LONDON (REUTERS) - Britain has more at stake than many other countries from a relaxation of Chinese capital controls and must be ready to cope with a tidal wave of renminbi flows over the next decade, according to a Bank of England study.
The paper suggests that China's external assets and liabilities could jump from less than 5 per cent of global gross domestic product today to more than 30 per cent by 2025.
"If China does liberalise, few other events over the next decade are likely to have more impact," said Mr John Hooley, author of the paper entitled Bringing down the Great Wall? Global implications of capital account liberalisation in China.
Britain's large and open financial system, combined with its fast-growing financial ties with China, means it is likely to be particularly affected by the expected further opening up of the Asian powerhouse to global financial markets.
Potential benefits include faster economic growth and more liquid capital markets but there is the risk that asset prices could inflate too quickly, the paper said.
"A rapid increase in liquidity from China could lead to absorption pressures in some asset markets in the short run, which could lead to a mispricing of risk with adverse consequences for financial stability," it says.
Citing examples where liberalisation brought instability - such as in Eastern Europe where large capital inflows contributed to a credit crisis in 2008 - the report warns that China will need to sequence its opening up to foreign financial markets with policies to curb excessive domestic credit growth.
"The potential changes in both the magnitude and composition of capital flows would dramatically alter the financial landscape in both China and globally," it concludes.
Britain's government is seeking to position London as the main centre outside of Asia for trading and transacting in the Chinese currency.
In October, the BoE's Prudential Regulation Authority made it easier for banks from China and other countries to open new branches in Britain. In June, the Bank of England established a currency swap facility with China, supporting yuan users by providing liquidity when needed.
"Given that Chinese capital account liberalisation could lead to dramatic changes in the global financial landscape, policymakers will be facing uncharted territory," the BoE report said.
"To succeed, policy co-operation between national authorities is likely to be necessary, both to increase understanding of the risks and to develop common policy approaches."