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China frees up overseas investment

China relaxed its capital controls on Friday to make it much easier for individuals and companies to buy foreign currencies and invest abroad.
/ Source: Reuters

China relaxed its capital controls on Friday to make it much easier for individuals and companies to buy foreign currencies and invest abroad.

The move will permit President Hu Jintao to tell U.S. President George W. Bush when they meet next Thursday that China has made another notable move towards a market-driven exchange rate.

"The deregulation is a concrete step fulfilling the central bank's commitment to gradually ease China's capital controls," said Li Yang, an economics professor who is a former member of the central bank's monetary policy committee.

Under rules announced by the central bank and the foreign exchange regulator, Chinese banks will be allowed to pool yuan deposits and convert them into foreign currencies for investment in overseas bonds.

Fund management firms may invest individuals' and companies' existing foreign exchange holdings in overseas bonds or shares, while insurers will be permitted to invest in foreign fixed-income assets and money market paper.

Individuals will be allowed to buy $20,000 a year, up from $8,000, and firms will be allowed to hold more foreign exchange.

By creating demand for dollars, the steps in theory could ease pressure for a further rise in the yuan generated by China's record trade surplus and investment inflows, which have boosted its foreign-exchange reserves to a world-beating $853.6 billion.

"An outflow of foreign currencies can ease pressure for further yuan appreciation. This offers a good argument before President Hu's U.S. visit to show the Americans China's commitment to further currency reform and ease the U.S clamour for a firmer yuan," said economist Yi Xianrong. Like Li Yang, Yi works at the Chinese Academy of Social Sciences.

In practice, though, economists say the initial impact will be muted because of a widespread view that the yuan, which has risen just 1.16 percent since it was revalued and unhooked from a decade-old dollar peg in July, is a one-way bet to rise further.

"Capital flight will occur if there are expectations of yuan depreciation, as people will seek to send money overseas. But in the short term, the latest measures will not have a significant effect given expectations of a yuan appreciation," said Gao Shanwen, an economist at China Everbright Securities in Shanghai.

What's more, the authorities have not said how much money they will allow to be invested overseas.

Still, analysts said China had taken a step towards making the yuan convertible for purely financial purposes instead of just for trade and direct investment deals, as is the case now.

It follows a series of other moves to build a two-way market for foreign exchange. These include the introduction of a system of market-makers, who constantly stand ready to buy or sell the yuan, and the development of derivatives so banks and firms can hedge new-found currency risk.

"Just as central bank officials have been saying, what really counts is reform of the foreign exchange formation mechanism rather than the level of the exchange rate. This move is a vital part of that reform," said economist Yi.

Underscoring the reform drive, China said on Friday it would launch interbank trading in currency swaps on April 24.

Depending on the pace of liberalisation, the easier foreign exchange rules provide a juicy business opportunity for Chinese banks and money managers.

"You're giving banks a huge opportunity. They already have a huge depositor base, so marketing is going to be very easy," said economist Stephen Green with Standard Chartered Bank in Shanghai.

Green rated the significance of Friday's announcement at five on a scale of one to 10. "It's giving them the tools they need to start allowing liquidity to move offshore. They've driven a wedge through the capital account," he said.