Capital Flows and Capital Controls: Main Arguments in China Today

1. Capital Flows and Capital Controls: Main Arguments in China Today Liping He Beijing Normal University December 20, 2011

2. Contents • Why for capital controls? • Why against capital controls (or for capital account liberalization)? • Possible policy moves in the future

3. Main Arguments for Capital Controls • An older view: free movements of capital would pose threats to domestic economic and financial stability. • A newer view: cross-border capital flows would increase further pressures on currency revaluation and render domestic monetary policy ineffective. • A rather “silent” view: capital account liberalization would ultimately undermine the power of the state over the economy.

4. Some quick checks…. • Having accumulated a huge amount of foreign exchange reserves, the Chinese economy has supposedly increased its immunity from external shocks to its economic and financial stability, and therefore, the necessity to maintain capital controls become much smaller than before. • Yet capital controls remain in substance, which may raise a question of the real reasons for either or any of the two facts: FX reserves and capital controls in the country.

5. ….Another quick check • The newer view actually reflects the so-called “impossibility of triangle”: monetary policy independence, fixed exchange rate regime, and capital account liberalization. • Some favor the first two at the sacrifice of the third: capital controls as a means for achieving monetary policy independence and floating exchange rate regime (also currency revaluation). • In fact, China today has a different mix: effectively reduced monetary policy autonomy (because of the burdens of sterilization), largely inflexible exchange rate regime, and half-way capital account liberalization.

6. The third might be the hardest question to answer…. • Capital de-control would in effect means that firms (including financial institutions) and individuals have unrestricted power to (re)allocate their assets across borders and to certain extend to borrow from abroad. • And this furthermore may lead to the power of the state to intervene in the economy diminishing, especially in the manner that the authorities used to enjoy in the old time. • In China today, many firms and individuals do have certain discretion to decide on the matter of cross-border asset reallocation and external borrowing on their own (de facto financial liberalization), and the government maintains largely nominal regulation on capital account transactions and reserves the power to shut all doors as an emergency management means.

7. Main Arguments (policy motivations)for Capital De-controls • There have been several new policy objectives, each of which would put forward a case for capital de-controls in China. • Investment “go abroad”. • Establishment and development of a major international finance center in Shanghai. • Pursuit of RMB internationalization. • (as the latest) geopolitical consideration: “mutual financial hostages”.

8. Chinese investment “go abroad” • There are several reasons for policy-driven “go abroad” moves: energy and raw material supply; growth of Chinese conglomerates; reducing external imbalances. • “Go abroad” requires capital de-controls as so requested by destination countries. • And that would apply to cases depending whether direct investment or financial investment is emphasized.

9. Establishment and development of international finance center • There seems to be a national sentiment that a strong economy should also have a large international financial center. • It emerges that Shanghai has been aimed to become a major international financial center, eying on cities like Hong Kong or Tokyo. • That has also required the government lift capital controls, especially for domestic and foreign financial institutions and investment funds. • Though it has not yet made major decision on the matter, it appears that the government is willing to consider the option.

10. Pursuit of RMB internationalization • “RMB internationalization” actually refers to the policy moves that aim at promoting a wider use of RMB in China’s external dealings, such as trade and investment (perhaps also aid). • The main motivation is understood to be make the currency become ultimately an international currency that is comparable to the dollar or the euro. • An essential prerequisite is RMB convertibility, i.e., capital de-control. • At the moment, the government has not conceded on the point, but some relaxing measures have been undertaken.

11. “Mutual financial hostages” • As China becomes a significant net creditor in the world and lots of its foreign exchange assets are invested in the U.S. and western Europe, a geopolitical issue emerges that they would possibly become a financial hostage at a time when sudden unexpected occurs. • For this reason, it is in theory desirable on the Chinese side that similar foreign assets are invested in the country’s financial market so that China also holds an equal financial hostage if and when such a situation happens. • In short, decision on capital (de)controls is an issue that weighs all positive and negative effects on one mind.

12. Possible Policy Moves in the Future • Tentative moves toward external financial liberalization. • No “Big Bang” may be expected. • No completion in the foreseeable future.