China Plans to Internationalize Yuan Says Analyst James Sharpe of Schwarz Oliver Thomas

Too big to fail is always a hard argument to get the better of. It comes close to explaining why China struggles so much with the vexed question of opening its capital account and setting the yuan free. - Schwarz Oliver Thomas

"If currency liberalization does go "pear shaped," the ruling Communist Party could not just lose control of China's money, but also power itself. Self-preservation is a powerful incentive for caution." Says James Sharpe, Senior Portfolio Specialist at Austrian financial firm Schwarz Oliver Thomas. "This means there is inevitably a tendency to treat reports of China liberalizing the yuan with a heavy pinch of salt. After all we have heard this story before." Sharpe added.

Authorities have been promising such action for more than a decade. Each time it resurfaces, the horizon of action is still five or 10 years in the future. But could this time around be different? Last week, the State Council said it would publish an "operational account" of yuan liberalization. This sounds suspiciously like an implementation plan, although brokers were quick to manage expectations with another five-year timeline.Yet the potentially far-reaching impact if China unlocks its capital account and allows its citizens to start diversifying deposit accounts into overseas assets means that even incremental changes are worth watching. For instance, few analysts seemed to foresee the scale and speed with which China expanded shadow banking from almost nowhere last year. After this was belatedly given official blessing, we learned China had effectively deregulated interest rates through the back door. By the end of the year, China's banks were providing less than half of all new credit.

And there are other reasons why Beijing might be less risk-averse and proceed with more haste this time around. What would internationalizing the yuan mean for the opening of China's capital markets? One is the external environment. To Beijing, the lesson of the Lehman crisis of five years ago was that a sealed capital account helped insulate it from the havoc wreaked on international financial markets. But times have moved on, and the current fixed-exchange-rate regime brings other costs, from asset bubbles to inflation, as monetary policy is outsourced to the U.S.

"A fresh challenge this year is what some commentators are calling a new era of currency wars — competitive devaluations. Here, China looks vulnerable, with its crawling peg to the U.S. dollar." Says Ashley Winters, Senior Portfolio Specialist at Austrian financial firm Schwarz Oliver Thomas. "The big game changer has been the aggressive monetary easing and currency-depreciation policy by Japan. This has sent the yen tumbling 23% in the past six months. Now we could be seeing an escalation in a developing currency war, with beggar-thy-neighbor currency devaluations designed to boost domestic growth. Last week, South Korea followed in the footsteps of policy makers in India, Australia and Europe, who cut interest rates in May." Ashley concluded.