By Zhang Ming
BEIJING, June 19 (Xinhuanet) -- At present, the debates on whether to speed up capital account openness are pretty intense in China. Looking at the recent posturing of the monetary officials, those in support of capital account liberalization appear to have got the upper hand. There are market rumors that the Chinese government will implement a basic liberalization of capital accounts in 2015, and a full liberalization in 2020.
However, in my opinion, China should only liberalize capital accounts in a gradual, cautious, and controllable manner. Analyzing the eight main reasons given for supporting China’s capital account liberalization, it is not hard to find them paradoxical.
The first myth: current capital account controls are ineffective; as they are ineffective, they might as well be opened up.
Indeed, although the Chinese government has not yet fully opened up capital accounts, in recent years the size of international capital flows faced by China has significantly enlarged, and their volatility has also increased. However, this does not mean China’s capital account controls are invalid. In fact, recently, most empirical literature studying China’s capital account controls reveals that, although there are some loopholes in China’s capital accounts, on the whole they are still effective. There are significant interest rate differentials and exchange rate differentials in the mainland and offshore RMB markets, which proves that China’s capital account controls are still effective. In addition, the covered interest rate parities in the mainland and offshore RMB markets are obviously different, which means that the cross-border arbitrageurs still face large transaction costs, and this shows the effectiveness of capital account controls.
The second myth: accelerating capital account liberalization contributes to optimize the allocation of resources.
In principle, this judgment is not problematic, but in the real world, there are two challenges: firstly, in a longer time-horizon, relaxing capital account controls may not be able to promote economic growth. If a country’s financial system is vulnerable, opening up its capital accounts too fast is likely to lead to the outbreak of financial crises, which will damage the optimal allocation of resources.
Secondly, capital account openness and financial market liberalization are usually parallel. And relevant research indicates that only when a country’s financial market develops to a certain “threshold” level, will the financial openness (capital account openness) be able to promote economic growth (the optimal allocation of resources).
The third myth: speeding up capital account openness, and especially accelerating capital outflows, will help to ease upward pressure on the RMB.
This is perhaps the most important reason for China’s central bank to support relaxing capital account controls. When short-term international capital fluctuates frequently, and its scale and volatility are significantly enlarged, relaxing capital account controls may aggravate the fluctuations of the RMB against major currencies.
For example, in the first quarter of 2013, loosening capital account controls have meant accelerating the RMB’s appreciation against the dollar. In addition, in view of China’s current-account surplus accounting for less than 3% of GDP during the last two years, the RMB exchange rate is not far from the equilibrium level, and there is no strong demand for easing the pressure on RMB appreciation by loosening capital account controls.
The fourth myth: accelerating capital account liberalization helps to force structural reform domestically.
Some supporters claim that, since domestic reforms have entered a stage of reform of inventory issues, it has been difficult to promote structural reform domestically due to the obstruction of vested interest groups. Therefore, accelerating capital account reform helps to introduce external pressure to promote domestic reform, which is known as “promoting reform by opening up”. It is a great example that China’s accession to the WTO has successfully promoted banking reform. However, “promoting reform through opening up” cannot apply at all times, all stages and on all issues. Forcing matters can cause both good and bad results. For example, under the premise of China’s financial market not yet opened up to domestic private capital, rashly opening up to the outside world will result in private financial institutions losing the space to grow and develop under the squeeze of state-owned financial institutions and foreign financial institutions.
Speeding up capital account openness, of course, is helpful for further promoting the marketization of the exchange rate and interest rate; but it is hard to believe that capital account liberalization can significantly promote the reform of income distribution domestically, as well as some structural reforms such as breaking up the monopoly of state-owned enterprises in some service sectors.
The fifth myth: accelerating capital account openness contributes to promoting the internationalization of the RMB.
Capital account liberalization and currency internationalization are two sides of the same coin, but the problem is why should the Chinese government vigorously promote the internationalization of the RMB? Can the internationalization of the RMB bring welfare improvement for China’s economy at this stage?
I am dubious about it.. International financial history shows that currency internationalization is the result of market selection, rather than government pushing. Under the premise of domestic financial markets having not yet developed to a certain level, and interest rates and exchange rates formation mechanisms remaining twisted, promoting the internationalization of the RMB, in fact, means encouraging residents and non-residents to undertake cross-border arbitrage through the exchange rate differential and interest rate differential of the mainland and offshore markets, which is not true currency internationalization.
In the final analysis, whether the RMB can become a truly international currency in the future depends on the sustained and rapid growth of China’s economy in the next 20 years, the sustained development of China’s financial market and the avoidance of the outbreak of systemic crisis. Accelerating capital account openness may damage the stability of China’s macroeconomic and financial markets, and over the medium and long term, speeding up capital account openness may not be able to truly promote the internationalization of the RMB.
The sixth myth: accelerating capital account liberalization does not need to follow a fixed order, and can be promoted in parallel with the market-oriented reforms of the exchange rate and interest rate.
Both the practices of emerging market economies opening their capital account and the theory and empirical research of international economic circles show that capital account openness not only needs to follow a specific order, but also requires certain preconditions. Without the interest rate and exchange rate formation mechanisms being fully market-oriented, opening up the capital accounts will bring frequent and large-scale cross-border arbitrage activities, which will exacerbate the accumulation of this country’s financial risks and cause the loss of national welfare.
In my opinion, there must be three prerequisites for China to fully open its capital accounts: the market-oriented reform of the RMB exchange rate formation mechanism should be basically complete, the market-oriented reform of the RMB interest rate should be basically complete, and China’s financial market should basically realize a full openness to private capital. However, these three prerequisites have not yet been achieved, and in particular the processes of interest rate liberalization and financial market opening to the interior are significantly behind the pace of the marketization of the exchange rate formation mechanism.
The seventh myth: it is a strategic opportunity for China to speed up capital account openness.
The logic of this judgment is that the outbreak of the international financial crisis has resulted in the decline of the capital market valuation of developed countries, which provides a time window for cross-border mergers and acquisitions for Chinese capital. However, because of the following three reasons, there is currently no strategic opportunity for China to accelerate capital account openness. Firstly, the central banks of developed countries such as the United States, Japan, Europe and Britain have been carrying out a new round of quantitative easing policy, which causes increased global liquidity; while many emerging market economies have already been facing sustained and massive short-term capital inflows. Secondly, in this context, some emerging market economies such as Brazil and South Korea that opened their capital accounts in the past have recently also readopted some tools for managing capital movements to cope with large capital inflows. Thirdly, IMF, which is responsible for promoting capital account liberalization, has also changed its view on capital account management, meaning that capital account management should become an important tool for emerging market economies to manage international capital movements with macroeconomic policies and macro-prudential supervision.
The eighth myth: China’s huge foreign exchange reserves are sufficient to deal with the risk after opening capital accounts.
The indicator of foreign exchange reserves/M2 suggests that China’s exchange reserves are not abnormally high. Taking into account that China’s household savings are about 60 trillion Yuan, and assuming that capital accounts open overnight, and China’s residents try to transfer a quarter of their savings to make diverse investment overseas, this would mean that 15 trillion Yuan would flow outwards and China’s foreign exchange reserves would fall by more than 60% in the short period.
In addition, considering that the domestic property rights reform has not been completed and there are still uncertainties in the process of institution evolution, once domestic capital massively outflows this is likely to lead to a sheep-flock effect. Thus, what is truly worrying is the outflow of capital, rather than the inflow of hot money.