Is China Ready for Full Yuan Convertibility?

Is China Ready for Full Yuan Convertibility?

Although China has made headway in reforming the exchange rate regime of its currency, the yuan, and expanding the use of it in cross-border trade during the past year, the yuan is far from fully convertible.Huang Yiping, a professor at the National School of Development of Peking University, said in an article forBeijing Reviewthat China has the conditions for capital account liberalization and should strive for basic convertibility within fve years. Edited excerpts follow:

In December 1996, the governor of the People’s Bank of China, the central bank, wrote to the then managing director of the IMF to outline China’s goal of realizing current account convertibility. At that time, Chinese officials planned to achieve capital account convertibility within a decade. But it was repeatedly delayed after the Asian financial crisis in 1997.

Ten years later, the world was struck by the U.S. subprime crisis and global economic recession. The Chinese economy performed relatively better compared to other countries in terms of recovering. Clearly, restrictions on cross-border capital flows also helped shield China from external economic and fnancial shocks.

These raise an important question: Is an open capital account really what China needs? The Chinese experience during the recent global financial crisis suggests that certain degrees of state intervention might be useful for maintaining economic stability. So why liberalize what apparently already works?

Findings from empirical studies on the benefts of capital account liberalization are also inconclusive. Some found positive impacts, some revealed no effect and yet others yielded mixed results. Pooling international data also showed no clear correlation between openness of the capital account and growth performance.

These results cast doubt on the conventional wisdom that the capital account and fnancial liberalization should help increase investment returns, reduce fnancial risks and improve growth performance.

So should China pursue its long-planned agenda of capital account liberalization? I approach this question by looking into three broad issues.

First, given that the economy is becoming increasingly open, how effective are the remaining restrictions on cross-border capital flows? Second, while capital controls were probably useful for maintaining domestic economic and fnancial stability in the past, what are the costs of not liberalizing? Third, if capital account convertibility is the right policy direction, is China ready to pursue it and what liberalization strategy should China adopt?

China has steadily liberalized capital account controls in recent years and the effectiveness of remaining controls has declined. Our estimates of short-term capital flows, which are subject to most severe restrictions, grew exponentially during the past decade. Empirical analyses also indicate that the controls are ineffective in the long run.

Also, remaining restrictions on crossborder capital flows impact negatively on economic growth and affect independence of monetary policy. Although the restrictions helped shield the economy from external shocks, they actually contribute to domestic fiscal and financial risks by allowing irresponsible lending and borrowing behaviors to fourish.

Meanwhile, without capital account convertibility, it is impossible for China to achieve other goals, such as internationalization of the yuan, turning Shanghai into an international financial center and including the yuan in the IMF’s special drawing rights basket.

China already possesses the necessary conditions for capital account liberalization and should push forward the reforms within the next five years. In fact, the macroeconomic and financial conditions in China today are already much better than those in India and Russia when they opened up their capital accounts. Importantly, favorable conditions, such as healthy fiscal condition and external surplus, may disappear over time. The 12th Five-Year Plan (2011-15) provides a rare historic opportunity for China to accomplish this reform. The government should first establish market-based interest rates and exchange rates and then lift most restrictions on cross-border capital flows, although special schemes for portfolio investment could remain in place for a while.

Ripe conditions

An open capital account promotes efficiency of capital allocation. But it could also bring about volatility. In some developing countries, capital account liberalization has sometimes been followed by a fnancial crisis. It is, therefore, important to emphasize the necessary conditions for liberalization and the proper order of reform.

During the past 30 years, China’s macroeconomic and financial conditions have improved significantly, including macroeconomic stability, healthy fiscal positions, good financial asset quality, large current account surplus, gigantic foreign reserves and improved financial regulations. These conditions are probably much better than those of other developing countries when they liberalized their capital accounts.

First, macroeconomic conditions are quite stable. China has maintained an average 10-percent GDP growth during the past three decades. In the meantime, inflation rates were kept low, generally around 3 percent, with exceptions in 1988, 1994 and 2004. Unfortunately, this environment may not last forever. For instance, strong growth and low inflation during the past decades were at least in part contributed to by low factor costs, including labor cost. But these costs are already rising, which is likely to lead to slower growth but higher inflation pressure in coming years.

