How would China liberalise its capital account?

THE "impossible trinity" theory addresses policy choices for international economics. It says that of the three goals of: (1) an independent monetary policy (that is, control of domestic interest rate), (2) a fixed or stable exchange rate, and (3) free capital movement, a country can only attain two of these three goals.

Before 2002, China chose to have full control of interest rate and exchange rate. In so doing, RMB deposit rates could be "repressed" to allow the Chinese government to allocate cheap credit to state-owned enterprises (SOEs), fuel China's investment and promote a state-owned economy. On the other hand, the exchange rate is controlled to create conducive conditions to implement an export-led growth model.

Having attained these two goals of controlling the interest rate and exchange rate, China had to restrict the cross-border capital movement, that is, forgoing the remaining third goal of capital mobility, so as to block market forces from determining the equilibrium level of exchange rate (given that the interest rate is fixed, according to interest rate parity theory).

China currently still imposes control on the capital account, but not the current account which was made convertible since December 1996.

Since 2002, China started the process of capital account liberalisation, initially to pursue inward foreign direct investment to help stimulate the domestic economy. However, despite being featured regularly in the five-year plans issued by the Chinese government since 2002, the pace of capital account liberalisation remains a slow and gradual process and no clear official timetable or road map has been published.

One needs to understand the intricacies of the interplay between external threats, national priorities, and domestic financial market developments in China to better appreciate the policy decision on the issue of capital account liberalisation.

TOP PRIORITY: FOCUS ON THE DOMESTIC

Despite how some Western commentators may portray it, China does not aspire to overtake the US as the world's number one power, nor take on the role of international police. Instead, it is steadfastly focused on building a strong and stable domestic economy to deliver a better life for its 1.4 billion people. Reflecting this in financial reform, the Chinese government's decision on capital account liberalisation and seeking global financial power must be predicated on the confidence of China's leadership in its economic system and stability in the face of greater financial volatility brought about by opening its capital account.

That is why, in the past, China chose to control the interest rate and exchange rate in order to promote its state-owned and export-driven economic development model and to shield its economy from global financial market turbulence and crises. China also requires domestic savings to be "trapped" at home to sustain its relatively high macroeconomic leverage, mainly in the form of bank loans largely granted to SOEs.

However, with the raging US-China trade war, a rising trend of antiglobalisation and protectionism which is aggravated by the current Covid-19 pandemic, and the growing middle-income population at home, China is changing its economic development model to what is now famously known as a "dual circulation" development strategy - where "internal circulation" (that is, the domestic cycle of production, distribution and consumption) plays a leading role while "external circulation" (that is, international trade and investment) remains its extension and supplement.

In essence, a domestic consumption-driven (instead of export-led) strategy will be the new growth model. Also, there will be stronger emphasis to promote services industries instead of capital-intensive industries to boost the share of labour income in national income; this is in line with economic transformation towards consumption-driven growth as the propensity to spend from lower- to middle-income groups is much higher.

With the shift to a domestic consumption-driven growth model, the need for China to assert full control of its capital account and exchange rate will be somewhat muted.

COLLATERAL BENEFITS

On the other hand, China is increasingly finding more reasons to open its capital account and help internationalise RMB in its financial reform, and because of a growing desire to exercise financial sovereignty.

Internationalising RMB can help curb the global hegemony of the US dollar and skirt US sanctions. With growing stature as a world economic power that is more integrated with the global economy and global financial markets, through international trade, investment and financial linkages, China finds the need to assert global influence more to protect its international interests and to provide a stable and conducive environment for its domestic economy to continue to grow and prosper.

Next, there are collateral benefits of a more open capital account for financial market development. China's growth story attracts increasing foreign portfolio investment inflows which can make up for China's falling current account surplus, due to increasingly unfavourable international trade conditions and China's strategy to move from "world factory" to advanced smart manufacturing. The foreign money also increases the market trading volume, and the associated outside scrutiny by foreign professional and institutional investors helps China to develop more efficient and sophisticated securities and futures markets.

Lastly, China's outbound investment has surged in recent years. More Chinese companies are investing overseas, including those for the Belt and Road Initiative, and more wealthy private individuals are looking to diversify their investments internationally. Authorities, on the other hand, also find capital control measures increasingly less effective as there are more loopholes to move money abroad, for example, by mis-invoicing imports and use of borderless cryptocurrencies.

A CONTROLLED APPROACH

As a result, we are seeing in recent times China adopting an interesting approach to deal with the issue of "impossible trinity": maintaining an independent monetary policy; taking gradual and controllable steps towards capital account liberalisation; and implementing a managed floating exchange rate regime to allow the RMB to fluctuate within a reasonable range.

In other words, China is not simply choosing two of the three goals, but attaining the full goal of controlling the domestic interest rate, while partially liberalising its capital account in a controlled fashion, and at the same time gradually allowing market forces to determine the exchange rate.

One clear example is that while China has since 2018 taken big steps to welcome more foreign capital inflows by scrapping foreign ownership limits in almost all areas of its financial sector and relaxing rules for portfolio investments going into domestic financial markets such as scrapping the quotas for the dollar-denominated Qualified Foreign Institutional Investor programme and the yuan-denominated RMB Qualified Foreign Institutional Investor in 2019, it continues to keep a tight lid on domestic capital outflows.

Such an approach would allow time for China to transit into a consumption-led and efficiency-driven economic development model, build capacity and experience to manage growing cross-border financial risks, and to deal with financial market turbulence and crises.

For China, the top priority is to ensure a strong and stable domestic economy and to further uplift the standard of living of its people. For now, this domestic and inward orientation is more important, outweighing any international considerations such as making RMB an international and reserve currency to replace the US dollar. After all, China is not interested and certainly not attracted to the kind of "privileges" being enjoyed by the greenback - ultra-high government borrowings and the ability to issue financial sanctions against countries or entities deemed hostile to the US.

So, China is likely to adopt a careful, calibrated, and gradual approach towards capital account liberalisation, while seeking to make good progress in economic transformation, reforming its SOEs, strengthening its banks and financial markets, and its ability to manage financial market turbulence and crises.

• The writer is an adjunct university professor, angel investor and adviser to fintech startups, and director of Libai Academy. He was formerly director of MAS Academy.