The 4.3tr yuan cost of financial openness

That's the net outflow from the mainland if Beijing were to scrap capital controls, the International Monetary Fund's number crunchers estimate

PUBLISHED : Tuesday, 01 October, 2013, 12:00am
UPDATED : Tuesday, 01 October, 2013, 3:02am

This column has argued ad nauseam that anyone who expects China to open up to free flows of cross-border capital will have a long wait.

But before I shut up on the topic, let's see what would happen if Beijing were to announce tomorrow that it was scrapping all its controls on capital movements.

Despite the recent opening initiatives, those controls are considerable.

"Every category of flow - whether by residents or non-residents, inflows or outflows - retains some approval requirement or quota in China," noted International Monetary Fund researchers in a recent working paper. "By comparison with other emerging markets, the existence of restrictions remains pervasive."

If those restrictions were abolished tomorrow, foreign investors would certainly sit up and take notice. With no more quotas for inward portfolio investments, and no more mandatory lock-up periods following asset sales, the big international index compilers like MSCI would announce the inclusion of China's onshore equity and debt markets in their global benchmark indices.

The volume of inflows would be dwarfed by the size of China’s investment outflows

As a result, every asset manager, pension fund and insurance company in the world that benchmarks its investment performance against an international index would have to reweight its portfolio, allocating assets to China's onshore markets.

Gauging the likely size of the resulting inflows is tricky, but in April Monitor estimated they would amount to "hundreds of billions of US dollars". That's at least 1.2 trillion yuan, or about 2.4 per cent of China's gross domestic product.

At the same time there would be outflows. At the moment, all but around 500 billion yuan of China's savings - or more than 99 per cent - must be invested domestically.

"It's hardly the optimal allocation," notes London Business School professor Avinash Persaud, who says the relaxation of controls would trigger significant outflows.

Again, putting a figure on the probable exodus is tough, but in April Monitor reckoned the capital outflow could reach 9 trillion yuan, or 18 per cent of China's GDP.

However, you don't have to accept my back-of-a-napkin sums. The financial boffins at the IMF have spent far more time and put far more brain power into estimating the likely size of capital flows should China scrap its restrictions.

They calculate that foreign investors would pump funds worth anywhere between 1.7 and 9.9 per cent of China's GDP into the onshore debt and equity markets.

Clearly the influx of so much money would risk a severe case of domestic financial indigestion.

But, warn the IMF staffers, the volume of inflows would be dwarfed by the size of China's investment outflows. They reckon a simple rebalancing of Chinese portfolio allocations could trigger outflows of between 2.6 and 7.3 per cent of GDP into global equity markets, while debt outflows could be anywhere between 10.5 and 21 per cent of China's GDP.

Even allowing for the relatively small proportion of China's stock market that floats freely, and the captive nature of much of China's domestic bond market, the IMF's researchers still estimate that gross outflows could reach 15 per cent of China's GDP.

Offset against likely inflows, that means the net movement of funds following any abolition of China's capital controls would be an outflow of between 4.1 and 8.2 per cent of GDP. That's as much as 4.3 trillion yuan, or almost US$700 billion.

To withstand such violent capital turbulence, China would need a solid banking system, highly developed capital markets and a well balanced economy. It has none.

As the IMF researchers note: "Capital account liberalisation has historically often been followed by exchange rate or banking crises."

China would be no different.