23 October 2018
Mainland officials describe the Shanghai free trade zone as a testing ground for reform that will be applied to the rest of China down the track. Photo:Bloomberg
Mainland officials describe the Shanghai free trade zone as a testing ground for reform that will be applied to the rest of China down the track. Photo:Bloomberg

China’s long march to a freer capital account

China’s leaders are not just talking about financial liberalization — they’ve started to act.

China may not be ready to make its currency fully convertible in the short term, and regulations and regulators may not be ready to ensure prudence in the financial sector. Concerns may also linger about the health of China’s banks. But the direction of reform is not in doubt.

In November, the Communist Party’s Central Committee approved a 60-point reform blueprint for a major policy change in the way resources are allocated. It can be difficult to interpret these documents but some commentators suggest that when the policies are implemented, markets will have a ”decisive” role in resource allocation, with 2020 the target date for key changes. The reasons for the changes are pragmatic. Many analysts believe that China must either emulate the structures and institutions of advanced countries or confine itself to permanent middle-income status.

This is based on the view that markets would do a better job than the existing administrative system at promoting growth, improving capital allocation, encouraging diversification of assets, smoothing consumption, and speeding the transition towards more balanced growth.

This means the pattern of growth should be rebalanced away from export and infrastructure investment and towards consumption. There is a need to slow or stop the accumulation of China’s vast international reserves. Currency market intervention complicates monetary policy, something a freely floating exchange rate would make unnecessary.

At the same time, the absence of competition has allowed banks to become complacent so opening up financial markets would create incentives for good decisions. And rising real wages in China make its exports vulnerable to competition from newly emerging economies, meaning it cannot rely on export growth alone to meet GDP growth targets.

So, what needs to be done?

Some of the necessary reforms have already been identified. The basic purpose of mainland law and regulation will need to change from directly allocating resources to creating the conditions for efficient financial markets.

Foreign exchange market policy must also change. All this begins with acknowledgment of the “Impossible Trinity” — the understanding that no country can have free capital movement, a fixed exchange rate, and simultaneously enjoy monetary independence. One of these objectives must be sacrificed to manage the other two. A modern financial system must also tolerate competition.

The People’s Bank of China (PBoC) has started with the foreign exchange market. It doubled the size of the yuan’s daily trading band in March to increase the currency’s two-way flexibility. This led to a managed depreciation of the exchange rate, a clear signal that currency appreciation is no longer a one-way bet. The authorities say the yuan’s trading limit will likely be abandoned altogether to allow the exchange rate to float more freely based on unified onshore and offshore trading of the currency. Central bank governor Zhou Xiaochuan has also said the PBoC will “basically exit” from regular intervention in the currency market.

Following the elimination of the floor on lending rates in July last year, the authorities now plan to remove the cap on deposit interest rates and implement deposit insurance, perhaps in under two years. Lifting the ceiling on deposit rates could, for example, damage the balance sheets of financial institutions that have a large portfolio of low-yielding assets so measures to deal with insolvent banks will also be required.

The weakness of financial institutions and inadequate regulation pose a different kind of challenge. This is where the Shanghai free trade zone fits into the picture. The zone is described by mainland officials as a testing ground or pilot for reform to apply to the rest of China at a later date. The zone got off to a slow start in September but a joint committee has since been established to improve coordination between the various financial regulators whose jurisdictions in the zone sometimes overlap. Both mainland and overseas financial institutions will be encouraged to set up in the Shanghai zones. The intention is for foreign firms to provide expertise and services previously unavailable in China; in return they will have access to sectors that were closed to foreign companies until now.

It is clear that the PBoC and other regulatory bodies will have to ease their control of some transactions originating in the Shanghai zone to encourage participation. The relief could affect inward and outward direct investment; cross-border and cross currency loans; capital market investments, and derivative transactions. The first steps are mainly of interest to Chinese residents.

New regulations will liberalize cross-border capital flows and increase currency convertibility. This includes: (1) easing cross-border use of the yuan, (2) liberalizing interest rates on foreign currency loans, (3) facilitating offshore financing and outbound investment.

Limits on investment will be eased later and quotas for qualified domestic and foreign investors (QFIIs and QDIIs) will be dropped “when the time is ripe”, according to the PBoC. But to the dismay of portfolio investors, it could still be years before the volume limits on investment are scrapped to give overseas investors full access to Chinese capital markets and Chinese investors access to global markets.

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Senior economist with Oxford Economics’ Macroeconomics division.

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