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Symposium 2013

Proposal - China’s experience in capital account liberalization

The Challenge

The global financial crisis has revealed regulatory failure in financial markets and demonstrated the urgent need for reform. In particular, it is now widely accepted that in addition to established m ...

The global financial crisis has revealed regulatory failure in financial markets and demonstrated the urgent need for reform. In particular, it is now widely accepted that in addition to established microprudential policies, macroprudential policies aimed at increasing the stability of the financial sector as a whole are imperative. But an active debate has emerged over what role the central bank should play with this augmented set of policies.

In February 2012, the PBOC released two policy research reports, in which there are four arguments deserving noticing. First, China is in a period of "strategic opportunity" for capital account liberalization and hence China’s capital account liberalization should be accelerated. Why? This is the time that “China can take advantage of lower valuations for Western companies”.1 Second, there will be no large risks, if China opens its capital account. In an interview, the author of the reports told the correspondent that "(t)he risk to take the move is not big," citing little likelihood of currency mismatch in commercial banks' assets and liabilities after opening the capital account, and limited effects of price changes on foreign reserves that were largely invested in bonds. According to the reports, the country's short-term external debt balance only takes a small share of total, debts and hazards posed by its property and capital markets are controllable.2 Third, the traditional view on the sequencing of capital account liberalization does not apply to China. The liberalization of interest rate, exchange rate and capital account can be implemented at the same time “in a coordinated way”. Fourth, there should be a timetable for the liberalization of capital account. Why? "There may never be a proper timing for pushing the reform, if the country waits until conditions mature for the interest rate and exchange rate to be decided by the market, the chance for capital account liberalization may have already missed."3

Recently, some officials from the PBOC went as far as saying that without the liberalization of capital account, there will be no liberalization of interest rate and exchange rates. In other words, the liberalization of capital account is a prerequisite for interest rate and exchange rate liberalization, not other way around. For example, in those officials’ view, if capital account is not liberalized, the exchange rate decided by current account balance (plus long term capital flows, perhaps) is not a truly market-determined exchange rate.4 It is argue that if domestic interest rates remain controlled by the government, with liberalized capital account, massive interest rate arbitrage will make the control of interest rates too costly and hence the government would be forced to allow interest rates to rise and fall in responding to market conditions. The same logic is applied to the exchange rate.

The aim of capital account liberalization is to push the reform of China’s financial system, interest rates and the exchange rate so as to complete China’s institutional reform. When asked why capital account liberalization is so important for China’s domestic financial reform? Chinese economists would invoke China’s experience in the WTO entry. The implementation of the rules and regulations stipulated by the WTO helped the Chinese government to overcome the resistance of interest groups to the reform of China’s production and trade systems. However, for skeptics, whether the full capital account liberalization will achieve similar results is questionable.

Over more than two decades’ pursuance of export-led growth and FDI attraction policy, China has ended up with becoming an economy with a very large exporting sector and foreign exchange reserves. This growth strategy has run out of steam and left lots of problems. Despite the fact that this growth paradigm should be changed long time ago and economists have been debating this issue for more than 10 years, the adjustment began only belatedly and has proceeded in a very slow pace. Due to the strong opposition of vested interests and the prevalent misconception among the public, it is difficult to tackle key problems such as exchange rate appreciation head on. As a result, the PBOC chose a round about way. Instead to solve exchange rate issue once for all, as most countries did in their road to become developed countries, China chose to encourage capital out flows when the renminbi appreciation expectations were strong, then to use renminbi internationalization to promote capital account liberalization, and now use capital account liberalization to build pressure on financial reforms including reforming the exchange rate regime.

In early 2012, the People’s Bank of China (PBOC) released a report calling for policymakers to take advantage of a “strategic opportunity” to accelerate capital-account liberalization. Shortly after the release, QFII quotas were relaxed significantly. Later, the RQFII quota was raised 50 billion yuan in April 2012, and the quota was raised to 270 billion yuan in November 2012. The release of the report marked a turning point in the PBOC’s strategy. The most important argument use to support capital account liberalization is that without capital account liberalization, it is difficult for China’s to reform China’s financial market, to pursue marketization of interest rates and exchange rate.

Now the question is in what sequence and how fast China should open up its capital account. PBOC officials dismiss the “impossible trinity” and “sequencing” of capital liberalization as irrelevant to China’s reality. The PBOC argued that capital account liberalization and interest rate and exchange rate liberalizations can be implemented abreast in a coordinate way, and these three liberalizations will be reinforced each other. They firmly believe that without capital account liberalization, there will be no right exchange rate in the foreign exchange market. Free floating without free flows of cross-border capital, the exchange rate is not a truly market-determined exchange rate. The crust of the PBOC’s argument is that without external shocks created by cross-border capital flows, Chinese financial institutions, non financial institution and government departments will never find enough motivation to carry out necessary reforms. China’s entry into the WTO is a frequently cited analogy. The PBOC now is signaling to the market that its has a time table for capital account liberalization. It is said that capital account will be liberalized in 2015 and the renminbi will be made fully convertible in 2020.

While supporting the eventual fully liberalize China’s capital account, many in China see no reason to rush for such liberalization. First, China needs capital controls to retain monetary-policy independence until it is ready to adopt a floating exchange-rate regime. Without adequate controls on short-term cross-border capital inflows, the PBOC will find it difficult to maintain monetary-policy independence and exchange-rate stability at the same time.

Second, China’s financial system is fragile, and its economic structure rigid. Hence, the Chinese economy is highly vulnerable to capital flight. In recent years, China’s financial vulnerability has been rising, with enterprise debt estimated to exceed 120% of GDP, and broad money supply (M2) amounting to more than 180% of GDP. Without capital controls, an unforeseen shock could trigger large-scale capital flight, leading to significant currency devaluation, skyrocketing interest rates, bursting asset bubbles, bankruptcy and default for financial and non-financial enterprises, and, ultimately, the collapse of China’s financial system.

Third, China’s economic reforms remain incomplete, with property rights not yet clearly defined. Amid ambiguity over ownership and pervasive corruption, the free flow of capital across borders would encourage money laundering and asset-stripping, which would incite social tension.

Finally, the Fed is considering exit from QE policy. Tapering will lead to the rise in US interest rates, which in turn will cause large capital exodus from developing countries to the US. Experience shows that whether there is a major rise in the US interest rates, more often than not, some sorts of financial crisis will happen in developing countries. Now the Fed has yet to exit, many Ems has suffered from capital outflow, devaluation of their national currencies. Despite China’s strong external position and large foreign exchange reserves, the possibility of large capital outflows from China cannot be ruled out. Taking into consideration its financial fragility, without the firewall of capital control, whether China can endure a large scale of capital outflows triggered by the Fed tapering is questionable.

In sum, with China’s financial system too fragile to withstand external shocks, and the global economy mired in turmoil, the PBOC would be unwise to gamble on the ability of rapid capital-account liberalization to generate a healthier and more robust financial system.


[1] Time right for China's capital account, Xinhua, English.news.cn, 2012-02-23; China Daily, February 24, 2012.

[2] Ditto.

[3] China Facing 'Strategic Opportunity' to Open Capital Account, wall street journal, June 30, 2012.

[4] Conference on Renminbi internationalization, Boyuan Foundation, 30 June, 2013

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