Some market watchers believe the renminbi’s slowing internationalisation trend of the last 12 months reflects the Chinese government’s unwillingness to relinquish control to market forces. They argue greater currency liberalisation is unlikely to materialise. But doubts about the inevitability of China’s financial opening ignore long-term forces.
Many governments can withstand controls on capital account flows because they do not lead to obvious costs. However, China is a net creditor to the rest of the world, which should produce higher net income. In China’s case the costs to its domestic economy ensue not so much because of capital controls, but because the funds it channels abroad are invested suboptimally. The former reflects the disproportionate share of low-yielding foreign reserves as a share of foreign assets. The latter is explained by the cheap lending practices of Chinese state-owned companies. These policy choices lead to high national costs, which would be lower if Beijing were to allow partial liberalisation of the capital account and promoted the renminbi as an international currency.
Over the last 12 months, a substantial portion of foreign reserves has been converted into foreign assets of Chinese banks and corporations, which should raise investment income in the future. Similarly, if China wishes to project geopolitical power through its lending capacity, its ability would be enhanced by adopting the renminbi for these operations, rather than foreign currencies.
The renminbi’s inclusion in the International Monetary Fund’s special drawing right, the Fund’s composite currency unit, strengthened its reserve currency status. But China can enjoy neither the tangible financial nor geopolitical benefits without increased convertibility and internationalisation of the renminbi.
Another macrofinancial cost to China’s capital account policies is the domestic effect of financial repression. As most financial products will offer only a zero-real rate of return and investment abroad is not permitted on a large scale, Chinese savers stock up unduly with domestic growth assets. This invariably creates financial bubbles.
Problems in parts of China’s property markets, the equity market in 2015 and the flourishing of wealth management products are examples of the risks that can stem from these financial imbalances.
In response, in July the Beijing national financial work conference endorsed a tighter regulatory and institutional approach to containing financial risks. Such measures are welcome and necessary in the short term. Loosening the capital account to permit the greater influence of market forces would be a complementary long-term step.
This would help remove some of the excess savings from China’s financial markets.
The inefficiencies of credit allocation raise further problems. A state-owned banking system combined with the political economy of local governments generates an institutional bias towards channelling credit to state-owned enterprises. This leads to declining overall productivity, as state-owned businesses are less productive than the private sector, weakening long-term growth.
The entry of foreign capital would help alleviate this problem by compelling state-owned enterprises to compete more fairly for credit and allocate funds more efficiently.
This would reduce China’s overhang of industrial capacity, and would probably accelerate state-owned enterprise reform. Likewise, capital account liberalisation would promote faster growth in services at the expense of manufacturing. These trends would help rebalance the economy away from state-directed manufacturing enterprises, and lower the investment rate and the size of export capacity. This would lower the current account surplus over the longer-term.
Excess savings pose systemic risks to China’s domestic financial system. Such circumstances are unsustainable. Since imbalances grow year by year, further market opening will, inevitably, proceed sooner rather than later. The internationalisation of the renminbi may have stalled over the last 12 months, but the long-term trajectory shows it taking its rightful place as a major global currency.
Elliot Hentov is Head of Policy & Research, Official Institutions Group, at State Street Global Advisors, and a Member of the OMFIF Advisory Board.
This is the second article in a two-part series on market liberalisation in China. The first part is available here.