Yuan push and pull

Last Updated: Tue, Aug 10, 2010 20:30 hrs

Yuan: Beijing wants a stable yuan and a bigger international role for the Chinese currency. It will be difficult to have both. Relaxing the use of the yuan outside China will cause more capital to flow into the country, making it harder to control the exchange rate. So far, Beijing has managed to limit the yuan's volatility. That may not last forever.

China is relaxing its capital controls by opening a small hole in the wall to Hong Kong. Since mid-July, it has allowed Hong Kong-based companies to keep yuan-denominated deposit accounts, transfer funds freely in the region and even remit funds back to China. Meanwhile, Hong Kong banks and insurance firms can now sell yuan-denominated structured products, which provide higher returns than basic deposits.

Chinese companies, not just financials, can now take advantage of borrowing costs by raising yuan in Hong Kong and sending them back home. But it would take a rush of issues to rival the $60 billion in foreign direct investment that China gets each year. Besides, each deal must first be approved by Beijing. Meanwhile, low deposit rates for yuan accounts are holding back Hong Kong savers. Hong Kong currently has 85 billion yuan ($12.5 billion) in deposits, less than 2 percent of its total deposit base.

So far, the capital flows have not affected Beijing's efforts to keep the yuan stable. Despite the high profile announcement that it was de-pegging the currency in June, the yuan spot rate was unchanged at 6.77 in the past month. However, volatility has increased: intra-day movements are now twice the level seen during the past year.

As capital flows increase, it will become harder to keep the yuan on a tight leash. True, Beijing could issue treasury bonds to soak up the liquidity generated by capital inflows, but that means paying interest costs. The risk of attracting more inflows will also compromise its ability to raise domestic interest rates. Either way, the cost of setting the yuan free is that it will be harder to control.