Understanding the Implications Behind Capital Account Liberalization in China
By Taylor W. Loeb
In this review, I will seek to gain a deeper understanding of the question of why China has yet to fully implement capital account liberalization despite its international economic importance.
FOR CHINA-SPECIFIC DISCUSSION, SKIP TO PART II
In Part I of this review, I will provide an overview of the capital account and its place in the global economy. In this section, I will first briefly explain what the capital account is and then discuss broad capital account liberalization theory, considering a few historical case studies. I will weigh the literature’s analysis of benefits and drawbacks to capital account liberalization.
In Part II, I will focus specifically on the Chinese case, first examining the historical trends in China’s capital account liberalization. I will then discuss the various pressures—internal and external—that exert influence on the tightening or loosening of capital account controls in China—and analyze whether or not this system is sustainable as China commands an even greater role in the international economy. Next, I will apply the theories and cost-benefit analyses of capital account liberalization from Part I to China’s case, paying special attention to government/political considerations.
Finally, in Part III, I will summarize the above material in an attempt to provide answers as to the key forces contributing to China’s anomalistic position as an international economic power with a relatively closed financial system.
Part I: Understanding the Capital Account + Capital Account Liberalization Theory
The “capital account,” known at the IMF as the “financial account,” refers to the change in a nation’s assets between foreigners and citizens (IMF, 2014). Essentially, it is a measure of how globalized or globally integrated a nation’s financial economy is—how free does money move in and out of the country? It is important to distinguish the capital account from the current account—the current account being focused on “net income,” generally referring to the import-export balance between a country and its trading partners.
The four primary components constituting the capital account are (IMF, 2014):
1). Foreign Direct Investment (FDI)
For example, if an American/American company buys a factory in China, China’s capital account increases—money is flowing into China in exchange for an asset (the factory).
On the other hand, if a Chinese citizen/company buys a factory in the US, China’s capital account decreases—money has left China in exchange for an asset.
For distinction, the future income resulting from these assets is recorded in the current account.
2). Portfolio Investment
If an American buys shares of a company on the Shenzhen stock exchange or the bonds of a Chinese company, China’s current account goes up. If a Chinese citizen buys shares of an NYSE-listed company or the bonds of an American company, the reverse is true.
3). Other Investments
This section deals primarily with cross-border loans—an American bank lending to a Chinese company or a Chinese citizen.
4). Reserve Account
This deals with the central bank’s handling of foreign currency reserves. In the case of China, as will be discussed at length, this is one of the key areas of focus for capital account liberalization. Full convertibility would necessitate a market-based exchange rate for the Yuan, something China has been slowly working towards for many years, but has yet to implement fully.
The more open or “liberalized” a capital account is, the more freely the above transactions are able to take place. The literature lists a host of benefits and drawbacks to liberalizing a country’s capital account.
An oft-repeated phrase in the literature is “increased efficiency of capital allocation.” (IMF, 2000). In this formulation, it is assumed that a more globally integrated financial system, and, thus, a wider array of both inbound and outbound investment opportunities means that it is more likely that money will go where it is most useful (Prasad, 2018). This is very much a free-market, capitalist conception and one whose validity the literature increasingly questions. This assertionis often accurate, however there are critical examples—notably the Asian Financial Crisis—that illuminate the dangers of too-quick capital account liberalization (Asian Contagion, 2011).
Benefits of Capital Account Liberalization
Generally speaking, the first benefit—and typically the first order of business— after capital account opening is FDI. (Klein, 2003). For poor countries, FDI is frequently the most efficient and often the only way to set about on the path of sustainable growth. (Kasekende, Schneider 2000) The literature generally argues that FDI—with its longer-term, sustainable focus, is a positive. (Rogoff, 2002)
Relaxing restrictions on FDI outflows can also help citizens more efficiently allocate their savings—and, as a consequence—potentially stabilize local prices. If citizens are only able to move their money within the domestic market, the result may be exorbitant prices on certain assets—the Chinese housing market may be one example (Gourinchas, Jeanne, 2002).
In terms of equity investment, domestic companies—who may often have business interests outside of their home country—will be able to access a much larger pool of potential investment if foreign portfolio investment is allowed. The country will also be able to issue debt to a broader base of potential creditors, with the natural effect of reductions in interest rates (Lardy, Douglass, 2011) This reasons that the nation can access more, cheaper financing.
