Despite fluctuations, China’s overall economic growth hasbeen stable over the last three decades, owing not only to the economy’s strongfundamentals, but also to the government’s successful management ofcross-border capital flows.
Capital controls enabled China to emerge from the Asianfinancial crisis of 1997-1998 largely unscathed, even though its financial system was atleast as fragile as those of the affected countries. The Asian financial crisispersuaded China’s leaders to shelve plans, launched in 1994, to liberalize thecapital account.
In 2002, China reinitiated liberalization efforts, liftingrestrictions on Chinese enterprises’ ability to open foreign-currency bankaccounts, and allowing residents both to open foreign-currency accounts and toconvert the renminbi equivalent of $50,000 annually into foreign currencies.The authorities also introduced the “qualified domestic institutionalinvestors” (QDII) program to enable residents to invest in foreign assets – oneof many initiatives aimed at easing upward pressure on the renminbi’s exchangerate by encouraging capital outflows. At the same time, the “qualified foreigninstitutional investors” (QFII) scheme allowed licensed foreign entities toinvest in domestic capital markets.
In early 2012, the People’s Bank of China (PBOC) released areport calling for policymakers to take advantage of a “strategic opportunity”to accelerate capital-account liberalization. Shortly after the release, QFIIquotas were relaxed significantly.
In fact, such an acceleration has been underway since thegovernment initiated renminbi internationalization in 2009. Although currencyinternationalization is not tantamountto capital-account liberalization, progress on the former presupposes progresson the latter. By allowing enterprises to choose currencies for tradesettlement, and creating renminbi “recycling mechanisms,” the governmenteffectively eased the restrictions on short-term cross-border capital flows.
Most economists in China seem to support the PBOC’s stance,citing the potential benefits of capital-account liberalization. But Chinesepolicymakers should also recognize the significant risks inherent in relaxingcapital controls.
First, China needs capital controls to retainmonetary-policy independence until it is ready to adopt a floatingexchange-rate regime. As BarryEichengreen has pointed out in the context of the post-WWII Bretton Woodssystem, capital controls weaken “the link between domestic and foreign economicpolicies, providing governments room to pursue other objectives.” Becausecapital controls capped “the resources that the markets could bring to bearagainst an exchange-rate peg,” they “limited the steps that governments had totake in its defense.” With current- and capital-account surpluses, therenminbi’s exchange rate is still under upward pressure. Without adequatecontrols on short-term cross-border capital inflows, the PBOC will find itdifficult to maintain monetary-policy independence and exchange-rate stabilityat the same time.
Second, China’s financial system is fragile, and itseconomic structure rigid. Hence, the Chinese economy is highly vulnerable tocapital flight. In recent years, China’s financial vulnerability has beenrising, with enterprise debt estimated to exceed 120% of GDP, and broad moneysupply (M2) amounting to more than 180% of GDP. At the beginning of 2012,China’s concerns centered on local-government debt, underground creditnetworks, and real-estate bubbles. Now, growth in shadow-banking activities has been added to thelist. Without capital controls, an unforeseen shock could trigger large-scalecapital flight, leading to significant currency devaluation, skyrocketinginterest rates, bursting asset bubbles, bankruptcy and default for financialand non-financial enterprises, and, ultimately, the collapse of China’sfinancial system.
A third reason to go slow on easing capital controls isthat China’s economic reforms remain incomplete, with property rights not yetclearly defined. Amid ambiguity over ownership and pervasive corruption, thefree flow of capital across borders would encourage money laundering and asset-stripping,which would incitesocial tension.
Finally, with more than $3.3 trillion in foreign-exchangereserves, China is a particularly attractive target for internationalspeculators. Owing to its underdeveloped financial system and inefficientcapital markets, China would be unable to withstand an attack akin to thosethat triggered the Asian financial crisis without the protection of capitalcontrols. Already, even without a major speculative attack, the exchange-rateand interest-rate arbitragefacilitated by renminbi internationalization have imposed significant losses onChina.
To be sure, a cautious approach should not be allowed toimpede incremental progress toward capital-account liberalization. But a broadframework for determining the timing of each policy step, based on rigorouscost-benefit analysis, is essential. While some measures that the PBOC hastaken under the banner of capital-account liberalization have turned out to beboth necessary and appropriately moderate, others may need to be reassessed andrescinded.
Today, as all major developed economies resort toexpansionary monetary policy, the global economy is being flooded with excessliquidity, and a “currency war” is looming large. As a result, short-termcapital inflows, whether seeking a safe haven or conducting carry trades, are bound to become larger and morevolatile.
In these circumstances, with China’s financial system toofragile to withstand external shocks, and the global economy mired in turmoil, thePBOC would be unwise to gamble on the ability of rapid capital-accountliberalization to generate a healthier and more robust financial system. On thecontrary, policymakers should tread carefully in their pursuit of financial liberalization.Given China’s extensive reform agenda, further opening of the capital accountcan wait; and, in view of liberalization’s ambiguous benefits and significantrisks, it should.