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Second, the fiscal system is sound. China has experienced important fiscal reforms during the past 30 years. In the late 1970s, fiscal revenues accounted for more than 30 percent of GDP. This share dropped to around 11 percent in the early 1990s as a result of market-oriented reform and fscal decentralization. After that, the government gradually raised the fscal revenues, through improved tax collection, to 21 percent of GDP in 2010. Even if we include all the contingent liabilities, including nonperforming fnancial assets, defcits of the pension fund and local government liabilities, total debt burden is still only around 50 percent of GDP. The fscal condition is very healthy. But this may also change over time. For instance, borrowing by local fnancing platforms and aggressive lending by the state-owned commercial banks could add signifcant potential liabilities, which could weaken the fscal position.

Third, currently the banks have very low nonperforming loans but high capital adequacy. From the 1990s, the Chinese Government began to focus on the banking reforms, including reducing nonperforming loans, adopting modern risk control mechanisms, injecting state capital, introducing foreign strategic investors and listing the banks in domestic and foreign stock markets. Over the years, the banking sector’s quality improved significantly. For instance, the average nonperforming loan ratio declined from 44 percent in 1999 to 2.4 percent in 2010. The banks are also adequately capitalized and highly liquid. Some of these features may change in the coming years, although the magnitude is likely to be limited. For instance, the massive lending during the global fnancial crisis and possible correction of housing prices might generate nonperforming loans.

Finally, the yuan is under pressure to appreciate. China is running a large current account surplus and the market expects the yuan to appreciate signifcantly in the coming years. Therefore, in the near term, we are not likely to see massive capital outfows even if all restrictions are removed. China holds more than $3 trillion in foreign exchange reserves, which are likely sufficient to stabilize the fnancial markets even if uncertainties arise. Over time, however, current account surplus may narrow as China and other countries work on global rebalancing. Pressures for currency appreciation may also disappear eventually.

All these factors suggest China already has the necessary conditions for capital account liberalization. Of course, not all the conditions are perfect. Some of them, such as regulation capability, have to be developed in the process of liberalization. An open capital account may enforce disciplines on domestic institutions and reduce future risks. It could also help discipline local governments’ spending behavior.

Proper order

So what are the main steps should China take to liberalize its capital account? U.S. economist Ronald I. McKinnon, the founder of modern financial theory, proposed the following order for developing countries in 1973: fiscal reform, financial and trade liberalization, exchange rate reform and capital account liberalization. China should probably follow the same order, although some steps could take place simultaneously.

China’s overall fscal position is strong, but there’s certainly room for improvement. One is to shift the focus of budget expenditure from investment projects to public goods services. The government should also reduce its intervention in commercial banks’lending decisions in order to minimize future fiscal responsibilities. Another area is the state-owned sector. The government still intervenes in prices of essential input such as energy. It has to subsidize these state-owned enterprises for operating losses. Finally, it is important to discipline local governments’spending and limit their deficits. Local governments’ borrowing has gotten out of control recently and could result in serious fscal consequences in the coming years.

Further substantial reforms are still needed. These include reduction of state intervention in the operation of major fnancial institutions, implementation of deposit insurance scheme, entry of more non-state-owned institutions into the fnancial industry, introduction of marketbased interest rates and improvement in central bank’s monetary policymaking. Market-based interest rates are a critical condition for capita account liberalization and require the formation of a full government bond yield, further development of the inter-bank market and removal of the benchmark interest rates for commercial banks.

One most important task is to achieve conditional free floating of the exchange rate. China adopted the managed foat for the yuan exchange rate in early 1994. After disruptions during the Asian and global fnancial crises, the government reintroduced the managed float regime in June 2010. The strategy of letting the yuan appreciate gradually caused some consequences, such as encouraged expectation of further appreciation, hot money infow, large current account surplus, massive liquidity, high inflation pressures and rapid accumulation of foreign exchange reserves.

It is advisable the authorities implement a free floating exchange rate by quickly reducing the central bank’s intervention in the foreign exchange market. Two-way fluctuation of the exchange rate, based on changing demand and supply relations, may be possible after a period of rapid currency appreciation. The government may wish to intervene in the market to avoid excessive volatility, possibly through a stabilization fund. But this kind of intervention should be two-directional.

Capital account liberalization can then take place alongside a floating exchange rate. Capital account convertibility does not necessarily mean that restrictions on capital flows will be completely done away with. Given China’s current fnancial situation and regulatory capability, it is probably better for the country to aim frst at basic convertibility. In particular, China should probably retain restrictions on certain types of volatile short-term capital flows, at least initially. This should help avoid excessive shocks to the fnancial system. It is also consistent with the IMF’s recent decision to allow temporary use of restriction measures on cross-border short-term capital fows.

Four factors suggest China already has the necessary conditions for capital account liberalization, which include stable macroeconomic conditions, a sound fscal system, low nonperforming loans but high capital adequacy of banks, and the pressure to appreciate the yuan.