Opinion

China gingerly taking the capital account liberalisation path

Since China is the number one trading nation, the second largest economy and a large net creditor, the world has a huge stake in how China manages its tricky transition from a state of binding capital controls to one of closer integration with the global financial market and system.

By: Date: October 16, 2014 Topic: Global Economics & Governance

Since China is the number one trading nation, the second largest economy and a large net creditor, the world has a huge stake in how China manages its tricky transition from a state of binding capital controls to one of closer integration with the global financial market and system.

A natural starting point is, of course, where China currently stands in its financial integration with the rest of the world. How open financially is China when we compare it to its own recent past or its major emerging market peers like India?

To answer this question, Robert N. McCauley and I conducted a study by analysing eight measures of capital account openness (four price-based measures and four non-price ones). Our four price-based measures were based on the ‘law of one price’: the same financial asset should trade at about the same price in the onshore and offshore markets. The study covered the forward market, money market, bond market and stock market.

The non-price indicators involved macroeconomic openness, cross-border financial flows and positions, banking market integration and currency internationalisation.

The study shows that China has been financially less open than India on average over the past decade, contradicting the conventional wisdom and other, more widely known measures of financial openness. This may have a lot to do with a mix of the need to fund current account deficits in India; the greater rigour with which the capital controls are enforced in China; the long-standing multinational operations of Indian private firms that can arbitrage onshore and offshore markets; and a larger footprint of global banks in the Indian domestic banking market.

Both economies over the years have been advancing in their financial integration with the world, though in the wake of the global financial crisis China has beencatching up with India. This in part could relate to the fact that emerging markets running current account deficits, like India, face a more binding external financing constraint, especially in a world of highly pro-cyclical and volatile capital flows. The policy-supported renminbi internationalisation in recent years has also punched holesin the Chinese wall of capital controls.

But both China and India still have quite some way to go in opening their financial markets to the outside world, suggesting that the task of capital opening is a real challenge. Controls of their capital accounts may be leaky but still bind substantially. This is true not only by comparison with advanced economies but also when measured against a benchmark of major emerging market economies.

The evidence indicates strong inward pressure on bond and bank flows in China upon full capital account opening, at least in the short term. This is because Chinese fixed income instruments have been cheaper onshore than offshore. This finding contrasts with consensus forecasts which have predicted that, over the medium term, China is likely to experience net private capital outflows under the channels of direct and portfolio investment. Also, our reading of net inflow pressure in the short term and the consensus reading of net outflow pressure over the medium term could imply that two-way capital flows can be highly volatile during the liberalisation process.

This implies three important things for Chinese policymakers.

Care needs to be taken when drawing lessons and insights from some of the freely available popular measures of financial openness. These do not reliably signal progress in capital account opening.

There must be careful monitoring of the risks that lie along the path of capital account liberalisation. Stronger and more transparent reporting and statistical systems should be put in place so that broad market positions and cross-border flows can be tracked in a timely and systematic fashion. In particular, bank flows need to be monitored closely and any seeming inconsistencies between national data and partner data like those compiled by the Bank for International Settlements need to be explained.

Finally, policymakers need to proactively manage the risks that come with liberalisation. A sustained increase in exchange rate variability ahead of substantial capital opening could serve to render the renminbi a less attractive carry-trade target. The widening of the permitted daily trading band of the renminbi — from plus or minus one per cent to plus or minus two per cent in March 2014 — might help ease short-term inflow pressure and facilitate the transition to medium-term net outflows upon full capital opening.

Republished from EAF with permission.

Read more on China

China seeking to cash in on Europe’s crises

China’s financial liberalisation: interest rate deregulation or currency flexibility first?

Review: The China slowdown effect

Financial openness of China and India: Implications for capital account liberalisation

Developing an underlying inflation gauge for China

Are financial conditions in China too lax or too stringent?

How tight is China’s monetary policy?

The Dragon awakes: Is Chinese competition policy a cause for concern?

How loose is China’s monetary policy?


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to communication@bruegel.org.

View comments
Read about event

Past Event

Past Event

A conversation with Jin Liqun, president of AIIB

We were pleased to host Jin Liqun, the president of Asian Infrastructure Investment Bank at Bruegel.

Speakers: Sven Biscop, Guntram B. Wolff and Jin Liqun Topic: Finance & Financial Regulation, Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: January 22, 2018
Read article More by this author

Opinion

China Fails to Woo U.S. With Financial Sector Opening

China's recent announcement of reforming its financial market has received little enthusiasm from the U.S. despite its potential benefits. The lack of a clear agenda regarding its economic rival has pushed the Trump administration to minor any significant progress of China's reform, and to maintain focus on strategic issues.

