Shenzhen is where China’s economic miracle began. Back in 1980, Deng Xiaoping and his Beijing comrades launched a special economic zone, or SEZ, in the southern enclave that became the center of a grand experiment in introducing free capitalism into Communist China. Foreign investors were invited to set up factories in the zone, cracking open the tightly controlled economy to the outside world, and as money poured in, attracted by China’s cheap and plentiful labor, world economic history was altered forever. The Asian giant was transformed from an agrarian basket case into the “Workshop of the World” and chief rival to American economic dominance.
Now Beijing is again turning to Shenzhen for a new batch of trials with capitalism by dusting off that old idea of the SEZ and repurposing it. The consequences could prove just as sweeping for both China and the world. On Friday, Chinese policymakers formally revealed that they would turn a slice of Shenzhen into a new sort of SEZ to experiment in currency convertibility. The SEZ, called the “Qianhai Shenzhen-Hong Kong Modern Service Industry Cooperation Zone” will be developed near the border with bustling Hong Kong at a cost of $45 billion. Details on exactly what financial reforms will take place in the zone were sparse. It is possible that the measures will include the permission of some cross-border yuan lending between Hong Kong and mainland firms. But the purpose was made clear: China is will take steps to free up the ways in which its currency, called the yuan or renminbi (RMB), can be used in international finance. “The country’s policy is to gradually open up its capital account and realize the full convertibility of the yuan,” said Zhang Xiaoqiang, vice chairman of China’s influential National Development and Reform Commission. “Qianhai, as the first experimental zone of the country’s modern service industry, should be a pioneer of that.”
In introducing this zone, China is taking an important step towards achieving one of its major goals – elevating itself from solely a global manufacturing power into a global financial power as well. Beijing has been striving to make its currency, called the yuan or renminbi (RMB), more widely used internationally, and thanks to the growing importance of China in global trade, the yuan has been gaining something of a worldwide profile. The yuan is being used more frequently in trade conducted between China and its trading partners. In a mere three years, the share of China’s international trade settled in yuan increased from nothing to 8% in 2011. Beijing has been encouraging this trend through a series of currency swap arrangements to make the yuan more readily available. China inked just such a deal, of nearly $30 billion, with Brazil in June. Some Chinese companies have been permitted to settle trade transactions in yuan through Hong Kong banks, turning the special administrative region into the primary offshore center for business in the Chinese currency. More yuan-dominated securities are available for investors, such as the “dim sum” bonds traded in Hong Kong. As China’s economic might continues to grow, the influence of its currency will inevitably increase with it. “It is apparent that more and more central banks are realizing that alongside the secular decline of the USD (U.S. dollar) as a reserve currency, the RMB is the most likely currency to challenge the near-monopoly position of the USD in the global reserve system,” Jun Ma, Deutsche Bank’s chief economist for Greater China, wrote in a June 25 report.
Yet there are clear limits to how quickly the yuan can become a true rival to the dollar or even the euro. The yuan is still not fully convertible for financial transactions, nor is it widely traded outside of China. The value of the yuan remains controlled by the Chinese government. And since access for foreign investors to Chinese stocks and other assets is restricted, they don’t have much to buy with the yuan they do hold. Until trade in the yuan becomes more market-oriented and transparent, the yuan and yuan-denominated assets become widely available, and China’s financial markets become more open, Beijing’s dream of an internationally prominent currency will be unattainable. “Without an open capital account, the internationalization of the RMB can only achieve less than 10% of its potential,” Jun Ma added. “Capital controls, if not removed, will become the key bottleneck for RMB internationalization in the coming years.”
That’s why the new Shenzhen currency zone is so important. By allowing freer, cross-border financial transactions in yuan, Beijing is taking a step towards dismantling the capital controls that hold back the currency from being a force in the global economy. History tells us that what happens in Shenzhen doesn’t stay in Shenzhen. The market-opening reforms that began in the city in the 1980s were eventually rolled out on a national scale. This time, the currency reforms proposed for the new Shenzhen zone will also likely prove just a first move towards a much wider liberalization process for the yuan, which, in theory, could end with its full convertibility.
That would truly transform the yuan into a major international currency able to pose a challenge to the dollar’s No. 1 status. But we are still very far away from such an outcome. The Shenzhen zone is one important reform in the many, many more that are needed. Jun Ma lists 18 important policy measures he feels need to take place to further the internationalization of the yuan, including opening up Chinese capital markets to foreign investors, promoting the pricing of commodities in yuan and increasing the flexibility of the currency’s exchange rate.
There is little reason to believe such reforms will take place quickly. In fact, there is no guarantee they will happen at all. China’s efforts to liberalize capital flows and its currency regime have been progressing at a glacial pace. The process of valuing the yuan is only slightly more market-oriented than it was seven years ago, when its peg to the dollar was first lifted. Chinese policymakers are still fearful of the sort of free cross-border capital flows that could become destabilizing in times of economic stress. They look upon the country’s capital controls as a key tool that protected the domestic economy from the ravages of the post-Lehman financial crisis in 2008. There are powerful interests, from exporters to state banks, which might be opposed to rapid financial liberalization. Achieving a fully convertible yuan will also require hefty reform of China’s domestic financial sector, which will entail deregulating interest rates and making the banking sector more competitive. With a major political transition due later this year, it is not clear what China’s new crop of cadres think about the pace of economic reform, placing a big question mark over future progress.
Yet the implications of the Shenzhen experiment for the global economy can’t be underestimated, either. Just as Shenzhen altered global manufacturing in the 1980s, it could alter global financial and currency markets in coming years. As China’s miracle continues, that’s probably more a matter of when than if.