Regional Focus

Unleashing the dragon: capital account liberalisation

Published: May 2014

China’s economic might is indisputable. At the end of 2012, it was the world’s largest exporter and the second largest economy. Of the major global economies, it is also the fastest-growing by several percent. And yet, until now, the development and opening up of its financial system has not matched China’s growth as an economic and trading powerhouse.

Its share of world financial integration, excluding reserves of less than 2%, makes a stark contrast against the country’s 10% share of world GDP. Its banking system, the largest in the world by total assets, is also one of the most sheltered to foreign exposure. Furthermore, the renminbi (RMB) is only starting to be traded outside of China – before 2010, Chinese companies were forbidden from paying import or export bills in RMB.

However, plans to open up the country’s capital account – which will effectively allow foreign investors to put money into China and the Chinese to invest overseas – could have major implications for the country itself and the rest of the world.

Steps thus far

The acceleration of capital account liberalisation was one of the pledges set out in China’s 12th Five-Year Plan, which was approved in 2011 and covers the period 2011-15. Indeed, China has been taking steps to deregulate its capital account since the early 1980s. But it is only in recent years that Beijing has redoubled its commitment to this opening up, thus boosting the momentum of reforms.

China took steps towards larger-scale capital account opening in 2002 with its Qualified Foreign Institutional Investor (QFII) programme, which allows licenced overseas investors to trade in RMB-denominated shares. This was followed up in 2007 with the Qualified Domestic Institutional Investor (QDII) scheme, which allows capital raised from Chinese investors to be invested abroad.

Given the scale of the financial resources effectively locked up in China, the impact on financial markets, both in China and internationally, of liberalising China’s capital account could be significant. Gross national savings in China are set to reach almost $5 trillion in 2014 (compared with $3 trillion in the US), and this wealth could be channelled to acquire a large portion of global financial assets in the long term if the capital account is opened up.

Before large-scale liberalisation is implemented, a pilot programme has been put in place to monitor how corporates adapt to the measures.

Pilot scheme

In late 2012, China’s State Administration of Foreign Exchange (SAFE) initiated a pilot scheme by which 13 Beijing- and Shanghai-based companies, including the China treasuries of Caterpillar, Intel, Samsung and Shell, could set up a cross-border FX cash pool. A second batch of companies, in other regions beyond Beijing and Shanghai, was added to the pilot in 2013.

“Capital account liberalisation is an important part of the RMB’s journey towards internationalisation – an idea which has been around in the market for some time now,” says Anthony Lin, China Head of Corporate Bank, Trade Finance and Cash Management for Corporates at Deutsche Bank. “We see the pilot scheme as a big move. It’s really the first strong signal from Beijing about capital account deregulation,” he adds.

The launch of the SAFE pilot programme allowed foreign currency, two-way cash pooling, as well as centralised payment and collection on a company’s current account. It also technically allowed netting for trade settlement to take place, explains Lin. Before the 2012 pilot scheme, cross-border cash pooling was a technical impossibility in China, so now the ability to pool cash is undoubtedly the biggest boon to treasurers to come out of the deregulation process so far. “This is definitely seen as a positive development by corporate treasurers, some of whom were very keen to take part in the pilot and get a first-mover advantage. It gives corporates opportunities to better integrate their cash pool in China with the rest of the world. You improve efficiency, and enhance your risk management, fully integrating the China business with the global franchise,” says Lin.

Free Trade Zone

Linked closely to the capital account liberalisation plans is the Shanghai Free Trade Zone (SFTZ). Launched in September 2013, the SFTZ is a testing ground for a number of China’s economic reforms. One of Beijing’s key goals in setting up the zone is facilitating foreign investment into China and Chinese investment abroad. The SFTZ is often spoken about in the same breath as capital account deregulation, as RMB convertibility and unlimited foreign currency exchange are permitted within the zone. “The SFTZ and the regulation around it is another big step to supporting capital account liberalisation. Indeed, we are seeing the establishment of semi-capital account convertibility in the zone,” says Deutsche’s Lin.

One advantage of the SFTZ is that it allows companies to further expand their business in China. “Companies in the zone now face a significantly simplified documentation process, which is very important when you come to the execution of some transactions,” says Lin. “There is also a smoother channel for direct investment. Companies are required to file a single registration, whereas before they had to order pre-approval from SAFE.”

“The SFTZ and the regulation around it is another big step to supporting capital account liberalisation. Indeed, we are seeing the establishment of semi-capital account convertibility in the zone.”

Anthony Lin, Deutsche Bank

As well as reducing the burden of bureaucracy, the SFTZ is, along with other regulatory changes, helping MNCs deal with the challenge of trapped cash in China. For example, full two-way cash sweeping is being trialled in the zone and is expected to be rolled out nationwide in the not-too-distant future. To find out more about trapped cash in China, see our Point of View feature.

Foreign companies in the zone are also allowed to convert 100% of their registered foreign currency capital at any time, subject to certain supervisions. Again, this was not possible under the former regulatory regime. “Corporates will have much better management of their capital from an exchange risk and timing perspective as a result,” adds Lin.

