Over the last two years, the strength and resilience of the Chinese economy, in the face of the worst global economic and financial crisis the world has experienced in nearly a century, has been exemplified by its continued inexorable build-up of reserves. These now amount to over $3.2 trillion?despite the impact of the post-Lehman financial crash of 2008 and the rapid deterioration in the economic circumstances of its two largest export markets, the US and the EU. This massive build-up of surplus capital, which it seems unable to use for its own needs, has led China to open its currency market through administrative measures.

My April visit suggested that China is deeply concerned that using the exchange rate adjustment policy tool would destabilise its labour and wage markets. After all, the key Chinese imperative to ensure its success as an export power has been to manage (manipulate?) its exchange and wage rates so as to import jobs from, and export goods to, the rest of the world for as long as the rest of the world permitted China to get away with it. And, so far, the rest of the world has done just that. In the process, China has built up reserves of over $3.2 trillion, which are likely to grow at 10-20% annually. Such unprecedented, large global reserves?perversely reflecting the limitations and dysfunctionality of China?s state-owned financial system?and the way in which they are managed, now pose an economic and political threat to the rest of the world.

Consequently, China has arrived at the stage where it has no option but to liberalise its currency market and export capital a little more easily in one way or another. It is choosing to do so through administrative measures, such as bilateral CNY swaps. Until this month, China had focused these swaps in local currencies of major emerging market trading partners, and not with developed market partners such as the US and the EU. But, a couple of weeks ago, China announced that it would do CNY:JPY swaps with Japan, a developed and large trading partner.

Partial capital account liberalisation is also being attempted through the gradual opening of the CNY (dimsum) bond-market in Hong Kong, which has taken off faster than the Chinese authorities seem comfortable with, rather than via traditional open market measures. These measures lead to a number of interesting interim possibilities before full and traditional capital and currency market liberalisation is undertaken.

What are the implications of the latest Chinese measure to introduce CNY:JPY swaps?

They are not likely to be significant immediately as few internationally traded contracts are denominated in either CNY or JPY. The same arrangement for CNY:USD or CNY:EUR would have been more globally significant and would have led to CNY internationalisation more quickly. However, the question raises some interesting possibilities where China-Japan, China-Asean and Japan-Asean trade is concerned. Triangulation on trade and trade-related long-term investment among these three large trading blocs/players (more if one includes Korea and Taiwan) holds out interesting possibilities for the growth of Asian markets in regional currency trades and derivative hedges. Also, Japanese multinationals are major investors in Chinese export production, which is linked to their own export production for global markets, in innumerable and intricate ways. If the CNY:JPY arrangements stabilise the influence of currency fluctuations on such bilateral and pass-through trade then the CNY/RMB will benefit and internationalise faster.

Of course, all that depends on how the Asian/Asean markets perceive future movements in the CNY/RMB and JPY in the short, medium and long term. As a long-term hold, the RMB seems more attractive than the JPY, which is a weak currency issued by a very heavily indebted country that is dying slowly demographically and is a waning global economic power in relative terms. Exactly the opposite is the case for China and the CNY/RMB. But long-term currency holds are for investors not traders. And China is denying the world full market access to probably the most significant currency num?raire for long-term investment over the next 30 years.

In the short and medium term, it is difficult for markets to predict what will happen to the value of the CNY relative to other currencies (especially the USD, EUR and JPY) because of administrative intervention. If currency markets were left alone, the CNY would appreciate significantly against all three, despite the arguments now being made that the CNY has found its real effective equilibrium rate and does not need appreciation. Anyone who believes that, does not understand currency markets. Right now, the JPY is an international currency that seems to be overvalued, taking Japan?s underlying fundamentals and economic prospects into account. Yet it is widely held in central bank reserves, though used to a more limited extent than should be the case, for Japan?s trade contracts with its various trading partners which, unfortunately, are still denominated more in USD than in JPY.

The Chinese authorities could of course internationalise the CNY faster and more efficiently by opening up their capital markets in a phased fashion and making the CNY at first (to 2016) a partially and then (2017 and beyond) a fully convertible currency. They are doing it instead in a clumsy, administratively burdensome fashion in the belief that going that route will result in more ?control? over the pace of internationalisation. A key concern is that this administrative approach (akin to the route that Indian bureaucrats love to take in the wrong-headed belief that their control somehow results in better outcomes despite substantial evidence to the contrary) will lead to a series of significant anomalies and distortions of the kind that usually arise with administrative intervention and an aversion to letting markets do what they do best?i.e. price discovery. Those anomalies and distortions will damage the world even more at a time when the global economy is singularly fragile.

Yet, the CNY is inevitably heading towards becoming a global currency. Indeed that outcome has been delayed too long. For the world?s second-largest economy, and its second-largest trading economy, to continue having a closed capital account, and a non-convertible currency with a fiat-determined price, is an intolerable anomaly that has damaged the world and provides an unfair structural advantage to China. Oddly, China has been permitted by the world trading community to play by its own rules to its own advantage (and to the considerable detriment of the rest of the world) for too long, by asserting the right to control the most significant price affecting its trade with the rest of the world i.e. the price of its own currency. In an open economy global trading model, world trading patterns, and consequently global investment patterns, as well as global production locations and market share, are all supposed to be determined/equilibrated (i.e. with trade, current and capital account surpluses and deficits?or imbalances?being sorted out) by markets and not by administrative interventions, with market forces being left to adjust all prices, including currency prices, that affect global trade.

When China respects the notion that market prices should determine the prices of all inputs and outputs that make up the cost of its production, but then asserts the right to control a key price (i.e. the price of its currency), which in turn affects the price of imports from China by other countries, it violates a fundamental precept of the open economy global trading model. The sustained violation of that principle for two decades has in large part been responsible for bringing the global economy to its knees, while allowing China to accumulate extreme reserve surpluses that now pose a fundamental political and economic threat to the rest of the world.

In the post-Bretton Woods world, China is the most egregiously anomalous case of a country (misusing the developing country argument) becoming as significant as it is in the world economy without being obliged to open its capital account and make its currency convertible. All the other rising economies in the 1960s & 1970s (Germany, Japan and several smaller European economies), and 1980s & 1990s (Korea, Singapore, Taiwan, some Asean and most Latin American economies) made their currencies convertible and opened their capital accounts. They did not suffer any of the kind of damage that China claims it would suffer if it did the same. Essentially, what China seems to be asserting through its currency management policy is the divine, inalienable right to import jobs from, and export manufactures to, the rest of the world indefinitely by manipulating the price of its currency. That cannot be permitted to continue given the devastating impact such a policy has had on the rest of the world. The CNY must be internationalised sooner rather than later in a market-oriented manner.

If that is the case for the CNY, then what about the future of the INR? As the next largest emerging global economy after China, shouldn?t the INR follow a similar trajectory? That question is dealt with in the next and final part (Part 3) of this tripartite series.

This piece is the second of a three-part series.

The author is chairman, Oxford International Associates Ltd