China's announcement of current account convertibility in December was hailed as a major step forward by foreign banks and businesses and brings closer the country's long-awaited entry into the World Trade Organisation (WTO). The news is particularly welcome to firms targeting the domestic market.
Current account convertibility makes it easier for foreign companies investing in China to convert yuan into foreign currencies for routine transactions such as importing materials, paying intellectual property licensing fees and repatriating dividends. Major capital flows associated with direct investment, loans and portfolio and share investment ? defined as capital account transactions ? remain strictly controlled
Influence on investment
Convertibility effectively spells the end of the need for foreign firms to 'balance' their foreign exchange, a practice which has for years been a millstone round the neck of many investors.
Current account convertibility particularly benefits foreign-invested businesses with imported components and other foreign exchange costs, seeking to sell primarily on the Chinese domestic market. In the past, these companies were restricted by the Chinese government's insistence that any profits, fees or payments for imports remitted out of China in hard currency had to be 'balanced' by hard currency receipts usually generated through exports.
The need to balance foreign exchange has been a major force shaping the strategy of foreign investors. It was, for instance, a factor in Courtaulds' decision to set up its first China joint venture manufacturing specialised shipping paint. International Paint Shanghai, set up in 1989, was able to average 45 percent export sales in the early 1990s, a pro-portion which was influenced by the need to balance the company's foreign exchange. To boost its foreign currency receipts in its start-up phase, the venture channelled coatings supplied to yards in southern China via a Courtaulds company in Hong Kong.
It was not until the mid-1990s that Courtaulds felt confident enough to invest in packaging and can-coating businesses, where domestic sales targets of up to 90 per cent were envisaged. Improvements in currency convertibility have also given Courtaulds more control over its working capital loans in China. In 1995, a shortage of yuan made banks unwilling to grant pure yuan loans, usually insisting that ventures take on US dollar loans as part of the package. The company was uncomfortable about taking these US dollar loans partly because of the restrictions placed on conversion. By early 1997, Courtaulds was able to determine its own currency loan mixture taking into account a combination of factors including the higher cost of yuan loans, with concerns about exchange rate fluctuations.
Domestic market focus
Lack of convertibility has been an important link in the chain tying penetration of the Chinese domestic market to localisation of components. The lack of currency convertibility was an important barrier preventing, for example, low value-added import-assembly operations being used as a vehicle by traders primarily interested in importing into China. Beijing was always aware of the lure that the domestic market presented to traders. The government feared that a surge in imports would erode China's scarce foreign currency reserves ? which stood at only about US$1bn in 1979 ? without adding to China's technological base. While trading remains a relatively restricted sector, the first few Sino-foreign trading joint ventures have now opened for business.
In practice, investors able to demonstrate that they were contributing valuable technology have been given a relatively long leash by China's exchange authorities. "There is certainly far greater penetration of the Chinese domestic market these days," says Mr Laurence Brahm, director and legal advisor at investment consultants Naga Group. "In mobiles, the major players Ericsson, Nokia and Motorola are now far more focused on the domestic market rather than exports, although they initially set up with foreign exchange balancing in mind."
Beijing Ericsson Communication System, for example, imports 90 per cent of the parts required to make its telephone exchange systems. "The reforms really helped us a lot," comments Ms Chen Dan, a financial controller at the company. She points out that transactions which used to take five days to clear under the old system can now be processed in just two days.
Mr Gordon Lam of the Hong Kong & Shanghai Banking Corporation, while believing that the Ministry of Foreign Trade and Economic Cooperation continues to look at foreign exchange balancing capability when approving foreign enterprises, notes that "90 per cent of the enterprises that we see nowadays are not export-oriented and they still get Moftec approval".
New investment agenda
The lack of convertibility worked well to encourage low value-added operations into exporting their finished products. Thousands of export-oriented factories ? many of which were overseas Chinese investments ? were set up along the China coast, attracted primarily by low labour costs. The foreign exchange proceeds from these enterprises helped China's foreign exchange reserves to exceed US$100bn by 1996. With the relaxation of currency restrictions, some of these pressures to export may now lessen.
Lam believes that "there will definitely be an impact" on China's balance of payments caused by the new currency convertibility, although, given China's large foreign exchange, reserves this may not become an issue until 1998 or 1999.
