The observation motivates a set of interesting policy questions: why has China changed its official stance on managing the capital account? And what is the appropriate strategy to rely upon to proceed with future reforms?

To answer the first question, one should review the history of China’s capital account management. In the late 1970s when China first launched economic reforms, the capital account remained tightly controlled and excessive borrowing was strictly forbidden. The next stage began in the early 1990s, as China’s financial institutions became more developed and capital account restrictions were loosened. China fell short of the ambitious goal of achieving full capital account convertibility by 2000, however, hindered by the 1997 Asian financial crisis in 1997. Between 1997 and China’s 2001 WTO accession, capital controls were actually strengthened to realise better financial stability. Intensive regulations continued in the post-WTO accession period, but a series of liberalising reforms were carried out to alleviate the accumulating pressure from current and capital account surpluses, such as opening the market to foreign investors in the form of qualified foreign institutional investors (QFII).

Two opposing views have emerged about what the ‘right’ strategy of further capital account liberalisation should be. The ‘big bang’ view stresses the limited capacity of countries to reform themselves in the absence of external pressures for reform, and cites the reform successes ensuing China’s accession to the WTO as supporting evidence. The alternative ‘gradualist’ view emphasises the importance of achieving macroeconomic stability and developing domestic financial institutions, markets, and instruments before liberalising the capital account, which should occur late in a country’s economic reform program.

But neither the ‘big-bang’ nor the ‘gradualist’ approach should be regarded as the optimal liberalisation strategy to guide China’s reforms. Instead, an integrated approach is best: such a strategy would not run the risk of financial crisis associated with the aggressiveness of ‘big bang’ reforms, but neither would reforms wait until ‘everything is in its place’, since it is impossible to know when the economy is ready for more liberalising reforms without actually being exposed to the strains caused by the reform process itself.

Capital account reforms should be accompanied by the introduction and the enforcement of an adequate degree of regulation and supervision. Inflows of foreign direct investment are broadly considered to result in net benefits. Nevertheless, this investment has potential negative effects, such as inhibiting local entrepreneurship and causing irreversible environmental damage. Authorities must create regulation and supervision about the type of inward investment that will maintain China’s competitiveness and guard its national interests.

On the other hand, the liberalisation of outward direct investment is also far from complete. The state must totally retreat from intervention in firms’ investment decisions. Regulation should shift away from a government approval system to a registration system to allow firms to more freely make overseas investment decisions based on their own commercial interests and risk appetites. It is also important to create a non-discriminatory investment framework, in which a set of transparent rules treat all firms equally regardless of their size and ownership.

Capital account reforms should still follow the traditional approach of ‘crossing the river by feeling the stones’. In this way, an important pilot scheme that was initiated in 2007 allowed qualified domestic institutional investors (QDII) to raise capital from Chinese investors to invest in foreign markets.

Although Chinese investors embraced the QDII scheme with enthusiasm, the explosive early growth failed to repeat itself in subsequent years. The primary cause of the diminished enthusiasm was the deficiency of knowledge and lack of professional training required for QDII fund managers to successfully invest in foreign markets. Further reforms to boost enthusiasm for the QDII scheme should include the push for exchange rate reforms, to reduce the negative impact of currency appreciation on QDII performance; granting tax deductions or exemptions to incentivise investors; and raising knowledge standards for QDII managers to improve the industry’s quality.

The integrated approach to liberalisation does not advocate that China should give up all capital restrictions or interventions. For instance, when China realises a free floating exchange rate, the government could create a fund for intervening in the foreign exchange market to avoid excessive volatility and achieve stability of the exchange rate. Again, the authorities could retain the QFII and QDII systems until domestic institutions are ready to withstand quick flow reversals of large volumes of capital. The government could also maintain some state ownership of financial institutions to boost investor confidence, although direct state influence in their operations should be eliminated quickly.

In the long run, the only right strategy to improve China’s capital account regulation and its financial institutions is through opening up and reforms. After all, the integrated approach is not a panacea for China’s institutional deficiencies, nor is it enough to drive the economic reforms needed for maintaining domestic financial stability.

China’s capital account liberalisation will impact the global economy by allowing foreign citizens to share in China’s growth potential by investing in a variety of China’s asset markets, like its stock and real-estate markets. Conversely, Chinese capital will be able to flow into foreign markets freely, catalysing growth in host economies. In addition, capital account liberalisation is a precondition towards achieving the ambitious goal of renminbi internationalisation. A freely convertible and widely accepted RMB will wipe out exchange rate uncertainty and facilitate regional trade development. China’s capital account liberalisation will be a big step toward a more efficient global financial architecture.

Daili Wang is a PhD Candidate at the China Center for Economic Research, Peking University. He was a visiting scholar at Columbia University in 2012–13.