25 June 2014
A premature opening of the capital account in the City of London could undermine stability.
Paola Subacchi

Dr Paola Subacchi

Senior Research Fellow, Global Economy and Finance


George Osborne, UK chancellor of the exchequer, leaves the stage as Li Keqiang, China's premier, waves following the UK China Financial Forum at Lancaster House in London on 18 June 2014. Photo by Chris Ratcliffe/Bloomberg via Getty Images.
George Osborne, UK chancellor of the exchequer, leaves the stage as Li Keqiang, China's premier, waves following the UK China Financial Forum at Lancaster House in London on 18 June 2014. Photo by Chris Ratcliffe/Bloomberg via Getty Images.


George Osborne was in ebullient mood last week as he greeted the news that China Construction Bank had been designated the official clearing bank in London for the renminbi. 'The number of historic changes in our financial world are few,' the UK chancellor of the exchequer said, adding that he wanted 'the City to facilitate that change and be central to it'.

The development gives London the infrastructure to compete with Hong Kong and Singapore, which until now had the offshore market in the Chinese currency more or less to themselves. London’s slice of the market is currently Rmb15 billion (£1.5 billion) – a mere drop in the ocean of the City of London’s capital markets. But optimists are seeing parallels with the development in the 1950s of a London-based eurodollar market, which allowed the US currency to be held outside the American financial system and helped propel London to the centre of the financial universe.

The eurodollar market was a reaction to exchange controls imposed in 1957 amid a crisis of confidence in Britain’s economy. The rules prevented the use of sterling for trade between parties outside the UK, threatening to diminish the role of the City’s banks. In response, some London banks began accepting dollar deposits and using them to fund dollar-denominated loans to clients in Britain or abroad. The new market was a commercial initiative rather than a regulatory one – although monetary and financial authorities on both sides of the Atlantic chose not to interfere.

The internationalization of the renminbi trade is something else altogether: a policy-led development, in which Chinese authorities set the pace and guide the market. This should not be too unsettling for Hong Kong, hitherto the leading venue for the renminbi trade, since it is part of China – albeit one with its own legal and regulatory framework. But it may be more problematic for London and other financial centres beyond Beijing’s jurisdiction. It is the Chinese authorities’ appetite for openness, rather than the private sector’s appetite for Chinese assets, that will set the trajectory of the renminbi trade for years to come.

The eurodollar market was built on the dollar’s pre-eminence, which by the end of the 1950s had become the leading international currency, used to settle and invoice more than 80 per cent of international trade. By 1970, $385 billion was held outside the US, where it could easily be enticed into offshore banks. The market for offshore dollar deposits grew at more than 25 per cent a year throughout the 1970s, and quadrupled its size between 1977 and 1987. Nowadays a quarter of the US dollar balance sheet is located offshore – a higher share than for any other currency.

Yet even if China is the world’s second-largest economy and largest exporter, its currency has limited international use. Beijing’s push for internationalization has increased the proportion of China’s trade that is settled in renminbi – but even so, the figure seems to have reached a plateau, at about 14 per cent of the country’s total trade. In the international payment system, the currency is hardly to be seen.

London had little choice but to engage with Beijing in its effort to internationalize the Chinese currency. The alternative would be to miss out on a trend that will only grow more important as the centre of economic gravity continues to shift eastward. But the result is that the City has to move at a pace set by Chinese authorities’ decisions concerning financial and monetary reform. Still, while Beijing remains in the driver’s seat, it is signalling a new willingness to open its financial sector to external participation and scrutiny.

The Chinese authorities’ caution is understandable. Even small steps towards liberalization can result in irresistible pressure to move faster. A premature opening of the capital account could unleash damaging financial flows and undermine the stability of China’s economy.

Zhou Xiaochuan, China’s central bank governor, warned last month that there would be new 'macroprudential' measures to regulate capital flows, even as the current 'administrative' restrictions are lifted. City financiers should take note. Their predecessors were given a free hand to develop the eurodollar market. The signs are that Beijing’s stewardship of the renminbi trade will be much more circumspect.

This article was originally published in the Financial Times

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