International use of yuan demands more financial reforms

China's pursuit of making the yuan an international currency will raise the demand for and may eventually accelerate reforms of the country's financial system, analysts have said.

China has pushed for wider use of the yuan in cross-border trade settlement and investment as well as the development of offshore yuan market in recent years.

However, the currency is not yet fully convertible under the capital account, which is viewed as a major threshold on its way of going global.

The government's currency ambition demands more reforms in economic and financial policies regarding the exchange rate, capital account management and interest rates, said some experts who attended a financial forum in Shanghai on Saturday.

China has made some progress in financial reforms but needs to improve the convertibility of its currency, said Eswar Prasad, former chief of the International Monetary Fund's China Division.

Ma Jun, Deutsche Bank's Chief Economist for Greater China, said the opening up of the capital account is inevitable for China as its highly-opened current account and massive international capital movement will render restrictions less effective.

A truly internationalized yuan should be based on a floating exchange rate system and a market-oriented interest rate system, said Fei Fangyu, deputy head of the China Academy of Financial Research under Shanghai Jiao Tong University.

To facilitate international use of the yuan, China has expanded cross-border trade settlements in yuan and planned to allow foreign direct investment (FDI) in yuan-denominated funds obtained overseas.

The government also launched the Renminbi Qualified Foreign Institutional Investors (RQFII) pilot program in December 2011, in a bid to create more investment channels for overseas yuan funds.

While concerns remain that moving too fast will cause currency instability with inadequate financial reforms or convertibility under the capital account, Hong Kong has been viewed as a test-bed for the yuan's pursuit of international status.

China has promoted Hong Kong as a major offshore yuan market, where the yuan is more convertible and yuan-denominated bonds are issued.

The yuan-denominated trade settlement conducted through Hong Kong amounted to 1.9 trillion yuan (about 301.6 billion U.S. dollars) in 2011, which was five times the value of the whole year of 2010, Hong Kong's financial chief John Tsang said in early February.

As at the end of last year, there were 116 yuan-denominated bond issuances with a total value approaching 180 billion yuan, and yuan deposits in Hong Kong amounted to nearly 590 billion yuan, representing an increase of nearly 90 percent from a year earlier, Tsang said.

The growth of offshore yuan market will in return impact the onshore market and facilitate the government to ease financial restrictions and open up the capital account, Ma said.

Former central bank deputy governor Wu Xiaoling said price distortions resulting from domestic financial market restrictions have created room for arbitrage and may force China to improve the flexibility of interest rates and the yuan's exchange rate.

Others believed the process of reforms and opening up the capital account will only be gradual.

Currently, China allows its currency to fluctuate against a basket of currencies in a managed way. In the country's foreign exchange spot market, the yuan is allowed to rise or fall by 0.5 percent from the central parity rate each trading day.

China's central bank said last month the country is ready to carry forward the marketization reform of interest rates to let market competition decide the rates.

"The internationalization of the yuan can not be realized without the opening of the capital account, and that is likely to be a very tortuous and complicated process," said Li Xunlei, chief economist of Haitong Securities.