Capital account risks 'can be managed'

An outlet of Bank of China in Yichang, Hubei province. Banks should ensure that their assets and liabilities are properly matched ahead of any sudden exchange rate movements. [Photo/China Daily]

Benefits of liberalization to outweigh fears of flight, currency speculation

The risks of a complete liberalization of China's capital account are manageable as long as the country carries through with financial reform, experts said.

The nation's tight controls on capital outflows prevent domestic investors from diversifying abroad. Meanwhile, cash is flowing in from exports, driving up foreign reserves.

All that liquidity has nowhere to go but into the lackluster stock market and the overheated real estate industry.

Many fear that the risks of full capital account liberalization, which entails a fully market-driven exchange rate and unfettered cross-border capital flows, outweigh the benefits.

For instance, during the Asian financial crisis in 1997-98, Thailand and South Korea - which had liberalized their capital accounts - experienced massive capital flight.

However, others believe that China faces a lower risk of volatile capital flows.

"The large problems that resulted in capital flight in the 1990s were mainly due to an excessive reliance on foreign credit," said Francis Cheung, head of China and Hong Kong strategy at investment bank CLSA.

"As capital outflows accelerated, foreign credit dried up, resulting in a domestic credit crunch. Foreign debt is equivalent to only 10 percent of China's GDP and is relatively small. Therefore, this is less of a risk for China."

Eiichi Sekine, Beijing chief representative of the Nomura Institute of Capital Markets Research, said: "During the crisis in Thailand, its financial reforms were not carried through when it opened the doors to volatile short-term foreign investment.

"The exchange rate was fixed, which resulted in inflation at home, the depreciation of the local currency and eventually, capital flight. China, on the other hand, has a very strong and stable economy. The country's rise in the past few decades mostly relied on domestic growth."

Another concern about full capital account liberalization is that the yuan would be manipulated by speculators. Cheng Guanlei, an analyst at Hongyuan Securities Co Ltd, wrote in a report that the proportion of yuan settlement in trade is significantly lower than settlement in the currencies of industrialized countries.

Foreign investors hold the Chinese currency because they believe it will appreciate further. Only when Chinese enterprises have grown strong enough to support yuan settlement as a matter of course, and the currency is used overseas for transactions instead of speculation, will full capital account liberalization be a net gain for China.

However, in Cheung's view, arbitrage activity in the yuan is not a major obstacle to capital account liberalization.

"As more and more trade transactions are settled in the yuan, it becomes more of a necessity to open up the capital account. Opening the capital account will help accurately price the exchange rate and domestic interest rates, and that will maintain a balanced economy to manage inflation and growth," he said.

China has recognized the irresistible force of capital account liberalization.

The Development Research Center of the State Council has stated: "Macroeconomic measures such as monetary and fiscal policies will be used to adjust the market instead of direct government intervention."

Last year, many preparatory steps were taken. In July, the People's Bank of China, the central bank, removed the loan rate floor. And in August, the China (Shanghai) Pilot Free Trade Zone was established as a testing ground for financial reform.

Since the yuan can be exchanged freely in the zone, it can lead to exchange arbitrage.

"The key is to push on with financial reform," said Sekine. "Financial agencies must fulfill their role. If the reform of the banking system is not effectively carried out, rich people will transfer their assets overseas. Concrete steps must be taken in establishing bankruptcy procedures for banks, the liberalization of interest rates and an increase of direct financing. Also, the government should speed up reform in the China (Shanghai) Pilot Free Trade Zone and expand it to other regions to prevent exchange arbitrage."

To minimize the risks, capital account liberalization should start with capital inflows and proceed to capital outflows. It should also prioritize direct, long-term, legal person and foreign currency-dominated investment before further opening up to securities, short-term, individual and yuan-dominated investment, Sekine said.

Cheung said that China is still in the process of liberalizing its interest rates and exchange rates before opening the capital account.

"The government needs to ensure that the financial system can handle sudden and large capital outflows, especially given that China's debt-to-GDP ratio is rising and there are potential large nonperforming loans in the system.

"Banks will need to ensure that their assets and liabilities are properly matched ahead of any sudden exchange rate movements."

As for the reform experiments in Shanghai, Cheung worries that too much reliance is being placed on the zone.

"The area is too small to make dramatic changes in the country," he said. "But it can serve as an example or catalyst. The Shanghai free trade zone's use of the 'negative list' appears to be gaining traction around the country, and it's a good example of best practices being spread."

James Lee, regional director of greater China at the Institute of Chartered Accountants in England and Wales, said that Shanghai will be at the forefront to benefit from free capital flows once the capital account is fully liberalized.

"Once capital controls are loosened, then Shanghai can set up its international (equities) board," he said.

"It will have strong global companies that will list on the Shanghai Securities Exchange, giving Chinese investors more opportunities to invest. Locally listed Chinese companies will have to improve their transparency so that the investing public can make good comparisons. This will also move money away from the housing market and stabilize the housing bubble."