Access to foreign exchange is not always the key issue. A prolonged credit squeeze introduced to cool the overheating economy in 1993 has resulted in severe shortages of yuan. IBM has found it necessary in recent years to convert hard currency into yuan to pay for the salaries of local employees as well as paying for services and rent. These routine currency conversions have become much easier in recent months, a company official said.
While lack of convertibility was consistent with China's desire to boost export earnings, it became increasingly at odds with other trade and investment goals. These included gaining entry into the WTO; the encouragement of high-tech investment; and investment in the interior regions.
Exporting from a low labour cost base was never the main draw for the multi-nationals investing in high-tech sectors. Their prime interest was gaining access to the Chinese domestic market. This goal was of sufficient importance to make them prepared to cooperate with China's investment authorities in providing technology transfer on the government's wish list. In many cases, the government found itself allowing the foreign exchange balancing rules to be stretched as part of the deal.
Encouraging investment in China's interior provinces is also difficult to square with foreign exchange balancing. Poor transport infrastructure adds to the cost of bringing finished products to the ports through which the bulk of the country's exports flow.
Relics of balancing
It is unlikely; however, that convertibility will, change the pattern of China investment immediately. Vestiges of the need' to balance foreign exchange earnings remain in a broad array of investment legislation which in theory gives the authorities an on-going mandate to influence revenue streams. "I wouldn't say that the need for foreign exchange balancing has totally gone out of the window," says Brahm. "The basic joint venture laws still mention the need to balance, but foreign exchange balancing is certainly far less relevant."
The biggest uncertainty, perhaps, lies in the fact that many joint ventures have export quotas written into the contracts under which they were set up. To what extent these requirements will continue to be enforced remains unclear. "If the situation with China's foreign exchange changed, this could become an issue," says Mr Michael Zipp, head of the German-owned Henkel China. "I would not feel comfortable with a situation where the bulk of materials were imported. We try to source raw materials locally because most of our sales are domestic."
Another indicator that export quotas have not been totally abandoned is the referral in the new foreign exchange regime to export commitments in the formula used to calculate the permitted ceiling on the amount of fund allowed to held in current accounts.
The tax system also continues to encourage exports. Import tariffs on many goods remain high by international standards with tariff rebates only available if the finished products are subsequently exported. On certain luxury goods, consumption tax provides an extra burden adding to the eventual retail cost of the item when sold on the domestic market. Tax breaks are still extended to enterprises that export more than 70 per cent of their production.
Road to convertibility
Until 1994, China operated a dual currency system with domestic trading being conducted in yuan while foreign trade transactions used a parallel, and nominally equivalent, currency of Foreign Exchange Certificates (FECs). Domestic enterprises were permitted to retain a proportion of the foreign exchange they earned, the remainder being sold to the banks. In practice, the separation of yuan from hard currency transactions led to many anomalies.
In effect, currency conversion did take place but at three different exchange rates. The first of these was the official government exchange rate in which the value of the yuan was inflated artificially. An alternative conversion rate applied at currency swap markets where individual firms with surpluses of either hard currency or yuan in a particular province could conduct swaps. Finally there was the black market rate, primarily brought about by the hard currency needs of individual consumers and Chinese domestic firms.
The move from this basically non-convertible system to full convertibility has been viewed by experts as a four-stage process: conditional convertibility on the current account; full convertibility on the current account; conditional convertibility on the capital account; and the ultimate aim of full convertibility on the capital account. China has now completed the first two stages.
The first step, to conditional convertibility on the current account, was taken in 1994 when the government unified the official yuan rate with the swap market rate. The yuan was effectively devalued by 33 per cent and FECs were phased out. Chinese domestic companies were now required to feed their entire foreign exchange earnings into a new interbank market. At first, access to this market was restricted to Chinese domestic companies with foreign-invested enterprises continuing to use the provincial swap markets. But the swap markets themselves became integrated gradually into the interbank market through the development of links to National Foreign Exchange Trading Centre ? the former Shanghai swap market.
The swap markets were not ideal, however. Apart from worries about limited liquidity, access to these centres was still strictly controlled by the State Administration of Exchange Control (SAEC) which granted approval for swaps on a case-by-case basis. Foreign enterprises' freedom to conduct currency swaps increased in 1995 with the introduction of annual SAEC audits of companies granting those that passed the audits Foreign Exchange Registration Certificates. These permits allowed firms free access to swap markets for the following year.
