China in Transition

China Should Be Cautious in Promoting Capital Account Liberalization:
Tightening of capital controls may still be needed in times of emergency

Chi Hung KWAN
Consulting Fellow, RIETI

Facing a massive outflow of capital and the downward pressure on the exchange rate accompanying it, China has recently tightened capital controls (Note 1). This represents one strategic step backward from its long-term goal of capital account liberalization, which, to be achieved successfully without major disruptions, should be preceded by market-oriented reforms in the financial sector and the foreign exchange rate system.

Pros and cons of capital account liberalization

In principle, citizens of countries with free capital movements face a wider choice of vehicles to invest and thus have more room for portfolio diversification. Capital account liberalization would also enable corporations to raise capital in international markets at a lower cost. In the case of China, the following factors also call for a faster pace of liberalization.

First, the government is promoting a wider use of the renminbi (RMB) as an international currency (or "internationalization of the RMB"), which presupposes the existence of deep, liquid, and open capital markets in China.

Second, China is promoting outward foreign investment in an effort to develop new markets and facilitate the acquisition of technology and resources from abroad. Toward this end, restrictions hindering the free flow of capital across national borders need to be removed.

Third, the effectiveness of regulations on capital transactions has declined because of the widespread use of illegal means such as disguising capital transactions as current transactions to get around them.

On the other hand, economists and policymakers have come to recognize that, for developing countries with immature financial markets, capital account liberalization should be pursued carefully because it could destabilize the economy.

First, there seems to be a strong correlation between capital account liberalization and the incidence of financial crises. The Asian financial crisis in the late 1990s, for example, clearly showed that the consequences of liberalizing capital account transactions at a premature stage when banks' risk appraisal is inadequate and monetary control is difficult could be disastrous.

Second, capital controls should be considered as emergency measures to prevent systemic risks when speculation threatens the soundness of the financial system and deprives the government of tools of macroeconomic management. For example, the introduction of capital controls helped Malaysia overcome the Asian financial crisis.

Third, capital account liberalization may imply a loss in policy-autonomy for economic policymaking, particularly under a fixed exchange rate system. As the "impossible trinity" theory in international finance advocates, it is impossible for any country to achieve the three goals of free capital flow, an independent monetary policy, and a fixed exchange rate at the same time. To maintain a fixed exchange rate in the face of massive capital flow, large-scale intervention in the foreign exchange market is needed, making it difficult for the monetary authorities to control the money supply.

These factors are particularly relevant to China, which is still halfway in its process of economic development and transition from a planned economy to a market economy.

First, China's financial system is fragile. In recent years, China's financial vulnerability has been rising, with corporate debt rising sharply and financial risks concentrated in the banking system. Without capital controls, an unforeseen shock could trigger large-scale capital outflow, leading to a financial crisis.

Second, although China has shifted from a de facto U.S. dollar peg system to a managed floating system in 2005, the RMB rate is still very much under the control of the monetary authorities through interventions and other means. China needs capital controls to retain monetary-policy independence until a freely floating exchange-rate regime is put in place.

Third, with insufficient protection of property rights and corruption still pervasive despite the government's determination to curb it, capital account liberalization would encourage capital flight and money laundering.

Finally, as part of the process of exiting from the quantitative easing (QE) policy adopted after the Lehman Brothers crisis, the U.S. Federal Reserve has started to raise interest rates, which has caused large amount of capital flowing from developing countries to the United States. Despite China's strong external position as a net creditor country, with the world's largest foreign exchange reserves, it is also facing significant outflow of capital and downward pressure on its currency.

The sequencing approach to capital account liberalization

One implication of the above analysis is that the liberalization of a country's capital account should not outpace the strengthening of its domestic financial sector. The literature on the sequencing of economic reform can be applied to study how capital account liberalization should proceed in China.

First, China should liberalize interest rates before fully opening the capital account. Capital account liberalization may lead to massive capital outflow if domestic interest rates continue to be suppressed artificially to low levels. Fortunately, much progress has already been made in interest rate liberalization in China, with both the ceilings and floors on bank lending and deposit rates completely abolished. A deposit insurance system has also been established in preparation for the collapse of banks affected by intensified competition as a result of the liberalization of interest rates.

Second, to maintain an independent stance of monetary policy in the face of rising capital mobility, China has no choice but to shift to the floating exchange rate system. This process will not be complete until the monetary authorities stop announcing the daily benchmark mid-rate of the RMB and refrain from intervening in the foreign exchange market.

Third, China should improve the domestic financial system in order to maintain financial stability. To reduce the risk facing banks, efforts should be devoted to develop indirect financing through capital markets. China's stock market is highly speculative because most transactions are carried out by individual investors. Increasing the share of institutional investors should enhance market stability. At the same time, the corporate governance of banks and borrowers, particularly state-owned enterprises, needs to be strengthened. Furthermore, China needs to build a prudential regulatory regime that also covers the rapidly expanding shadow banking sector to avoid asset bubbles.

Fourth, China should adhere to its cautious stance on capital account liberalization, which has helped absorb foreign capital while maintaining economic stability. This involves liberalizing (1) capital inflows before capital outflows; (2) long-term transactions before short-term transactions; (3) direct investments before portfolio investments; and (4) investments by institutional investors before investments by individual investors.

Should China commit to these reforms and be able to maintain steady economic growth without being interrupted by any major financial crisis, the size of its economy in terms of gross domestic product (GDP) should exceed that of the United States in about 10 years. By that time, the RMB will become a fully convertible currency widely used not only in neighboring countries, but also in other parts of the world.

The original text in Japanese was posted on February 15, 2017.

  1. ^ Capital control measures implemented since 2016 includes the following: (1) limit the amount of cross-border outflow of yuan through banks to a certain percentage of the amount of inflow, and instruct the selling of foreign currencies by banks not to exceed the buying of foreign currencies; (2) limit the loan that the local subsidiary in China of a foreign company lends to the head office to 30% of the shareholders' equity; (3) require enterprises to report regularly on the plan and the actual result of foreign currency purchases; (4) require the reporting in advance of large amount overseas remittances; (5) prohibit the prepayment of debt in foreign currencies, in principle, (6) require the approval in advance of overseas investments such as corporate M&A and the exchange of foreign exchange amounting to $5 million or more per case; (7) require the submission of an application form for foreign exchange and a declaration of the use of funds by individuals; and (8) limit the purchase of insurance products for investment purposes in Hong Kong and overseas ("China Steps up Efforts to Stop Capital Outflow," Nihon Keizai Shimbun on January 6, 2017, and "China Limits the Amount of Outflow of Yuan Overseas," Nihon Keizai Shimbun on February 1, 2017). Some of these regulations have not been formally announced but have been communicated through verbal notification by the authorities.

February 28, 2017