Another aspect of a liberalized capital account is a freely floating exchange rate. An exchange rate in free float means that the central bank no longer has to focus its efforts on maintaining the exchange rate against other currencies and can help the country enter a more stable, affluent status quo (McCowage, 2018). In the case of the RMB, the exchange rate has generally been kept slightly below market to keep the aforementioned Chinese export machine strong. This has strong implications for the economy and the labor market composition of China. Floating the currency—in this case, likely letting its value appreciate—will give the country more purchasing power abroad. This will bring down the price of commodities and make citizens relatively wealthier internationally. (Pasricha, Kruger, 2016)
Governance is also a frequently cited reason and benefit for capital account liberalization. Almost by definition, an opening of the capital account means more transparency. This is an inextricable component of liberalization—as markets and financial practices become more transparent and accessible, outside investors will be more willing to put money into the country (Pasricha, Kruger, 2016).
Finally, currency internationalization. This topic is of particular interest to me as I am writing a thesis review on RMB internationalization. If currency internationalization is a goal, then capital account liberalization is imperative (Yu, 2017). It is essentially oxymoronic to have both a robust international currency and a closed capital account. This is because an international currency must be readily convertible—meaning, if I hold it, I must be able to “convert” it to goods, physical assets, bonds, stocks, other currencies etc. In conjunction with this, foreign entities must also be assured that the assets they purchase with your currency are reliable and your country’s financial data is sound. Otherwise, they will look for safer places to put their money (Dunkley, 2018).
Klein notes that further capital account liberalization accrues the most benefits to middle income countries (Klein, 2003). The risks are more salient for poor countries, as will be discussed below, while wealthy countries tend to have relatively open capital accounts and the benefit of continued opening—if even possible—is minimal (Klein, 2003).
Risks of Capital Account Liberalization
For many years, the economic consensus was that more open capital accounts and, thus, capital markets, were an overwhelming positive. In the words of former Deputy Treasury Secretary and investment banker Roger C. Altman, “The worldwide elimination of barriers to trade and capital . . . have created the global financial marketplace, which informed observers hailed for bringing private capital to the developing world, encouraging economic growth and democracy." (Altman, 1998) However, following the Asian Financial Crisis of 1997 and China’s impressive growth under a gradually liberalized capital account regime, the argument has shifted markedly.
In “The Capital Myth,” Columbia economist Jagdish N. Bhagwati is extremely critical of this consensus and lays out many of the most prominent arguments against liberalization (Bhagwati, 1998). He discusses supply-side greed as a fundamental incentive to capital account liberalization. In his formulation, it is Wall Street that craves the free movement of capital. His argument appears to be well founded and there is a growing consensus around it.
When a government opens its financial markets, it implicitly gives up some control. A purely socialist system is fundamentally at odds with a purely capitalist one. In the former, all exchanges are completely controlled by the government. In the latter, the government does not exist and the market makes every decision. Of course, no country falls into either category—countries lie on a spectrum somewhere between the likes of Hong Kong and North Korea. Cato’s Economic Freedom of the World report placed China 112thon this “spectrum” in 2015. (Cato, 2018). Opening the capital account would move China up this list and would be followed by the PBOC having less control over the waymoney flows in and out of the country. This will also require more financial and governance transparency from public companies—many of which, in China, are SOEs.
If a country’s financial system is not prepared, liberalization can induce severe, rapid crisis. This is what happened during the 1997 Asian Financial Crisis. Currency traders on the other side of the world will be able to drive the price of the currency up or down, which will end up having real, nearly uncontrollable effects on the local economy. (Asian Contagion, 2011). This practice ended up bankrupting Thailand, Indonesia, and South Korea, which ultimately necessitated conditional loans from the IMF and extremely unpopular domestic austerity.
Opening the floodgates on portfolio (stock and bond) flows—like currency—will lead to an influx of “hot money.” These are short term flows that enter the market and leave quickly with no interest in long term development. (Yu, 2017). This can be extremely destabilizing to countries. And, politically, it is a non-gain, as foreign speculators have no political stake in the country.
In this same vein, liberalization means that citizens within the country will be able to more rapidly and flexibly move their money out. This means that there will be less money available for domestic projects or international projects that don’t fit the country’s strategic goals. China has been re-tightening controls on outflows since 2017 with these concerns explicitly in mind (Clover, Mitchell 2017). Presumably, in a liberalized capital account regime, international inbound investment would offset domestic outbound investment based on market forces. It is unlikely that a country would be able to successfully have it both ways—restrictions on outbound investment but accommodation of foreign FDI, which may be what China would like to do.
