money flows underground. It can be said that the FTZ experiment opens a hole in China's capital account wall," said Wang Tao, chief China economist at UBS.

"It's technically possible to completely segregate the FTZ from the rest of China, but that will be unnecessary. If China completely segregates the FTZ, there will be no meaning for building such a test bed," Ding said. "But unlimited opening is also unlikely. The regulators may adopt quota regulation."

While such reforms have long been advocated, some analysts argue rolling them out now could be hasty, saying opening the capital account would make China vulnerable to the Federal Reserve's quantitative easing (QE) tapering and add to risks rising from other reforms at home.

It is feared that demolishing the currency curb will trigger a capital flight draining China of liquidity. According to foreign media reports, it was reported that cash in billions of U.S. dollars has already left China through money trafficking to seek better yields or alternative investments overseas.

Although the general plan is about to be released, until now, no detailed proposal of how to operate the test bed has been finalized, which suggests the regulators vary on the pace and steps of opening the capital account, according to sources with direct knowledge of the issue.

Jitters over the Fed's reduction of its stimulus have spawned a broad sell off in emerging economies, reeling the capital markets in Asia and plunging the Indian rupee and Indonesian rupiah to lowest levels in years.

Economists say it is the closed capital account that kept China immune to the QE tapering while other emerging economies saw their asset prices and currency exchange rates dive.

"Once the capital account is open, closing it will be very hard. And when China realizes it needs to re-regulate the capital account, big problems may have already happened," Wang said.

Yu Yongding, a strong opponent to the capital account opening, said China should focus on reforms of currency exchange rate and interest rate.

"Before those reforms are done, opening the capital account can lead to unexpected risks," said Yu, who sat on the central bank's monetary policy committee from 2004 to 2006, when China was planning to allow the yuan to appreciate.

The central bank, however, said China had already made significant achievements in liberalizing capital movements and risks for further deregulation are manageable.

"The FTZ will play a useful role in China's new round of reforms and opening-up in the coming decade, the success of which will be crucial to invigorate the Chinese economy and unleash its growth potential," wrote Barclays chief china economist Chang Jian.

Wang Xinkui, an economist participating in the draft of the FTZ plan, said China built the Shanghai FTZ to accumulate experience and confidence. "Experiences learnt in the FTZ will be shared nationwide," Wang said.