Note: This post is based on an author’s intervention at the International Conference of RCIE, KIET, and APEA on China and the World Economy, Seattle, March 16, 2012.
The progress of China towards financial integration and the internationalization of renminbi is a matter of great importance. While the world economy remains financially unstable, accessing the world financial market can be a challenging and perhaps troublesome task for an emerging economy like China, which is also pursuing an ambitious number of policy goals. Monetary authorities in China have so far dealt prudently with this challenge, while seeking full international status for the renminbi. This goal has been pursued gradually and has entailed testing and experimenting with new financial arrangements.
The goal of achieving capital convertibility in the medium run is envisaged in the 12th Five-Year Plan for 2011–2015. Chinese authorities have displayed interest in enhancing financial openness long before this time frame, however. They have employed Qualified Foreign Institutional Investor (QFII)1 and Qualified Domestic Institutional Investor (QDII)2 standards for foreign and domestic investors respectively, to soften the limits placed to cross-border capital flows. They have also allowed a greater capital freedom across the mainland’s border and granted access of private and official financial entities to the renminbi interbank bond market. Transfers among individual accounts have been made possible in Hong Kong, with obvious implications for the local bond market.
The question is whether these developments represent a challenge for China’s overall regime of capital controls.
The comparison with the eurodollar market is helpful in this respect. Monetary authorities always felt uneasy and even disturbed by the unexpected rise of the market for dollar deposits in financial institutions outside the United States (eurodollars) in the late 1950s, followed by its growth throughout 1960s and later. In 1973 Guillaume Guindey, former general manager of the Bank for International Settlements (BIS) from 1958 to 1963, wrote: “The so-called eurodollar markets escaped the control of the monetary authorities. They challenged the national credit policies. The impotence of monetary cooperation of the Eleven [The Group of Ten countries plus Switzerland, which joined in 1964] will be hardly explainable by the historians of the future.”3
Most officials felt that Central Banks had become “prisoners of the market,” to quote André De Lattre, deputy Governor of the Banque de France. Their main frustration was that the growth of eurodollar markets (and of other foreign currency deposit markets) seriously weakened the monetary power of central banks. They had less control over the supply side of their domestic money market and over the structure of national interest rates. Finally, wherever capital controls were still in force, they could be easily circumvented.
Do Chinese authorities run the risk of the same frustration in the future? A number of considerations suggest that the answer is no. For example, according to recent projections, the size of renminbi offshore deposits as a percentage of mainland deposits in 2010–2020 is forecast to be considerably smaller than the share of eurodollar deposits as a percentage of US deposits in 1963–1973.4 The destabilizing potential of the Hong Kong offshore market today should therefore be smaller than the eurodollar market was in the sixties.
It should be added that the eurodollar market in the sixties was far from being controlled as strictly as Chinese authorities seem to be controlling offshore renminbi today. For example, Hong Kong banks are allowed to extend credit to customers in offshore renminbi, but tight reserve restrictions provide a check on credit growth rates. Hong Kong banks are subject to agreements with the mainland that set the amount of interest payable to deposit. It other words, while the eurodollar is a dollar, a Chinese renminbi (CNY) is different from an offshore renminbi (CNH).
Capital controls are still binding, according to the literature in recent years.5 Chinese authorities are clearly trying to maintain control over the internationalization process. While it is true that pursuing a larger international use of the renminbi will require a greater exchange flexibility and further relaxation of capital controls, the Chinese seem aware of the dangerously high risk to banks posed by a large foreign currency exposure. Capital convertibility will clearly require a series of actions, including the establishment of a sound financial sector with improved corporate governance in banks and other financial institutions. There should also be a network of well-functioning legal, supervisory, regulatory, and crisis management frameworks, along with deep financial markets with credible indirect monetary controls to manage liquidity. A fully flexible exchange rate is also a fundamental prerequisite.
A recent joint report of the World Bank and the Development Research Center [pdf] of the State Council of the People’s Republic of China (China 2030: Building a Modern, Harmonious, and Creative High-Income Society) points out that many European countries took nearly 20 years after the collapse of the Bretton Woods system to achieve full capital liberalization. A prudent approach is needed in order to achieve a safe transition to a more open and efficient financial and exchange rate system.
Capital controls have so far protected China from episodes of external turbulence like the 1997 Asian financial crisis and the financial turmoil of the past four years. They nonetheless limit the range of financial choices offered to Chinese savers, who see few options other than to invest their money in the real estate market. Such controls might also hamper the effort to achieve a greater international role for the renminbi, since foreign companies have little incentive to hold a currency that cannot be invested in its country of origin.
Interestingly enough, a recent People’s Bank of China study reportedly expresses a favorable view on opening up China’s capital account soon. The study suggests that if China waits until conditions for interest rate liberalization, currency liberalization and renminbi internationalization to mature, the appropriate time to open up the capital account will never come. The study points out that “too much emphasis on preconditions could easily make (a process of) gradual reform become negative and stationary, thus delaying the right time.” According to the report, the preconditions and the full convertibility of the renminbi could promote each other simultaneously.
It is unlikely for such an ambitious timetable to be included among the priorities of policymakers in China soon, however, and such a step would be ill-advised. The Chinese have too little incentive today to accelerate a process that has so far proceeded smoothly, and has helped prevent excessive amounts of overseas capital from entering the country’s banking system, increasing the availability of loanable funds. The risk of a rise in non-performing loans and bad assets is too high for an accelerated timetable to make sense at present. One also wonders if the Chinese banking system is ready to meet the challenges posed by competitive pressure from foreign banks. In this respect one cannot but endorse the suggestion recently expressed in a study by the BIS that allowing a preferential route for offshore renminbi to access the domestic market can be a suitable means to lessen the risks stemming from a greater financial openness.6
There is little or no doubt that a growing internationalization of the renminbi will produce positive effects for China in the long term. A more intense use of renminbi as a denomination currency for China’s assets and trade will help reduce the potential implications of the dollar-renminbi fluctuations for domestic stability. Caution is needed, however, if these benefits are not to be exceeded by the costs and the potential risk of a premature transition to that new status.
1. The Qualified Foreign Institutional Investors a transitional program (introduced in 2002) to allow foreign investors to buy and sell yuan-denominated “A” shares in mainland China (Shanghai‘s and Shenzhen‘s stock exchanges).
3. Olivier Feiertag, Central Banks versus International Money Markets? In International Monetary Cooperation Across Atlantic, Harold James and Juan Carlos Martinez Oliva eds., Adelmann GmbH, Frankfurt am Main, 2008.
4. Vanessa Rossi and William Jackson, Hong Kong’s Role in Building the Offshore Renminbi Market, International Economics Programme Paper: IE PP 2011/01 Chatham House, August 2011.
5. See for example Guonan Ma and Robert McCauley, Do China’s Capital Controls Still Bind? Implications for Monetary Autonomy and Capital Liberalization, BIS Working Papers No 233, August 2007.
6. Robert McCauley, Renminbi internationalization and China’s financial development, BIS Quarterly Review, December 2011.