Whether China Should Accelerate Capital Account Liberalization Now?

1. Whether China Should Accelerate Capital Account Liberalization Now? Ming Zhang Institute of World Economics and Politics Chinese Academy of Social Science February 13th, 2014 BU zhangming@cass.org.cn

2. Outline • Some changes about China’s recent capital flows; • New plan to accelerate capital account liberalization; • Major arguments for accelerating capital account liberalization; • Seven critiques; • Policy recommendations;

3. Some prominent changes about China’s capital flows after US subprime crisis • Capital account surplus takes place of current account surplus to become the major resource of foreign exchange reserve accumulation; • The volatilities of both current and capital account balances increase significantly;

4. China’s Quarterly Balance of Payments Sources: CEIC.

5. Breakdown of China’s Quarterly Capital Account Sources: CEIC.

6. New plan to accelerate capital account liberalization • PBC published two reports in 2012, suggesting speed up capital account liberalization (PBC, 2012a, 2012b); • A more radical two-step liberalization proposal which suggested basically liberalizing capital account by 2015, and completely liberalizing it by 2020; • As the 3rd plenum decision of the 18th CPC central committee showed, RMB’s convertibility under capital account should be accelerated; • The operation of Shanghai Free Trade Zone would materially promote capital account openness;

7. The major arguments for the accelerating of capital account liberalization • Capital account openness could push forward domestic structural adjustment; • Capital account liberalization could promote RMB internationalization; • The risks of capital account liberalization were controllable, considering China having stable financial system, huge foreign exchange reserve, and low foreign debt; • Since China’s capital account control is not effective any more, it’s better to open capital account; • The global financial crisis offered China a time window to encourage outward investments; • Chinese government need not follow any specific policy sequencing to liberalize capital account. RMB interest rate reform, RMB exchange rate reform and capital account liberalization should be pushed forward concertedly;

8. Critique 1 • There is huge uncertainty about whether capital account liberalization could promote domestic structural reform. • It could not push forward the following structural reforms such as income redistribution from government and corporate sector to household sector, or opening service sector to private companies; • if this effort triggers some financial crisis, the domestic structural reforms would very likely be suspended or even reversed after the crisis;

9. Critique 2 • Using capital account liberalization to promote RMB internationalization is merely a tautology. • A deep reason why PBC began to promote RMB internationalization since 2009 was exactly that PBC want to advance capital account liberalization. • Our field investigation and data analysis shows that, the seemingly fast development of both RMB settlement in cross border trade and offshore RMB market so far could be largely attributed to RMB exchange rate and interest rate arbitraging between onshore and offshore markets.

10. Critique 3 • The tail risk of accelerated capital account liberalization might be too huge for Chinese economy to bear. • If Chinese households initiate a massive capital outflow (always being accompanied by foreign investors), it would be very difficult for PBC to stabilize RMB exchange rate even if using foreign exchange reserve. • The existing financial fragilities will exacerbate the tail risk of rapid capital account liberalization, especially inside the shadow banking system.

11. Critiques 4 • The efficacy of China’s capital account control has been declining, but it is still effective on the whole. • The proofs include the persistent and significant RMB interest rate and exchange rate spreads between onshore and offshore market, and the large transaction costs of cross-border capital movements. • More ironically, PBC’s efforts to push RMB internationalization significantly weaken the efficacy of capital account control.(Two flows, two regulators).

12. Critique 5 • It is a bad timing now for China to accelerate capital account liberalization. • After several rounds of QE, the western companies are not cheap any more. Beside that, China’s outward direct investment faces an awkward dilemma. • Considering both the surging of domestic financial risk and the tapering of QE, if China’s capital account is open, the most possible scenario would be a massive and destructive capital outflow.

13. Critique 6 • China’s capital account liberalization should follow appropriate policy sequencing, fulfilling at least three preconditions: liberalizing RMB exchange rate and interest rate, and further reforming domestic financial market. • If Chinese government liberalizes capital account before the liberalization of RMB exchange rate and interest rate, there would be larger and more volatile arbitraging flows, leading to bitter boom-bust cycles of both asset price and inflation. • Chinese government has at least two urgent issues to do about domestic financial market: First, opening financial market to domestic private capital as soon as possible; Second, adopting comprehensive macro-prudential policies to control the existing financial fragilities, especially in the shadow banking system.

14. Critique 7 • The new international trend forming after global financial crisis is no longer the preference on fast capital account liberalization, but the preference on proper capital flow management. • Some emerging economies which had already liberalized their capital account chose to re-introduce certain capital flow managing measures; • IMF, the former trumpeter of free international capital flows, changed its tone; • Chinese officials, especially those in PBC, should abandon their over-confidence and complacency, show more respect to other emerging economies’ experiences of capital account liberalization, and pay more attention to the new international trend regarding capital flow management.

15. Policy recommendations • RMB exchange rate should be liberalized as soon as possible. • RMB interest rate liberalization should be accelerated with some matched reforms (national deposit insurance corporation and better macro prudential regulatory regime). • Domestic financial market reforms should be pushed forward in time (Opening to domestic private capital and mitigating financial vulnerabilities). • Domestic structural adjustments should be propelled in spite of strong resistance from vested interest groups. • Chinese government should actively participate in the international cooperation to coordinate capital flow management efforts.