16 October 2018
A fully convertible renminbi could cause economic catastrophe when the government loses control of the exchange rate. Photo: CNSA
A fully convertible renminbi could cause economic catastrophe when the government loses control of the exchange rate. Photo: CNSA

How liberalizing the capital account could be a disaster

It has been reported that China may include full renminbi convertibility in its 13th Five-Year Plan.

Top communist leaders, meeting in the fifth plenum of the 18th CPC central committee from Oct. 26 to 29, are expected to approve the blueprint.

However, a fully convertible renminbi could cause economic catastrophe for China in three ways.

First, free capital flow means Beijing will lose control of the renminbi exchange rate.

Instead, the exchange rate will be determined by forces driving those capital flows.

A market-based exchange rate could be more than the Chinese government and the economy can afford, resulting in huge economic losses.

Second, liberalizing the capital account will attract massive capital inflow in the first five to 10 years which would push up the renminbi, as well as asset prices, consumer prices and wages to extremely high levels.

That could lead to future financial turmoil.

Also, continued hot money inflows, coupled with a booming economy, a strong currency and high inflation, would create a huge foreign trade deficit.

If that happens, China could be targeted by hedge funds as we’ve seen in Thailand in 1997 and in Vietnam in recent years.

That could trigger renminbi depreciation and increase the risk of a financial crisis or recession.

Third, Beijing is able to use monetary easing and other policy tools to manage financial risks and instability, such as the stock market crash and the shadow banking problem, but only as long as it can maintain capital controls and a foreign trade surplus.

By contrast, if China allows free capital flow and begins to post huge trade deficits, these internal financial issues could trigger a currency crisis, which could lead to heavy sell-off of Chinese assets.

For example, many foreign investors would be interested in Chinese assets such as stocks, property, natural resources, banks, tech firms, public utilities etc. if China removes capital controls.

That would lure massive capital inflow in the first five to 10 years.

These foreign investors would dump Chinese assets if they sense a currency crisis or financial turmoil.

That would bring down the renminbi and asset prices, as well as worsen the economic and financial damage.

A huge trade surplus and a competitive foreign exchange rate have enabled China to focus on developing its economy and escape currency crises and financial turmoil in past decade.

The Chinese central bank was able to print money indefinitely to provide liquidity and defuse a financial crisis thanks to its huge trade surplus and competitive foreign exchange rate.

But the switch to free capital flow might thwart Beijing’s efforts to become a global economic powerhouse.

Global speculators would target the renminbi which could spark an exchange rate slump, asset sell-off, banking crisis, liquidity crunch and severe economic recession.

The central bank may find its hands are tied and cannot use expansionary monetary policy to fix the problem.

Without capital controls, a huge trade surplus and a competitive exchange rate, the recent equity market crash would have triggered a chain reaction, leading to panic selling of property and other asset classes.

The authorities need capital controls in order to use expansionary monetary and fiscal policy to boost economic recovery.

Chinese leaders should watch out for the aftermath of capital liberalization.

Leaders in Malaysia, Thailand, Indonesia and South Korea stepped down after the 1997 Asian financial crisis.

Also, a financial crisis might trigger political turmoil and threaten the legitimacy of the Communist Party.

This article appeared in the Hong Kong Economic Journal on Oct. 26.

Translation by Julie Zhu

[Chinese version中文版]

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Associate Professor, Division of Economics, School of Humanities and Social Sciences at Nanyang Technological University

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