CHINA last month issued new policies for financial reforms in China's southern Pearl Delta Region. Among the measures to promote private investment, agricultural financing, a trial program to allow capital account opening and more cross-border financial corporation between the mainland and Hong Kong have caught the widest attention from economists. Here are some comments on the program's initiatives and its impacts on the capital market.

Hong Kong benefits from reforms in Qianhai

Kelvin Lau

Economist at Standard Chartered Bank

Money wants to move around - and the yuan is no exception. The Chinese yuan has been busy expanding into its new offshore universe: Singapore may soon have its own yuan clearing bank, and Taiwan looks set to take a step toward allowing the yuan to be used there soon.

At the same time, Hong Kong is enjoying its leading role both as the incubator and as the enabler of the yuan's foray overseas.

For the offshore yuan market to work, however, the currency also needs to be able to move easily across the mainland border.

Recent policy moves suggest that China wants to link the yuan with broader moves to integrate Hong Kong's economy further with the Pearl River Delta region.

In the run-up to the 15th anniversary of HK's return of sovereignty to Chinese mainland on July 1, President Hu Jintao announced a series of policy moves.

The main thrust of the moves was to deepen the economic and financial integration between Hong Kong and the mainland, especially Guangdong, and of course, having a currency that can be used freely on both sides of the border helps.

Rather than just tapping China's middle-class consumer boom via tourist spending, Hong Kong would benefit by extending the reach of its firms into the Pearl River Delta region.

But it is the Qianhai pilot scheme that truly embraces the concept of bringing Hong Kong into the mainland, and getting offshore yuan moving back and forth across the border more freely.

Test bed

The Qianhai zone, just across the border from Hong Kong, is now to be developed as a test bed for cross-border yuan business and yuan convertibility.

The experiment will involve companies in Qianhai being encouraged to issue Dim Sum bonds in Hong Kong, Hong Kong lenders being allowed to extend yuan-denominated loans to companies and projects established in the zone and banks established in Qianhai being encouraged to grant yuan loans to offshore projects.

Qualified companies operating in the zone can enjoy a 15 percent preferential corporate profit tax rate, 10 percentage points lower than the normal rate; concessions on personal income tax will be granted to certain workers, such as overseas professionals working in the zone; foreign-invested equity investment funds in Qianhai will be supported; and there are chances to explore the possibility of establishing branches of Hong Kong arbitration institutions.

Expectations need to be managed, of course.

Cross-border yuan lending, for example, is likely to be ring-fenced, possibly by limiting participation to certain companies and banks, and/or by introducing a quota.

The much-narrowed, but persistent, interest rate differential for yuan on- and offshore means that China should still be worried about completely freeing up cross-border flows.

The potential drain on Hong Kong yuan deposits is also a valid concern, especially when only one month's worth of new loan growth onshore, close to 902 billion yuan (US$142 billion) in June, is bigger than Hong Kong's entire yuan liquidity pool (554 billion yuan).

And then there is the small size of Qianhai to begin with, meaning that the pilot project is unlikely to shake the offshore yuan landscape in any material way anytime soon.

Certainly, we believe that talk of Qianhai threatening Hong Kong's position as a financial center is unfounded.

If anything, Qianhai will operate, by design, as an extension of Hong Kong, and it will be Hong Kong-based institutions that will populate the zone.

Capital account overhauls well under way

Niathan Chow

Economist at Development Bank of Singapore

The Chinese authority said to explore the feasibility of opening up Shenzhen's Qianhai district for yuan conversion under capital account, albeit without giving details. Currently, 10 of the 40 specific items under China's capital account transactions classified by the International Monetary Fund are tightly restricted, and the other items are all, to a certain degree, convertible.

The degree of openness for direct investments is the highest amongst all. Those remain strictly controlled are related to cross-border derivative transactions and short-term capital inflow. They are expected to be on the yuan conversion trial list.

In particular, firms located in the Qianhai Bay development zone may borrow yuan fund directly from banks in Hong Kong. This, if implemented, will lead to a "win-win-win" situation.

First, it provides a direct channel for Qianhai firms to tap cheap offshore yuan funding, thereby enhancing their operating margin.

Second, the establishment of a new attractive avenue for yuan fund investments for Hong Kong's banks will boost their yuan lending business, the growth of which has far been lagging behind that of other offshore yuan products.

For instance, the outstanding of Dim Sum bonds has ballooned over six-folds to about 300 billion yuan (US$ 47 billion) last year. In contrast, the total outstanding local currency loans worth 42 billion yuan are merely a fraction of the 554 billion yuan pool offshore.

Third, deposit competition amongst banks will subsequently exert upward pressure on the offshore yuan deposit rates, which will in turn facilitate the growth in Hong Kong's yuan deposit. It will help boost yuan circulation in the offshore market.

With respect to the securities sector, the authorities will push forward joint ventures for stock exchanges in Hong Kong, Shenzhen, and Shanghai. Getting exchange traded funds to be listed on both Hong Kong and mainland stock markets is also on the agenda.

The regulatory bodies will also lower the threshold for Hong Kong financial institutions to invest in the mainland security under the qualified foreign institutional investor scheme.

Prudent manner

Nonetheless, the trial scheme is likely to be carried forward in a prudent manner to avoid unforeseen negative consequences. As such, a quota system will be adopted in its initial stage.

Meanwhile, to strengthen financial cooperation between Hong Kong and the Pearl River Delta, companies from Hong Kong will be allowed to set up consumer-finance arms in neighboring Guangdong province.

Although details of such plans are yet to announce and the scale of the moves seems to be limited, it highlights the determination of China to open up the capital account orderly alongside reinforcing Hong Kong's status as a financial center globally.

Deepening utilization of the offshore market subsequently increases Hong Kong's yuan liquidity, which has been recently showing signs of flagging due to narrowing spread of offshore-onshore yuan, and a more balanced cross-border trade.