Currency moves vital for shaping city as an international financial center

The government has set an ambitious goal that "Shanghai will be built into an international financial center in correspondence to the size of China's economy and the yuan international position in 2020".

The advantages for Shanghai as a city to be an international financial center are obvious: with the increasing number of banks and financial institutions and their head offices, and the expanding services associated with accounting, auditing and legal affairs, the city will see more international financial activities, and more revenue and employment in the services sector.

Since one of the basic requirements for a global financial center is full convertibility, which refers to the opening up of the current as well as the capital account, to allow free flow of capital in and out of the country.

The general advantages of having full convertibility of the capital account are: to provide more investment opportunities and options for currency holders; to facilitate economic growth by giving greater confidence level of global investors with more investment; to improve efficiency of the financial sector through greater competition.

Some of these general advantages may not be applied to China. Statistics show that China already has partial convertibility and received a large amount of foreign investment. According to the State Administration of Foreign Exchange, among 40 items of capital account, five have been completely liberalized, 17 partially liberalized, eight under moderate restriction, while only 10 are completely prohibited.

Calculations based on the International Monetary Fund formula showed that more than 80 percent of China's capital account has been at least partially liberalized.

So what are the extra advantages of a fuller convertibility?

I believe that key advantage is to help China to achieve its goal of yuan internationalization. The government is now actively promoting international use of the yuan offshore. The yuan has begun to internationalize: a yuan bond market has grown rapidly in Hong Kong, the currency is starting to be used to invoice some of China's international transactions to settle cross border trade, and foreign central banks have been able to hold the yuan since August 2010.

The purpose of yuan internationalization is, in the short run, to avoid exchange loss of China's export companies under yuan appreciation pressure. From the long-term perspective, the yuan could become a reserve currency if the country undertakes further economic reform, and develops a stronger, more flexible exchange rate system.

Despite various advantages of full capital account convertibility, there are some major risks associated with it. Given an international environment of big financial players with huge blocs of money for speculation and investment, developing countries are often subjected to great volatility and financial and economic danger. Few governments can withstand a determined bid by a few big hedge funds to speculate on their currencies and financial markets.

China, as a developing country, may be prone to these problems due to its higher degree of vulnerability from the deficiencies in the banking system and relatively immature financial markets.

The weakness of Chinese banks is reflected in a serious accumulation of non-performing loans (NPLs). In recent years, the NPL situation in China may have been worsened by the stimulus program and the emergence of "local government funding platforms" that generated an estimated $1.7 trillion in local government debt.

When the capital account's door is wide open, China's domestic banking system has to absorb money flow from overseas on the one hand, and avoid asset bubbles or massive credit splurge on the other hand.

Many economists and policymakers believe that capital account convertibility should be the ultimate step in the process of marketizing the economy and connecting the country to a globalized world. It is also recognized as a precondition of building a financial center.

We can expect that with free flow of capital and fully convertible currency, Shanghai's international financial transactions will soar, and the yuan will be more acceptable as an international currency, and the city will become an international financial center by 2020, based on China's definition of the international financial center for Shanghai ("correspondent to the size of China's economy and the yuan's international position").

However, the success of Shanghai as an international financial center will depend mainly on a strong macroeconomic policy framework, a maturing financial system and market, and transparent and prudential regulations. To be an international financial center may just be the initial step for Shanghai.

Extra efforts have to be made for Shanghai to be a truly global financial center that attracts a very high level of international financial expertise and for it to feature as a global city with a free economy buttressed by the rule of law.

The author is an economics professor at the University of Maryland.