Crucially, there appears to be a consensus in the literature that the optimal method of capital account liberalization is a gradual, sequenced process (Rogoff, 2002). This would be complemented by an open current account (trade flows) and enthusiastic reforms of financial norms (Liu, 2019). Countries must have relatively strong and resilient economies before they can go about liberalization. Is their economic structure able to compete with the global economy on a level, market-determined playing field? This is a critical question, as we will see below, that China has yet to convincingly answer.
Part II: The China Case; Historical Trends and Cost Benefit Analysis
To examine the literature on China’s financial reforms and capital account opening is to receive a lesson in forbearance and gradualism. Reforms have been instituted slowly, beginning with the current account in the early-mid 90s (Lardy, 2011) and slowly extending to the capital account, particularly in the 2009-10 period. China has followed the gradual, sequenced approach to economic opening advanced by many scholars (Schneider, 2000). It has been a process 40 years in the making, and, as stated above, defies much of the previous assertions.
China’s capital account liberalization has followed roughly the orthodox sequence: liberalizing the current account before liberalizing capital account, liberalizing FDI before liberalizing indirect investment, liberalizing long term capital before liberalizing short-term capital, liberalizing portfolio before liberalizing borrowing, and liberalizing capital inflows before liberalizing capital outflows. (Yu, 2017) This has all been done, methodically, since 1978.
Today, politically, it can be said that there are two broad “coalitions” on either side of the further liberalization debate. In favor of liberalization appear to be the People’s Bank of China and more liberalminded members of China’s financial circles. It is not hard to see that Chinese savers and investors could also benefit—as they would be allowed to more freely move their money out of the country and even have better financing and investment options within China. With a floating exchange rate, they would also receive more for their money abroad—as would China in general, as a stronger Yuan would lead to cheaper import—the most important of which are natural resources (Investopedia, 2019). Further, on the pro-liberalization side sits the Bretton Woods community. The proverbial Wall Street, in particular, would be eager for China to further open its financial markets and float its exchange rate. The potential profits are enormous (Bhagwati, 1998).
On the other hand, China has long benefitted from a restricted capital account. The managed exchange rate has kept Chinese exports globally competitive (Ma, Maddock 2016). One of the primary reasons for the Asian Financial Crisis was that when the central banks of Thailand, Indonesia, and South Korea were no longer able to devalue their currencies, their exports became too expensive (Carson, Clark 2013). China has long wanted to move in the direction of a more service-oriented, consumption-based economy, but there is much debate over how drastic the change should/will be. Floating the exchange rate, whenever it may happen, will hurt low-cost exports. (Ma, Maddock 2016). State banks and SOEs are two interest group that will likely see pain from a more open capital account.
The banks had long benefited from tight controls on interest rates, however, the PBOC abolished all controls in October 2017 (Lo, 2018). This means that average Chinese citizens—mentioned above—will likely have better options for borrowing. However—and this is perhaps most important—the government and the SOEs are still able to borrow at preferential interest rates set by Beijing (Lo, 2018). 90% of domestic investment is carried out by local governments while SOEs account for 1/3 of all investment (there is overlap between the two). SOEs have also received over 60% of all new Chinese loans since 2013—and this number has grown in recent years (Zhang, 2018). It is widely agreed that SOEs and governments lack the efficiency that might be realized by private investment (Cary, 2013). As such, they receive preferential financial treatment and implicit guarantees of government support. The previous financial system had been very much geared toward channeling household savings into large government projects. Interest rate liberalization changes this paradigm. If the capital account is fully liberalized, the majority of SOEs simply cannot continue to exist in their current forms. At stake here is a full-on structural adjustment of the Chinese commercial and economic system.
Despite the aforementioned structural deficiencies, China has done an impressive job over the past few decades in developing sustainably. Yes, there are unfinished tourist attractions and unoccupied apartment blocks, but, generally, development has been carried out effectively. This success is largely due to capital controls. Without a solid, resilient financial system in place, developing countries may be subject to the vagaries of the international market—“hot money.” It is capital controls that defend against inflows and outflows of “hot money,” in favor of sustainable financing.
Lastly, the current political environment—a trade war with the US, China’s growing international economic presence, and a party-oriented, nationalist leader—combine to make capital account liberalization an even more sensitive proposition. Capital account liberalization is meant to engender efficiency. Efficiency generally means a reduction in state support. One could imagine this endangering Chinese projects abroad—many of whose profitability is questionable. Official estimates state that SOEs account for over 70% of all BRI projects (Zhang, 2018). A floating exchange rate would also likely mean an appreciation for the RMB—at least once the trade war concludes. This would put more money in Chinese pockets, but would, again, necessitate an acceleration of employment reforms that the country may not be ready for.
