AFRICANGLOBE – This year China’s gross national savings will be close to $5tn. US savings will be only $3tn. If, as planned, China were to open its capital account – allowing foreigners to invest in China and the Chinese to invest abroad – the scale of its savings would surely reshape global finance. Done well, liberalisation would bring huge changes. Done badly, it could shake the foundations of already fragile global finance.
China’s closed capital account brings an important benefit both to the country itself and to the world. It makes it relatively simple for Beijing to manage domestic financial shocks. A severe and unexpected Chinese slowdown would be a big event but at least the spillover to the financial systems of the rest of the world would be relatively minor.
If the capital account were to be opened, that would change: any crises might become more difficult to manage and their impact on the rest of the world’s financial system would also be far greater. If, in the long run, Chinese entities became the world’s largest owners of financial assets, any big shock within China would become a global event, just as the Great Depression of the 1930s and the Great Recession of the 2000s in the US shook the world economy.
In a document published in 2012, the People’s Bank of China argued that an open capital account would improve the quality of Chinese foreign assets, promote cross-border use of the renminbi and help the country’s enterprises restructure. Moreover, it insisted, capital controls were becoming ineffective. In addition, it suggested that “China would not face big risks” if it opened the capital account, since the assets and liabilities of banks were denominated in renminbi, short-term debt was a small proportion of China’s foreign debts and risks in the domestic property and capital markets were manageable.
Pride may go before a fall. As we have seen many times, the quality of balance sheets can deteriorate frighteningly quickly, particularly if unfamiliar opportunities and players enter the domestic markets. In 1998 Stanley Fischer, then first deputy managing director of the International Monetary Fund, argued that the preconditions for successful capital account liberalisation were a stable macroeconomic environment, a sound banking system and developed financial markets. China certainly lacks the third. Whether it has the second is very much open to debate and so, for this reason, is the first. Given the risks of capital account liberalisation, particularly in such a huge economy, the sensible view is that China is not yet ready.
The People’s Bank recognised this. It proposed dividing the task into three periods. In the first three years, controls on foreign direct investment by enterprises would be relaxed. Over three to five years, the aim would be to relax controls on trade-related credit and spur internationalisation of the renminbi. Over five to 10 years, the plan was to open up capital inflows before outflows. The People’s Bank planned to leave personal transactions, money-market instruments and derivatives to the end. It also wished to rule out (hard-to-define) speculative transactions indefinitely.
It is easy to see why such a plan for opening is attractive. First, it could prove to be a sharp spur to domestic reform. Second, China’s huge savings are now locked up inside China. The principal form of capital outflow has been the accumulation of foreign currency reserves by the government. At $3.8tn last December (almost $3,000 for each Chinese person), these are gigantic and extremely unrewarding. It would be far better if some of this were converted into real assets.
Yet opening is also risky. Very large increases in gross flows (and so stocks) would follow on both sides of the balance sheet. A study published by the Bank of England at the end of last year suggests that the combination of opening, relatively rapid economic growth and a reduction in the tendency to prefer domestic assets might raise China’s external assets and liabilities from less than 5 per cent of world gross domestic product to nearly 35 per cent by 2025. Similarly, an IMF study published last August argued: “Capital account liberalisation may be followed by a stock adjustment of Chinese assets abroad on the order of 15-25 per cent of GDP and a smaller stock adjustment for foreign assets in China on the order of 2-10 per cent of GDP. This would imply a net accumulation of Chinese net international assets of 11-18 per cent of GDP.” China would then move from being a relatively minor actor in global capital markets to one of the central players.
A chapter in China’s Road to Greater Financial Stability, published by the IMF last year, lists some of the countries that embarked on liberalisation of the financial system and the capital account only to hit the rocks: Indonesia, Mexico and South Korea are among them. All liberalisation opens up unfamiliar opportunities. But opening the capital account then adds both to the opportunities and the unfamiliarity. If the system being opened up is riddled with price distortions and suffused with moral hazard – China’s suffers from both on a huge scale – the chances of mishap are great. If the regulators are operating in an unfamiliar environment, as would be the case in China, the chances become greater still. And if the ratio of domestic credit and money to GDP is also very high (as in China), the chances become even greater. Finally, this is a matter of global concern when the economy in question will be the world’s biggest.
The instinct of the People’s Bank that capital account liberalisation could be a battering ram for reform is correct. Moreover, such a reform would not be merely financial and economic. It would also be political. If China’s capital account were to be fully liberalised, the government would lose its grip on the most effective of all its economic levers.
Whatever the attractions of speed, this process has to be carefully managed. For China and the world, the risks are too big to approach this in any other way. We have all surely had enough fun with financial crises to last a long time. China needs to reform first and only then open up, ideally in close dialogue with its partners. In the long run China’s capital account will presumably become largely open and in time, no doubt, China’s savers will own large parts of the world. But, as the Romans said, let them hurry slowly.
By: Martin Wolf