CAC is the freedom to convert local financial assets into foreign financial assets and vice-versa at market-determined rates of exchange.

With reserves of US$853.7 billion (Bt32.5 trillion) and strong headline growth in gross domestic product, market watchers say China should pursue a quicker pace of capital-account liberalisation (the easing of restrictions on international capital flows).

"However, the [Chinese] government has been taking a cautious approach so far. In contrast, India's Prime Minister Manmohan Singh recently pushed for a road map for his country's full CAC, even though India has started off on the economic reform path much later than China," DBS said.

The main reason for China's cautious approach towards CAC is the fragility of the local banking sector. Despite past reform, including the recapitalisation of state banks, introduction of new accounting standards, and the establishment of four asset-management companies, the most important area - the pricing of risk or interest rates - is still strictly controlled by the central bank, DBS said.

If capital account regulations are liberalised without lifting interest rate controls, foreign and domestic capital may simply flood into asset markets, thereby sparking an asset-price spiral, the bank predicted.

"Currently, the slow pace of interest rate liberalisation has prevented banks from charging an appropriate risk premium to borrowers. Moreover, as lending rates do not reflect the degree of capital scarcity, misallocation of resources is the end result," the bank said.

In addition, the efficiency of capital investments has fallen by more than half, with China's incremental capital-output ratio rising to five in 2005 from 3-2.5 in the early 1990s.

However, interest rate deregulation is not easy to achieve due to strong political resistance from banks and their major debtors, mainly state-owned enterprises.

"As such, CAC will not be easily achieved before 2008, even if all key state banks are successfully listed by the end of 2006. As a benchmark, international experience suggests that the gap between current-account liberalisation and CAC is around 20 years.

"There is still a long road ahead for CAC in China, given that full current-account liberalisation was only attained in 1996," the bank said.

DBS Bank predicted that China's foreign reserves may reach $1 trillion by end of the year. The bottom line, however, is that internal economic conditions and the strong external position are not on an equal footing.