Eye on China: Chinese soap opera has canny plot

This time it was a ploy by the Chinese Government to kill several birds with one stone: keep the yuan weak, prevent the build-up of even more mountainous foreign exchange reserves and portray the exercise as a market liberalisation measure to the United States Government. The latter, of course, argues the yuan is being kept artificially low through central bank intervention.

The whole process is known as QDII, short for qualified domestic institutional investor, and refers to allowing, for the first time, investments in foreign assets by Chinese companies and individuals. These have hitherto been strictly regulated, mainly because the Government wishes to keep tight control on the export of capital to ensure domestic liquidity.

You can picture the Chinese financial system as a pool. The wall surrounding the pool ensures that the Chinese banks, who are hugely important to the financial system, have plenty of funds to keep their cashflow strong - even if they are technically insolvent. That wall has now been breached for the first time.

It's a shrewd move, since QDII helps maintain a weak yuan and thereby props up Chinese exports - but in such a way that the Chinese Government can say to Washington: "Hey, we are deregulating capital flows, so don't blame us if that has the side-effect of depreciating the yuan."

The mechanism is simple. The central bank keeps the yuan pegged to the US dollar at a certain level and maintains that level through buying and selling the currency. That is, if the currency threatens to become more expensive the central bank steps in and floods the system with yuan.

Increasing supply decreases the price and the currency stays fixed within its range. For economic purists, this smacks more of mercantilist monetary manipulation than merely a concern for stability - and is one reason why China has been getting so many potshots from the US.

Under the QDII system, China's insurance companies will be able to invest in overseas debt instruments, banks will able to invest yuan deposits in foreign assets and fund management companies will be able to invest their foreign exchange savings abroad as well. Chinese individuals will be able to buy up to US$20,000 ($32,000) of foreign exchange. The reason this will help keep the yuan weak is that as these companies sell yuan, the supply will go up and the pressure on the yuan will be downward.

This helps one of the biggest problems facing the central bank; namely how to ensure that the huge forex inflows obtained through trade and foreign direct investment don't have an inflationary effect. The inflation comes from the conversion of the forex earnings into yuan, which then creates liquidity in the banking system. Banks naturally want to lend these funds. But the central bank doesn't let them, in case the lending is reckless and inflationary (as it has proved in the past).

The central bank, therefore, borrows these funds off the banks and effectively takes them out of their control. These funds are then converted back into foreign exchange and invested overseas.

Still, the situation is not straightforward. The yuan has been gradually appreciating, partly in response to political pressure. Does the Chinese Government hope that positioning the latest shift in the currency regime as a sign of deregulation will cause US observers to overlook the fact that the move could actually increase the trade deficit with the US?

The Chinese Government could be hoping that this possibility will be overlooked because of the effect on asset prices. The prospect of huge amounts of Chinese capital being unleashed on global stock and debt markets has brought financiers close to ecstasy, especially in Hong Kong, seen as the most likely recipient of funds from China.

Foreign governments with large deficits will likely notice that the change in the rules doesn't alter the fact that the yuan is pegged and that its value is fixed by the People's Bank of China - it simply makes the process easier for the bank to manage. So ironically, what is being marketed as a reform measure is actually making it easier for the bank to manipulate the terms of trade by helping it solve the main problem of how to cope with excess, potentially inflationary, yuan (simply export it). In addition, the whole process doesn't really free up the market, so can't be called genuine market liberalisation. Overall, it looks like a clever move, appealing on some level to everybody while masking the fact the Government has not retreated an inch. If the scheme takes shape, Chinese citizens will also benefit. They need investment options to diversify risk and increase yield - now a pitiful 2.25 per cent on one-year bank deposits, compared with 5 per cent for a US Treasury bill.

* Each week the Business Herald's columnists track the latest developments in the world's two emerging economic superpowers. Dan Slater is a journalist based in Beijing.