Crossing this Chinese river needs building a large bridge

Author: Peter Drysdale, Editor, East Asia Forum

China’s approach to economic reform is commonly characterised by Deng Xiaoping’s metaphor of ‘crossing the river by feeling the stones’. This is the experimental approach to economic and social reform. It is typified by the successful implementation of the household responsibility system that saw the transformation of Chinese agriculture and the early liberalisation of trade and investment through the establishment of Special Economic Zones together with economic experimentation in Guangzhou.

What was foreshadowed in the Third Plenum package at the end of last year was a somewhat different approach to reform. With capital account liberalisation, the river to be crossed now is altogether too deep and swift flowing for the old strategy to allow getting to the other side safely. The reform package requires top-level design: the building of a bridge that starts from both sides and comes together in the middle, hopefully on the schedule to which the Chinese leadership has aspired; five or six years, perhaps a decade down the track.

The current challenge is enormous — the full integration of China’s capital markets into international capital markets. The big challenge earlier — of fully integrating Chinese commodities markets into the international commodities markets, consummated after entry to the WTO in 2001 — took time and the gritty leadership of former Premier Zhu Rongji and Assistant Trade Minister Long Yongtu. But capital account liberalisation, even embarked on now, is an ambition that won’t be quickly achieved. And it requires the total commitment of President Xi and Premier Li.

For one thing, financial reform is at the centre of the new reform agenda. Distortions in interest rates have long caused enormous misallocation of capital — favouring state-owned enterprises and shielding the banking sector from the need to build risk-management capacity, and hurting employment by diverting China’s financial resources from the more dynamic private sector. Financial reform is critical to capital account liberalisation and internationalisation of the RMB. The RMB can only become an effective regional or international currency under a convertible capital account. The need for a convertible capital account is a consequence of the scale of China’s cross-border trade and investment payments. Progress toward achieving capital account convertibility and toward the RMB becoming a global currency is a key to China’s future capacity for economic growth.

For another thing, as noted before, it’s not just a narrowly technical economic challenge; integration of China into international capital markets will require a much more open and transparent set of institutional arrangements that push at the envelope of political reform. These problems are embedded deeply in China’s political economy. They have a political dimension that will cut deeply into the close relationship between state-owned enterprises and the ruling Communist Party. The priority is economic reform, the structural imperatives of which are full of unintended consequences for the political system, the risks of which the new leadership seems willing to embrace. And its purchase on political legitimacy with China’s new middle class rests primarily with success in this next phase of economic reform.

Yu Yongding, one of China’s most distinguished economists, observes in this week’s lead essay that China gradually embarked upon the process of capital account liberalisation after 1996, and that the remaining capital controls are mainly used to regulate short-term capital movements. The enthusiasm for capital account reform was dulled by the onset of the Asian Financial Crisis.

There were, nonetheless, great hopes for internationalisation of the RMB — its increasingly widespread use as a transaction currency, as a measure of international value and as a reserve currency — with bullish predictions, a few years ago, of the growth in offshore RMB deposits in Hong Kong, the increase in RMB trade settlements, and the expansion of RMB-denominated bonds and loans. Indeed, trade settlements already amounted to 10 per cent of Chinese total trade at the end of 2012 and there have been increased holdings of RMB as a reserve currency by central banks with the inexorable growth of China’s share in international trade transactions.

These are remarkable developments but other dimensions of international capital market integration have proceeded more slowly than some anticipated.

As Yu points out, even with a partially opened capital account, there are two drivers of capital market integration, apart from the sheer size of China in international trade transactions and the convenience of using RMB for settlement. One is the opportunity for exchange rate arbitration (now diminishing as the expectation of further RMB appreciation has weakened). Another is interest rate arbitrage, which has led to a rapid increase in RMB-denominated letters of credit. As Chinese businesses and individuals expand their activities around the world, the opportunity for interest rate arbitrage has grown, and it will continue to grow further. This development both frustrates some of the principal objectives of short-term capital controls at the same time as it urges hastier preparation for their abandonment.

Yu says that the question now facing the Chinese government is whether it should abandon these controls. In the right circumstances, capital account liberalisation will give a boost to RMB internationalisation. But, as Yu points out, before the capital account can be fully opened up and the RMB made freely convertible, China needs to do a lot of other things to avoid financial and foreign exchange rate risks. ‘Macroeconomic stability has to be achieved; the high ratio of financial leverage should be reduced; a rational and flexible interest rate structure must be created; risk management capacity across industries should be established; and intervention in the foreign exchange market minimised’, Yu notes. And ‘most importantly, China must make the RMB exchange rate flexible to reflect demand for and supply of foreign exchange in the forex market’. The problem needs to be attacked from both sides of the river. Without completing reforms at home as well as in the regulation of the foreign exchange market, the Chinese economy would be exposed to unacceptably dangerous risks.

Clearly all of this will take time. It will not be achieved through a bottom-up process. It is a hugely complex task that requires putting in place the right structures at both ends, structures that will come together successfully in the middle. As Yu concludes, China is just at the beginning; but the rest of the world now needs to be ready for what will be a fundamental change in how the international financial system will work not very far down the track at all.

Peter Drysdale is Editor of the East Asia Forum.