China must not backtrack on capital account liberalisation
Hu Shuli says the government must manage the risks involved and allow liberalisation to go hand in hand with other financial reforms
China is taking solid steps to open up its capital account, while easing control on its interest rates and currency exchange. The question now isn't how fast it can liberalise, but how to avoid the potential pitfalls of a more open system and how the process may spur wider reforms.
An open capital account will allow Chinese citizens and foreigners alike the freer movement of their assets and investments, and the free exchange of currencies.
Chinese leaders are determined to speed up the pace of liberalisation. In the government work report in March, they pledged to work towards full convertibility of the renminbi, a promise reiterated by People's Bank of China governor Zhou Xiaochuan . Zhou said the regulator has also been working to facilitate personal investments in and outside China; further open its capital market to global investors; and, revamp the regulation of foreign exchange.
These efforts are especially timely, as the International Monetary Fund could begin informal discussions as early as next month on China's application to include the renminbi in the special drawing rights, the IMF's composite currency unit.
The need for liberalisation was recognised early on. In 1993, the Communist Party's 14th Central Committee proposed to gradually allow the free exchange of the renminbi. Nevertheless, any such plans were scuttled by the Asian financial crisis that erupted several years later. The 16th committee renewed the pledge in 2003 and, a decade later, the 18th committee declared an all-out push to open up the capital markets under a sound regulatory regime.
Typically, a country takes seven years to open up its capital account after removing controls on its current account. For China, the lag is already 20 years and counting. The main reason is the snail's pace of Chinese reforms.
Chinese officials point out that China has already met at least partial or basic convertibility on more than 70 per cent of the criteria set out by the IMF. But much of the controls on the capital market remain intact.
For over 20 years, especially since 2012, opinions have been divided on capital account liberalisation. More and more people today agree that an open capital account can facilitate the global flow of capital and ensure efficient resource allocation. In China's case, it will also greatly aid the internationalisation of the renminbi, making its financial system more compatible with the country's growing stature as a major power. Yet, some have warned that if controls are removed before a sound regulatory system is in place and while reforms are stalled, the free movement of funds may accentuate cyclical fluctuations and trigger a financial crisis.
Some of these calls for caution should indeed be taken seriously. For instance, as critics point out, policymakers ought to pay more attention to structural reforms and risk management of financial organisations.
Nonetheless, there can be no argument that the capital account must be opened up, though within effective oversight. Some controls must remain, such as in the regulation of debt and short-term capital flows.
What China most needs is a good road map to capital liberalisation, which would in turn hasten the pace of market reform. It's also up to critics to be constructive, by analysing the pros and cons of liberalisation and suggesting solutions to potential problems.
One thing is for sure: allowing the controls to remain is no "safer" choice for China. Proponents of this view claim that China weathered the 1998 Asian financial crisis, and became one of the first to recover from the fallout of the recent global financial crisis, only because of its strict capital controls.
This is false logic. China's strength in overcoming both crises should be credited to the robust adjustments of its fiscal and foreign exchange policies. Several other factors also played a part during the 2008 crisis: financial reforms, the increase in its foreign exchange reserves and the rise in the country's global standing. Besides, studies have shown that keeping the capital account closed will not immunise an economy to a global crisis.
Fair-minded observers will conclude that China's current controls have not been working well, given the size and the openness of the economy. The government must change its model of management to one based on confidence: on the one hand, it must hasten the opening up so that all fund flows are open to scrutiny; on the other hand, it must consider exercising short-term controls to even out the market peaks and troughs.
China must press ahead with liberalisation without ignoring the risks involved. This means liberalisation must go hand in hand with the other reform measures set out during the 2012 third plenum, such as interest rates liberalisation, in order to minimise the risks of failure and maximise the profit of success.