Part III: The Path Forward
Former PBOC Governor Zhou Xiaochuan called for a “basically open capital account by the end of 2015,” (Ma, Maddock 2016). “Gradually realizing capital account convertibility” was a key goal of the 12thFive Year Plan (Lardy, Douglass 2011). Yi Gang, former Vice-Governor of the PBOC stated in 2010 that, “a convertible Yuan remains the ultimate goal for the nation’s exchange rate reform.” Convertibility was also implicit in the State Council’s desire to make Shanghai an international financial center by 2020 (Lardy, Douglass, 2011). As far back as December 1993, China’s authorities publicly stated that “The long-term goal of China’s foreign exchange reforms is to realize the convertibility of the renminbi. In order to reach this goal, we must move gradually and in the proper sequence of events” (Hu, 2009).
It is clear that Chinese financial policymakers have understood the need for opening for many years. Further, all actors within Chinese political economy circles agree that prudential gradualism is the appropriate method for achieving these goals. In general, it is hard to argue that China has not pursued capital account liberalization. It is more valuable, then, to consider the debate in terms of when as opposed to if.
Because of the unprecedented magnitude and temporal persistence of Chinese growth, the government has been able to slow down the liberalization process. So much money has been coming in to Chinese coffers for so long that pressures to open further has been easy to ignore. Going forward, this gradualist approach is going to be tested and questioned severely by both internal and external forces. It is not unreasonable to argue that China’s closed capital account and socialist financial preferability are the primary reasons for Trump’s trade attacks.
China is the world’s largest trading nation (CSIS, 2019). China, by itself, accounts for 12.4% of global trade. While this number appears large—especially when considering that 25 years ago China only accounted for 3% of global trade—it is imperative that such figures are viewed through a relative lens. As of 2018, 18.4% of the global population was Chinese (DES, 2018). By comparison, the United States accounts for 11.9% of total global trade but just 4.4% of global population.
China is highly unusual in that its nominal GDP ranks first or second globally (depending on calculation method), yet its GDP per capita ranks in the 70s (World Bank, 2017) or even as low as 108 (CIA, 2017) depending on calculation methods. In short, China and its economy have a gross wealth and influence that are currently incongruous with its global per capita wealth and influence.
Clearly, China still has a great deal of development left to achieve.
From the literature, it appears that becoming the world’s largest economy and increasing its per capita GDP will be extraordinarily difficult, politically and economically, with a restricted capital account. The principal areas of focus/concern will be SOE reform vis-à-vis both domestic and international growth, a focus on RMB internationalization, a restructuring of the Chinese economic mix, and an expansion of savings and investment options for Chinese citizens. All of these areas overlap in some form or another.
My analysis of the literature, outlined above, illuminates a central paradox within the Chinese system. Namely, the conflict between China’s international aspirations and its relatively closed political economy. This is a fundamental ideological conflict. Its proxies may be said to be the more conservative, statist old guard, led by the SOEs and the current party leadership versus the proponents of liberalism, led in many ways by the PBOC and the private sector. Full liberalization of the capital account, full convertibility of the RMB, and increased allocative competition are enormous and necessary steps toward China becoming a wealthy and accepted global economic leader. However, in China’s case they also necessitate a loss of government control over the way money is spent domestically and abroad, the distribution of employment, and the preference of particular industries. In this sense, we may in fact be talking about the final piece of the reform and opening up puzzle. Is China—the China of Xi Jinping in 2019—prepared for this?
Bibliography + Works Consulted:
“Asian Contagion.” YouTube, YouTube, 11 Jan. 2011, www.youtube.com/watch?v=PIQdsAQs37Y.
“China Population (LIVE).” Worldometers, 2018, www.worldometers.info/world-population/china-population/.
“COUNTRY COMPARISON :: GDP - PER CAPITA (PPP).” Central Intelligence Agency, Central Intelligence Agency, 2017, www.cia.gov/library/publications/the-world-factbook/rankorder/2004rank.html.
“Economic Freedom of the World Report.” Economic Freedom of the World, Cato Institute, Feb. 2018, www.cato.org/economic-freedom-world.
“GDP per Capita (Current US$).” Data, 2017, data.worldbank.org/indicator/ny.gdp.pcap.cd.
“Is China the World's Top Trader?” ChinaPower Project, 9 May 2019, chinapower.csis.org/trade-partner/.
