Led by Finance Minister Masajuro Shiokawa, senior Japanese officials have repeatedly urged China to appreciate the yuan and further liberalize capital account transactions. Japan is making the same demands to China as the United States made to Japan around the mid-1980s through the "Yen-Dollar Committee" and the "Plaza Accord." However, it should be understood that the current strength of the Chinese economy is a far cry from that of Japan in the mid-1980s, and when it comes to opening up its financial sector, its fundamentals are more in line with those of Japan in the early 1970s. In other words, Japan moved from a fixed rate system to a floating rate system after the Nixon Shock of 1971, and full-scale liberalization of capital transactions had to wait almost another decade, until the Foreign Exchange and Foreign Trade Control Law was amended in 1979 and implemented in December the following year. In China, also, the appreciation of the currency should come first, and the liberalization of capital transactions should remain a mid-to-long term target.
As the Asian financial crisis of 1997 shows, developing countries with weak financial sectors need to take a cautious approach toward liberalizing capital transactions. China managed to avoid a crisis, but this was not because the domestic economy and financial markets were sound, but largely because capital transactions were strictly regulated and depositors believed that banks were protected by government guarantees. In fact, as symbolized by the very high ratio of non-performing loans, it is now a well-known fact that China's banking sector is as weak as that of the Asian countries that were hit by the crisis. Domestic banks will likely face more difficulties as China's entry into the World Trade Organization leads to a full-scale influx of foreign-owned banks, triggering further competition in the banking sector.
It would be dangerous for China to rush to liberalize capital transactions without paying heed to the weakness of the domestic financial system. In particular, if the movement of short-term capital is liberalized, it would exacerbate the expansion of an economic bubble, as huge amounts of "hot money" from overseas would pour into real estate and stock markets. A subsequent reversal in the direction of foreign capital flow could give rise to serious non-performing loan problems and cause the bubble to burst. On the other hand, the full-scale foray of foreign banks into China upon its WTO entry is gradually eroding the predominance enjoyed by state-owned banks, further increasing the possibility of depositors making a run on these financial institutions. In order to cope with such situations, China would have to print more money at the cost of surging inflation or to accept harsh conditions imposed by lenders in case it has to seek assistance from international organizations. In either case, China's economic development would suffer a major setback.
If capital transactions are to be liberalized without causing financial instability, the following preconditions must be in place. First, capital markets need to be developed further so that companies can procure funds through direct finance and correct their excessive dependence on banks. In addition, banks themselves must swiftly establish better corporate governance through privatization and organizational reforms, while at the same time reforms at their borrowers - state-owned corporations - must also be accelerated. Finally, the government must guarantee deposits to a degree while keeping moral hazard at bay by bolstering its regulation of the financial system and its supervision of banks.
So far, China has been reforming and opening its economy simultaneously. As for the financial sector, it should now concentrate on reforms but be more cautious with liberalizing capital transactions. A financial crisis could occur if these policies are implemented in the wrong order. For Japan, whose economic ties with China have deepened through trade and direct investment, such a situation will certainly have negative repercussions on its economy. As this shows, demanding China to liberalize capital transactions is not necessarily in line with Japan's interests.
