Easing the reins on money flows

PUBLISHED : Friday, 28 April, 2006, 12:00am
UPDATED : Friday, 28 April, 2006, 12:00am

The arguments in favour of China drastically relaxing its capital controls are compelling. The mainland has become a major exporter of capital in recent years. Thanks mainly to its consistently large current-account surplus, it must export capital either by purchasing securities denominated in foreign currencies - to build up its foreign reserves - or by allowing domestic companies and private individuals to acquire foreign assets with fewer restrictions.

But, so far, China's export of capital has been mostly state-driven, resulting in rapid increases of foreign reserves. However, the recent policy initiative unveiled by the People's Bank of China - aimed at facilitating outward Chinese investment - suggests that Beijing is ready to relax capital controls earlier, and at a faster pace, than expected. If so, this will have many positive effects.

Another reason why China will remain an exporter of capital for the foreseeable future is the high savings rate among consumers. This situation - and the investment excesses it fuels - will persist for a long time. But the risk is that state-led investment, and the inefficient allocation of resources, will depress private demand, resulting in low-quality economic growth.

On the surface, China's first-quarter growth of 10.2 per cent and continued low inflation suggest the economy is in an enviable state. But the growth continues to rely on fixed-asset investment, which rose at a blistering pace of 27.7 per cent in the first quarter. Meanwhile, according to the central bank's survey, consumers' willingness to spend has declined for the third consecutive quarter.

The question is what should - or can - policymakers do to redress such imbalances and promote more sustainable growth? Monetary tightening is an easy choice, but it would not tackle the fundamental problem of local governments' strong desire to pursue faster economic growth in their areas. Moreover, this entails its own risks - namely, in the banking sector: yields for three-year and five-year government bonds are barely above one-year deposit rates. If the central bank slams on the brakes too hard by raising interest rates, banks could immediately face large losses from their higher short-term borrowing costs when their long-term lending rates remain low.

What, then, is the best available policy option for improving the allocation of resources? The answer is a much faster pace of capital-account liberalisation - easing restrictions on capital flows. This is the most effective way to rein in fixed-asset investment and ease the persistent upward pressure on the yuan.

More importantly, as the central bank advocates, such liberalisation would make China's foreign-exchange market deeper by 'storing foreign reserves among individuals rather than in the state'. This would enable the central bank to scale back its intervention in the foreign-exchange market, which should silence foreign critics.

The easing of capital controls should be meaningful as well as gradual, and the central bank's latest measures are much bolder than previous ones. Individuals will be able to purchase up to US$20,000 a year in foreign currency; domestic banks will be allowed to tap into less risky fixed-income instruments overseas; and domestic institutional investors will be able to invest in foreign equities.

Hopefully these measures, which begin on May 1, will be implemented smoothly. A faster pace of capital-account relaxation promises the best way to improve investment returns for China's domestic capital - and thereby ease the economic imbalances that are increasing the risk of a hard landing.

Steven Sitao Xu , an economist by training, is the Economist Intelligence Unit Corporate Network's director of advisory services in China