The SAFE era
After the initial devaluation, the value of the yuan stabilised and even appreciated, rising from an exchange rate of 8.7 to the US dollar in 1994 to reach 8.3 by 1996. The successful 'managed currency float' gave the authorities the confidence to move on to the next stage of full convertibility on the current account. This effectively allows foreign firms to conduct currency swaps on their current accounts on the interbank market by means of over-the-counter bank transactions. A pilot scheme was introduced in Shenzhen, Shanghai, Dalian and Jiangsu in March last year, which was extended to the whole country in July.
In December, Dai Xianglong, the head of the People's Bank of China, announced that China had put the finishing touches to convertibility on the current account, enabling China to comply with the definition of current account convertibility contained in Article VIII of the International Monetary Fund's charter. The old State Administration of Exchange Control was renamed as the State Administration of Foreign Exchange (SAFE) to mark the change.
Under the new system, yuan can be converted into hard currency (or vice versa) at any one of 16 Chinese designated foreign exchange banks (see box) as well as foreign bank branches and Sino-foreign joint venture banks. In the context of the new reforms, the swap markets are increasingly becoming an anachronism.
Transactions under the current account include foreign exchange involved in imports and exports, transfer of intellectual property and remittance of profits and dividends overseas. However, some items still require verification by SAFE. "The amount of documentation is tedious, but it's rare that you can't get the foreign exchange," says Lam.
Multiple current accounts
Initially it was planned to restrict foreign enterprises to one basic foreign currency current account but under pressure from foreign banks hoping to develop yuan business in China, this was later relaxed. Foreign ventures in Shanghai are now to be allowed to open two or more accounts with different banks if they satisfy two out of the following five criteria:
1. The HE must be jointly owned by at least two different foreign companies
2. Registered capital must be timely and fully injected
3. Paid up capital must exceed US$5m, and the difference between the FIE's total investment and registered capital must be greater than 50 per cent
4. The FIE must conduct foreign trade with more than three foreign countries or 'regions'
5. The FIE must have an annual export or import volume of more than US$20m.
HSBC has been advised that slightly different rules may apply in other cities,
including Wuhan and Suzhou.
While convertibility has been introduced on the current account, regulatory restrictions remain tight on the capital account conversion. Indeed, current account convertibility has been accompanied by measures to tighten up on capital account transactions. The precise definition of capital account transactions has been defined clearly in the July 1996 Regulations on Foreign Exchange Sale, Purchase and Payment. Ceilings have also been placed on the amount of money that can be held in a current account to prevent transfers of capital items onto current accounts.
Capital account items include the registered capital of FIEs: the principals of foreign exchange loans; payments for guarantees for foreign exchange loans; proceeds from foreign exchange bond and share issues; outward investment from China; and repatriation of foreign capital after liquidation of an enterprise.
The ceilings on current accounts are calculated according to a formula depending on the investment capital of a foreign enterprise and its contractual export commitments. Generally, enterprises with investments of between US$6m and US$30m are allowed to hold up to US$4.5m in their current accounts. Larger ventures are allowed up to US$7.5m, although if the investment is much greater than US$30m there is thought to be some room for negotiation.
Although reversals cannot be ruled out, most play down this possibility and look forward to the next stage of full convertibility. While it took Japan 20 years to move from convertibility on the current account to full convertibility, it is possible that China may accomplish the same feat in just four years. "Basically, China's currency reforms are on target, though several aspects have to be improved," says Brahm. "What we have now is partial convertibility, but China is on target to achieve full convertibility by the year 2000." PBOC officials have indicated that it is most likely that liberalisation of the capital account will be introduced incrementally.
Gao Hucheng of Moftec recently sketched the way forward here: "One of the feasible options is to first relax trade-related capital flows and then abolish the restrictions on long-term foreign direct investment and portfolio investment and finally eliminating the restrictions on short-term capital flows."
But for the time being the pressure will be off China's investment authorities as capital account convertibility is not an IMF requirement. Even developed countries such as Japan and Italy retained some restrictions on capital account until relatively recently. But indirectly freer access to the domestic market will increase the already considerable competitive pressures on China's ailing state sector, making difficult reform decisions more urgent. Enditerm