Pedestrians walk past the People's Bank of China in Beijing, China, Dec. 23, 2011.
Amid all of the aggressive market reform that has taken place in China over the past 30 years, the country’s financial and capital markets are a glaring exception. Capital controls restrict flows of money in and out of the economy. The value of the currency, the yuan, is stage-managed by the state. The yuan isn’t fully convertible or allowed to trade freely outside the country, either. Foreign investors can buy stocks on local exchanges only on a very limited basis. Interest rates are controlled by the government as well. Foreign banks hold a measly 2% of the country’s banking assets.
For the good of China’s future economic development, this situation can’t persist. At the same time, opening up China’s financial markets and liberalizing capital flows will prove to be one of the most difficult reform efforts ever undertaken by Beijing’s policymakers. The leadership is presented with a nasty catch-22. Keep capital markets and the financial industry tied up in regulatory knots and run the risk of an economic crisis. Liberalize capital flows and free up the financial sector and run the risk of a financial crisis. How China in coming years manages this problem will have huge implications not just for the health of the Chinese economy but for the entire world.
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It is true that China has gained tremendous benefits from its control of finance and capital. During both the Asian financial crisis (1997–98) and the recent Wall Street meltdown (2008), China was better able to shield itself from the worst fallout from these outside shocks than countries with more-open financial systems. The controls have helped China develop industry by funneling the country’s vast pool of savings into investment. Protection from the outside world has also given Chinese banks and other finance firms an opportunity to transition from a communist command system to a market economy.
As the economy advances, however, the costs of maintaining these controls are becoming a major threat to the country’s future growth. Unable to invest overseas, and with few options at home, increasingly wealthy Chinese are forced to plow their savings into real estate, fueling an unsustainable property boom. By controlling the yuan and limiting access by foreigners to yuan-denominated investments in China’s domestic economy, Beijing is hamstringing its own efforts to make the currency more widely used in global trade and finance. That’s because the controls make it less attractive to hold yuan — when there are so few options for investing yuan, what’s the point of holding the currency? China’s banks could benefit greatly from competition from more experienced international players. Most of all, state control over financial markets is skewing prices in the economy and nudging China toward an economic disaster. By manipulating interest rates, policymakers are both punishing savers (holding back badly needed consumption growth) while subsidizing investment (creating excess capacity and weakening the banks’ balance sheets). The longer all of these controls remain, the deeper the distortions they will create in the economy, the higher the risk of a financial crisis.
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The Chinese government is well aware of the need to change. The People’s Bank of China, the central bank, recently released a report that proposed a series of reforms to liberalize capital flows. It is hard to tell if this program is official government policy. More likely, it is a just suggestion floated by some policymakers in favor of more rapid liberalization. But it still gives us a good picture of where China might be headed on financial reform.
The study recommended opening up China in stages. At first, the focus would be on encouraging outward investment by Chinese enterprises since “low valuations in overseas markets offer a rare investment opportunity for Chinese companies,” the bank said. The next stage, over three to five years, would be to further liberalize trading of the yuan, while in the longer term, between five and 10 years away, foreign investors would be given more access to Chinese stocks, bonds and property. At some point, this would lead to full convertibility of the yuan.
This is obviously a go-slow approach. But there is good reason for that. Opening up too quickly would potentially put tremendous strain on a financial sector unprepared for the uncertainties created by free capital flows. Here’s what Martin Wolf had to say in the Financial Times:
The next big global financial crisis will emanate from China. That is not a firm prediction. But few countries have avoided crises after financial liberalisation and global integration. Think of the US in the 1930s, Japan and Sweden in the early 1990s, Mexico and South Korea in the later 1990s and the US, UK and much of the eurozone now. Financial crises afflict every kind of country … Would China be different? Only if Chinese policymakers retain their caution … The arguments for such opening up to the world are closely connected to those for domestic reform. Indeed, the former cannot be undertaken prior to the latter: opening up today’s highly regulated financial system to the world is a recipe for disaster, as Chinese policymakers know. It is for this reason that full convertibility (of the yuan) would come in the distant future, as this plan suggests.
However, the risks of going too slow are just as big. The longer China delays financial reform, the longer the controls will feed the distortions rotting the core of the Chinese economy. And the pattern of the central-bank reform plan could also cause problems. Notice how the early stages of capital-market reform are focused on Chinese investment going global to take advantage of the weakness of advanced economies, while keeping its own domestic economy closed off. That’s a formula for creating resentment in China’s trading partners, and possibly reciprocity-based retaliation.
My biggest worry is that Beijing’s policy mandarins will drag their feet on reform. By freeing up the exchange rate, interest rates and capital flows, they would be forcing drastic change on the pillars of the country’s investment-and-export-led growth model — change that is badly needed, but not happening quickly enough. By continuing to cling to old policies, however, Beijing is potentially leading the economy into a dead end. I have tremendous sympathy for the difficulties China’s leaders face on the issue of financial liberalization. Navigating financial and capital reform will take the skill and daring of an economic neurosurgeon. But inaction, in my opinion, is much more dangerous.
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