Financial market reform on track

Deutsche Bank, which opened its seventh office in China - a sub-branch in the Pilot Free Trade Zone in Shanghai - on May 8, has a positive outlook on China's economic growth and the government's commitment to market liberalization. In fact, at 7.8 percent, our (Deutsche Bank's) economic outlook for China's GDP growth for 2014 is at the higher end of the consensus.

We also believe that reforms in the financial market, in which the bank plays a large role, are likely to occur more quickly than the broader market expects. This will have profound implications for China's financial system and its participation in the global economy.

The Chinese government's recent financial market reforms should be applauded. They include accelerating the opening up of the capital account and domestic financial markets through initiatives such as the Renminbi Qualified Foreign Institutional Investors and the recent joint in-principle approval by the China Securities Regulatory Commission and Securities and Futures Commission of the pilot Shanghai-Hong Kong Stock Connect program, which is aimed at establishing mutual stock market access between the Chinese mainland and Hong Kong.

Also, the renminbi-US dollar spot intra-day trading band has been widened from +/-1 percent to +/-2 percent, which indicates the government is committed to increasing the renminbi exchange rate flexibility and liberalizing its currency's exchange rate regulation.

The approval of the Shanghai-Hong Kong Stock Connect program demonstrates China is committed to accelerating the pace of capital account liberalization. This program is another policy milestone in the move to internationalize the renminbi, because it offers additional investment channel in the offshore renminbi circulation mechanism. It will also boost the demand for renminbi-denominated assets and promote the use of the Chinese currency for investment settlement purposes.

There is already a consensus in China on the direction of renminbi internationalization. But issues such as macroeconomic risks arising from the process and whether and how policies should promote the internationalization of the renminbi, and what pace the process should adopt remain subjects of debate. Our view is that there are three main areas of development that need to be addressed to enable the renminbi internationalization process to proceed smoothly.

First, China needs to put more policies in place to support the increased use of the renminbi in trade settlement. Second, the development of the offshore renminbi market must remain a priority, and ensuring sufficient renminbi liquidity provision is key. But most importantly, it is capital account liberalization that is critical to the internationalization of the renminbi.

Without it, according to our analysts, the Chinese currency can only achieve less than 10 percent of its potential. Currently, the openness of China's domestic capital market is only about 3 percent compared with 10-30 percent in most emerging market economies, and we believe that China can afford to permit a significantly increased portfolio inflow into the domestic capital market for the next few years without endangering its macroeconomic stability.

For instance, we feel that China should aim to raise the openness of the domestic bond market from less than 3 percent to 10 percent in the next five years. Since permitting greater cross-border renminbi capital flows and capital account liberalization (convertibility) are mutually substitutable, these two reforms would need to be synchronized.

The risks of the renminbi's internationalization and the development of an offshore market to China's domestic macroeconomic and financial stability - including their impact on money supply, foreign exchange reserves, interest rates, the exchange rate and the external balance sheet - are quantifiable and manageable in the coming few years.

At present, the most important item on the economic reform agenda is to complete the reform of the financial sector. The key policy measure, it appears, is the introduction of deposit insurance. This should formalize the growing recognition among depositors that not all financial products are guaranteed.

Besides, China's interest rate liberalization has been an orderly process and we believe it will continue on the path toward full-scale interest rate liberalization. We expect to see the development and popularization of the usage of certificates of deposits and gradual relaxation of the deposit rate ceiling, paving the way to complete liberalization of deposit rates, and gradually transiting the monetary policy framework to one which combines an interest-rate-targeting framework for the short term with aggregate money-supply-growth-targeting framework over the medium to long term.

With still some way to go, the progress till date, however, should give market observers and players considerable reason for confidence that the reform and liberalization process is well on track.

The author Alan Cloete is co-CEO of Deutsche Bank for Asia Pacific and member of the group executive committee.