CHINA'S rise as an economy of systemic significance is among the most remarkable stories of the 21st century and has come to define modern international economic relations.

However, China's domestic financial depth does not match its global economic significance. Despite being the world's second-largest economy, it does not have a currency that can be used in international transactions, owing to restrictions on its capital account. Its financial integration is largely restricted to accumulation of reserve assets, while its capital assets abroad, in particular portfolio assets, remain underdeveloped.

For example, a close look at China's international investment position as a percentage of global stocks shows that China's foreign direct investment and international portfolio assets and liabilities are a tiny percentage - less than 3 percent - of total global stocks. Compare this with its foreign-exchange reserves, which account for about 30 percent of global stocks.

Policy makers acknowledge the need to develop a deeper financial sector and a currency that is widely used to settle international trade, thereby reflecting the significance of China's economic power.

Cautious journey

Deng Xiaoping championed a policy of incremental economic reform that he called "touching stones to cross the river." It is in this spirit that China is embarking on a cautious journey to reform and open up its financial market and its currency, integrating them into the international financial and monetary system.

As clusters of activities and services that connect different operators and facilitate financial transactions among them, financial centers are where China's reform measures are seen in action and where their impact can be assessed and measured.

China's financial reform, and in particular the process of internationalizing its currency and eventually making it fully convertible, binds these financial centers together and shapes their future development.

The development of Hong Kong, Shanghai, Shenzhen and Taipei as financial centers provides a picture of the complex evolution of China's financial reform, which is a policy-driven process where political considerations directly interact with market forces.

Hong Kong will remain the dominant international financial center in the region because of its well-developed regulatory system, its existing reputation as the most liberalized financial center in Asia and its unique competitive advantage over other IFCs, such as New York or London, i.e. the "China dimension."

Despite concerns that mainland authorities may expect it to make way for Shanghai eventually to become the largest yuan onshore financial center in Chinese mainland by 2020, Hong Kong is likely to maintain its competitive edge for a long time to come, irrespective of policy shifts or decisions made in Beijing. Hong Kong has the advantage over Shanghai of operating a legal and regulatory system that international investors trust.

Ample capacity

We agree with many market practitioners we talked to during the course of this research that Chinese mainland's legal system needs to be reformed in order to develop Shanghai, or any other city, as an international financial center.

Even if Shanghai is unlikely to supplant Hong Kong as the region's dominant international financial center in the next few years, the size of Chinese mainland's real economy indicates that the country has ample capacity to accommodate two major international financial centers in the longer term.

Moreover, the decision by China's State Council in 2009 to develop Shanghai as an international financial center by 2020 suggests that, by the beginning of the next decade, Shanghai may have considerably narrowed the gap that now exists with Hong Kong.

But Shanghai's tremendous market size and fairly well-developed financial market, especially in the banking and insurance sectors, give it the potential to extend its influence regionally and internationally as the liberalization of the yuan progresses.

Shanghai rose into the top five in the Global Financial Centers Index for the first time in 2011. However, perceptions on the rise of those financial centers in China have recently changed as the result of concerns about the convertibility of the Chinese yuan. Consequently, this is reflected in the GFCI's lower ranking for Shanghai this year.

For its part, Shenzhen will mainly serve as a domestic financial center, focused on the needs of small and medium-sized enterprises and start-ups located in Guangdong that currently have difficulty in obtaining credit through the banking sector.

Though not comparable with Shanghai in terms of market size or financial infrastructure, it will be at the forefront of China's experiments with its internationalization strategy for the yuan.

The newly proposed scheme allows the Shenzhen port area of Qianhai autonomy in setting preferential policies to attract financial institutions and to act as the experimental region for cross-border renminbi transactions.

Though the details of the proposal are still unclear, China hinted at the possibility of a low tax regime and free convertibility of the yuan in Qianhai.

In Shenzhen, the financial sector contributed about 13 percent of the local GDP in 2011, slightly lower than that of Hong Kong at 15 percent. This is quite remarkable considering that apart from the Shenzhen Stock Exchange, Shenzhen does not have any other exchange (such as a commodity or futures exchange) of national significance that would help attract financial activities to the city.

Taipei, on the other hand, can benefit from its experience with high-tech SMEs in the broader Asia region to target Chinese SMEs at a relatively advanced stage of growth.

Although the capital markets in Taiwan remain small relative to other centers in the region at present, further cross-Strait cooperation in the financial sector, along with Chinese mainland's financial reform process, will provide Taipei with new opportunities as a complementary regional financial center.

Division of labor

From a policy maker's point of view, the degree of cooperation among the four financial centers implies the emergence of a "division of labor," each with its own designated role.

But it is hard to see this as a sustainable arrangement, particularly once the Chinese capital account is fully liberalized. If and when the policy barriers are relaxed, market forces will ultimately lead capital resources, business and talent to cities where the market is most efficient, cost-effective and profitable, and where it is most pleasant to live. By that time, only those financial centers with a strong competitive edge that cannot be eroded by policy decisions from Beijing will find themselves at the top of the league table of international financial centers.

Building modern financial centers and an efficient national financial system in China will be fraught with challenges, and the future of these four cities is yet to be determined. In order to address some of these challenges we offer the following ideas to Chinese decision-makers:

￥ Accelerate the reform of the banking sector: Expedite the ongoing reform to develop a market-driven banking sector that adheres to international standards and regulations. Free the country's banks from welfare goals and liberalize interest rates to remove market distortions and minimize misguided investment decisions, as well as creating and reinforcing appropriate incentives and capital allocation mechanisms.

￥ Develop capital markets and reduce reliance on the banking sector for the financing requirements of the economy: Rebalance the financial sector by creating a level playing field for various types of financial institutions. Encourage greater private-sector presence in the market and fundraising through capital markets, particularly in bond markets.

￥ Increase Hong Kong's exposure to the financial systems of the BRICs and other emerging-market economies: Improve Hong Kong's international market influence in these markets and achieve a greater competitive advantage vis-?-vis London and New York.

￥ Promote greater cooperation and coordination between Hong Kong and Shanghai: Take steps to ensure that the comparative advantage of both cities is managed through effective cooperation and coordination to achieve the macro goals of China's financial reform process.

￥ Develop Shenzhen as a regional financial center: Encourage Shenzhen to serve the demand stemming from the growing number of SMEs that lack adequate credit facilities, enabling it to support entrepreneurship and indirectly contribute to the deepening of capital markets.

The article was adapted from a Chatham House report written by Paola Subacchi, Helena Huang, Alberta Molajoni and Richard Varghese. The opinions are their own.