By: Alicia García-Herrero Topic: Finance & Financial Regulation, Global Economics & Governance Date: January 5, 2018
Read article

Opinion

Chinese banks’ improved asset quality cannot hide other phantoms

The recent improvement in asset quality cannot mask other growing concerns in China’s banking sector. Beyond liquidity concerns, other structural issues such as low profitability and insufficient generation of organic capital, are emerging.

By: Alicia García-Herrero and Gary Ng Topic: Finance & Financial Regulation, Global Economics & Governance Date: December 20, 2017
Read article More by this author

Opinion

South Korea needs to watch the BOJ rather than the Fed

Due its actual economic structure, South Korea should be more worried about BOJ's extremely lax stance than about monetary policy normalization by the Fed.

By: Alicia García-Herrero Topic: Finance & Financial Regulation, Global Economics & Governance Date: December 14, 2017
Read article Download PDF More on this topic

External Publication

Central Asia—twenty-five years after the breakup of the USSR

Central Asia consists of five culturally and ethnically diverse countries that have followed different paths to political and economic transformation in the past 25 years. The main policy challenge for the five Central Asian economies is to move away from commodity-based growth strategies to market-oriented diversification and adoption of a broad spectrum of economic, institutional and political reforms

By: Marek Dabrowski and Uuriintuya Batsaikhan Topic: Global Economics & Governance Date: November 14, 2017
Read article More by this author

Blog Post

European worries about isolationist trends

Populist shocks in the UK and US threaten the multilateral order on which the EU depends. What lies behind these earthquakes, and what does it mean for Europe? Withdrawing from the world is no solution to geo-political upheavals, but Europe needs to reassess the future of globalisation.

By: Maria Demertzis Topic: European Macroeconomics & Governance, Global Economics & Governance Date: November 7, 2017
Read about event More on this topic

Past Event

Past Event

EU - CELAC Economic Forum - Channels for a joint future

On 11 October Bruegel together with GIGA and Real Instituto Elcano will organise a conference on relations between the EU and the Community of Latin American and Caribbean States.

Speakers: Paola Amadei, Angel Badillo, Paulo Carreño King, Linda Corugedo Steneberg, Gonzalo de Castro, Gonzalo Gutiérrez, Bert Hoffmann, Edita Hrdá, Ramón Jáuregui, Emilio Lamo de Espinosa, Eduardo Levy Yeyati, Gabriel Lopez, Enrique Medina Malo, Maryleana Méndez Jiménez, Luicy Pedroza, Mario Pezzini, Mario Soares, Everton Vargas, Dylan Vernon and Guntram B. Wolff Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: October 11, 2017
Read article More on this topic More by this author

Blog Post

Long-term growth potential, or dead in the long run?

By linking growth with both employment and the imperative for India to hold its own with China for strategic autonomy, Prime Minister Modi has brought sustainable, high quality, inclusive economic growth to the centre of political discussion, which is where it rightfully belongs.

By: Suman Bery Topic: Global Economics & Governance Date: October 5, 2017
Read article More on this topic More by this author

Blog Post

Ukraine’s oligarchs are bad for democracy and economic reform

Ukraine’s late and incomplete economic reform created a class of super-wealthy oligarchs who now stand in the way of further liberalisation. The oligarchs’ oversized influence only deepens public distrust in a structurally weak political system. Nevertheless, Ukraine is making some attempts to uproot corruption and the next steps are clear.

By: Marek Dabrowski Topic: European Macroeconomics & Governance Date: October 3, 2017
Read article More on this topic More by this author

Blog Post

Chinese banks: An endless cat and mouse game benefitting large players

As deleveraging moves up in the scale of objectives of the Chinese leadership, banks now face more restrictions from regulators. As a result, banks have been very creative in playing the cat and mouse game in front of evolving regulations.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: September 26, 2017
Read about event More on this topic

Past Event

Past Event

14th Asia Europe Economic Forum (AEEF)

The 14th Asia Europe Economic Forum will be held in Seoul on 20-21 September 2017.

Topic: Global Economics & Governance Location: Seoul, Korea Date: September 20, 2017
Read article Download PDF

Policy Contribution

Capital Markets Union and the fintech opportunity

Fintech has the potential to change financial intermediation structures substantially. It could disrupt existing financial intermediation with new business models empowered by intelligent algorithms, big data, cloud computing and artificial intelligence. Policymakers need to consider four questions urgently: Develop a European or national fintech market? What regulatory framework to pursue? Should supervision of fintech be exercised at the European level? What is the overall vision for the EU’s financial system?

By: Maria Demertzis, Silvia Merler and Guntram B. Wolff Topic: Finance & Financial Regulation, Innovation & Competition Policy Date: September 15, 2017
Load more posts