Playing it SAFE

Although some ambiguity is inevitable with any new regulation, it appears that SAFE is largely taking on board the needs of corporates as it proceeds with the reforms. Li-Gang Liu, Chief Economist, Greater China at ANZ, believes the regulator’s willingness to listen to companies has been key in expanding the pilot to the wider market. “In the very beginning when the programme was announced, it was launched as a pilot programme because SAFE wanted to see how enthusiastically MNCs would take this opportunity. It then quickly spread to other corporates who had been waiting to pool cash,” says Liu. “SAFE understands corporates’ challenges – partly because it listened to a number of MNC treasurers’ suggestions before the pilot was launched.”

Lin agrees that SAFE’s approach to keep corporates in the loop as it proceeds with the deregulation is working so far. “The regulators have demonstrated they know the market and understand customer needs very well. They are very open-minded,” he says. “They welcome new ideas, and we’ve spent a lot of time bringing clients, and their new ideas, to the regulators. Not every single idea will get through, of course, but through this process, it helps regulators to understand the actual market situation.”

Deutsche’s Lin thinks the measures instigated by SAFE could encourage more MNCs to set up treasury functions in China, but cautions there is more to it than capital account liberalisation. “These measures have made it more attractive for MNCs, and corporates are generally very excited about the direction things are going in. But there are still many other factors that companies will consider when they’re setting up treasury operations, such as the FX environment, interest rates, logistics, and tax, and these other factors also need to be developed together with the regulators,” he says.

ANZ’s Liu, on the other hand, believes the issue is not attracting more MNCs to China, but better connecting the treasuries of those already there with their central offices abroad. “Most of the big MNCs already have treasury operations in China. The key is whether their operations in China can now be easily linked with their treasury operating centre in London, Hong Kong, Singapore, or wherever that may be. SAFE is attempting to allow just that kind of linkage, with fewer restrictions, with the liberalisation measures,” he says.

“If China proceeds to liberalise its capital account over the next decade or so, it has the potential to be a force for growth and stability not just in China but also for the international monetary and financial system.”

John Hooley, Bank of England

Complex business

Given the scale of the task, deregulating China’s capital account will not always be plain sailing, nor will it be fast. “Everyone involved understands that this is essential, but it is also a very large and complex process, and it should be no surprise if you don’t get everything you want from it in one go,” says Lin. “If you expect everything to happen overnight, then you’ll be disappointed. The regulators are taking a step-by-step, progressive approach to implementing it, and the development of the SFTZ has created an environment that allows more aggressive liberalisation in a managed manner, but it will take time.”

Not only is the process complex, but Beijing is moving into the unknown. Regulators may need to seek advice from outside. “This will not be a trivial task. Given that Chinese capital account liberalisation could lead to dramatic changes in the global financial landscape, policymakers will be facing uncharted territory. To succeed, policy co-operation between national authorities is likely to be necessary, both to increase understanding of the risks and to develop common policy approaches,” writes Bank of England’s John Hooley in a Q4 2013 quarterly bulletin.

Beyond the initial complexities, deregulation also poses a larger macroeconomic risk. If liberalisation continues at its current pace, and as a result large portions of the world’s financial assets are acquired by Chinese owners, future unexpected shocks to China’s economy – which, with a closed capital account, would be dealt with domestically by Beijing – could have serious repercussions for the world economy. China should also take note of other countries’ experience with capital account deregulation; as such a move has often historically been followed by exchange rate or banking crises. However, these crises have not always occurred in the immediate aftermath of the liberalisation – indeed, in the cases of Japan and the UK, it was a full decade after the reforms were put in place.

Some observers feel China is not ready for full capital account liberalisation, given the underdeveloped nature of its financial markets. And there is the risk that if China opens up its capital account too much, too soon, it will be hit with a significant liquidity shortage. After all, with such a heavy reliance on domestic deposits, moving just a small portion of those funds overseas could pose significant problems to its large but China-focused banking system.

However, under certain conditions, Chinese companies may prefer to keep their money at home. Liu points out that many corporates in China have recently chosen to keep their RMB onshore, as a response to the RMB’s steady appreciation against the dollar and the high-yield on RMB bonds, adding that Chinese corporates with funds abroad have repatriated the money for investment for the same reason. He says that it may take some time before a reverse flow – that is, corporates sending RMB abroad for investment – takes place.

Incremental benefits

Despite the risks, if handled correctly, the benefits of capital account liberalisation could be huge, not just to China. “If China proceeds to liberalise its capital account over the next decade or so, it has the potential to be a force for growth and stability not just in China but also for the international monetary and financial system,” says Bank of England’s Hooley.

With the 12th Five-Year Plan approved in 2011, and the first SAFE pilot schemes coming into effect just over a year later, the effects of capital account liberalisation are likely to be felt incrementally. “We have probably already started to feel the impact, albeit slightly,” says Liu. “This is a continuous process, alongside the SFTZ experiment. We expect China’s capital account liberalisation to accelerate, to the point where the RMB could be a freely convertible currency by 2020, by which time the capital account could be mostly open,” says Liu.

He also believes that given the scale of the financial resources within China, some of those funds will eventually work their way out of the country. “It’s inevitable that there will at some point be a capital outflow from China because the reserve is currently huge. Chinese corporates and residents have very little foreign currency exposure and they cannot diversify their home-bias at the moment. If the government can actively encourage this capital outflow, there could be a very large initial movement from China to the rest of the world, and to some extent countries with close trade relationships with China could benefit from such a capital outflow.”


This will be an extremely interesting space for treasurers to watch going forward, and not just those with operations in China. After all, once the dragon has been allowed out of the box, and the capital starts to flow from China to the rest of the world, the global financial system may never be the same again.

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