“The Capital Account.” Balance of Payments and International Investment Position Compilation Guide, International Monetary Fund, 2014, pp. 250–256.
“The Impact of China Devaluing the Yuan.” Investopedia, Investopedia, 29 Apr. 2019, www.investopedia.com/trading/chinese-devaluation-yuan/.
Bhagwati, Jagdish N. “The Capital Myth: The Difference between Trade in Widgets and Dollars.” Foreign Affairs, Foreign Affairs Magazine, May 1998, www.foreignaffairs.com/articles/asia/1998-05-01/capital-myth-difference-between-trade-widgets-and-dollars.
Blood, David. “How Foreign Groups Fare in China's Slowing Two-Track Economy.” Financial Times, Financial Times, 14 May 2019, www.ft.com/content/c4001b5a-43d8-11e9-b168-96a37d002cd3.
Carson, Michael, and John Clark. “Asian Financial Crisis.” Federal Reserve History, Federal Reserve Bank of New York, 22 Nov. 2013, www.federalreservehistory.org/essays/asian_financial_crisis.
Clover, Charles, Tom Mitchell. “China Steps up Capital Controls with Overseas Withdrawal Cap” Financial Times, 31 December, 2017. https://www.ft.com/content/b69166fa-ee01-11e7-b220-857e26d1aca4
Dunkley, Emma. “Chinese Shares to Transform Emerging Market Investing.” Financial Times, Financial Times, 31 May 2018, www.ft.com/content/3ea51148-632f-11e8-a39d-4df188287fff.
Gourinchas, Pierre-Olivier, and Olivier Jeanne. On the Benefits of Capital Account Liberalization for Emerging Economies. IMF, May 2002, siteresources.worldbank.org/INTFR/Resources/capital_account_lib2.pdf.
Lardy, Nicholas, and Patrick Douglass. “Capital Account Liberalization and the Role of the Renminbi.” PIIE, PIIE, 2 Feb. 2011, piie.com/publications/working-papers/capital-account-liberalization-and-role-renminbi.
Liu, Zheng. Optimal Capital Account Liberalization in China. FEDERAL RESERVE BANK OF SAN FRANCISCO, May 2019, www.frbsf.org/economic-research/files/wp2018-10.pdf.
McCowage, Madeleine. “Trends in China's Capital Account | Bulletin – June Quarter 2018.” Reserve Bank of Australia, Reserve Bank of Australia, 29 Mar. 2019, www.rba.gov.au/publications/bulletin/2018/jun/trends-in-chinas-capital-account.html.
Pasricha, Gurnain Kaur, and Mark Kruger. What to Expect When China Liberalizes Its Capital Account. Bank of Canada, Apr. 2016, www.bankofcanada.ca/wp-content/uploads/2016/04/sdp2016-10.pdf.
Prasad, Eswar. “Finance & Development.” Finance & Development | F&D, 18 Dec. 2018, www.imf.org/external/pubs/ft/fandd/basics/capital.htm.
Roger C. Altman, "The Nuke of the 90's," The New York Times Magazine, March 1, 1998, p. 34.
Rogoff, Kenneth. “Straight Talk -- Rethinking Capital Controls: When Should We Keep an Open Mind? .” Finance and Development | F&D, IMF, Dec. 2002, www.imf.org/external/pubs/ft/fandd/2002/12/rogoff.htm.
Schneider, Benu, and Louis Kasekende. “Capital Account Liberalisation: A Developing Country Perspective.” ODI, 1 June 2000, www.odi.org/publications/3522-capital-account-liberalisation-developing-country-perspective.
Shen, Timmy. “China Stock Markets Tighten Rules on When Share Trading Can Be Suspended.” Caixin Global, 29 Dec. 2018, www.caixinglobal.com/2018-12-29/china-stock-markets-tighten-rules-on-when-share-trading-can-be-suspended-101364970.html.
Smith, Colby. “China's Capital Markets: a Progress Report.” FT Alphaville, 1 Mar. 2019, ftalphaville.ft.com/2019/03/01/1551420000000/China-s-capital-markets--a-progress-report/.
Yu, Yongding. “Why China's Capital-Account Liberalization Has Stalled.” China, 3 Nov. 2017, www.chinausfocus.com/finance-economy/why-chinas-capital-account-liberalization-has-stalled.
Yu, Yongding. Débat 4: The Evolution of Capital Controls in China. Chinese Academy of Social Sciences, 2017, lesrencontreseconomiques.fr/2014/wp-content/uploads/sites/2/2014/07/yu.y_theevolutionofcapitalcontrolsinchina.pdf.