Shi Jianhuai

 

Since China has made the renminbi convertible for its current account for a decade, liberalizing the capital account becomes an increasingly pressing issue for the country.

 

Financial globalization has evolved to such an extent since the 1990s that the international currency trade is more than 100 times the commodity trade.

 

The flow of financial assets across borders is gaining an increasingly important position in world economic development. International financial transactions have taken the place of international trade as the powerhouse for global growth.

 

Against such a backdrop, it is easy to understand why Chinese administrative control of the capital account is being strained.

 

Liberalizing the capital account would also help China promote reform in several key aspects.

 

As required, China's financial sector fully opened after the five-year transition period for its World Trade Organization membership came to close in 2006. When the foreign-invested commercial banks, insurance companies and investment banks offer financial products and services to clients in China, cross-border capital flows are inevitable.

 

The huge capital flows will mean a heavy workload for the authorities in charge of capital account control. Meanwhile, the control will probably prevent the country from enjoying the full benefits from the financial opening-up.

 

China's economy depends heavily on the outside world after three decades of opening-up. The total volume of commodity imports and exports amounted to $1.76 trillion in 2006. The size of the trade involves massive risks in the country's balance of international payments.

 

China's giant trade surplus means that China gains more money from the commodities it sells than it spends. Because of the closed capital account, all foreign currencies from the trade surplus must be sold to the central bank.

 

Thus, the central bank becomes the major holder of the foreign currency and the State is pressured for holding the massive amount of money.

 

If this right is divided among numerous private owners, they would manage it with greater efficiency and flexibility. But this perspective is only possible with a liberal capital account.

More cash in renminbi is used in payment and trade settlement with other countries. But the Chinese monetary authorities are reluctant to make renminbi an international currency for fear of possible shock to the economy in case overseas renminbi cash is brought into China.

 

Such fear will be unnecessary if China opens its capital account. Then the money circulating overseas will mainly be in bank deposits and not in cash so will not have much influence on the domestic money supply.

 

Actually, the scheme of capital account control has been less strict than it is meant to be due to both internal and external pressure. As the third biggest trade power in the world, China is seeing increasingly open trade. The free trade scheme is often used to facilitate capital flows across the border without being watched by the authorities. Some international hot money sneaks into China's capital market with the help of exporters.

 

The financial opening-up has facilitated such money flows because the monetary authorities have no way to control foreign financial institutions in their business details.

 

The short-term foreign debt has been rapidly rising in recent years. The major source of such debt is the foreign invested financial institutions. The strong growth is propelled by the international expectation of a renminbi appreciation.

 

Moreover, it is now mission impossible for the monetary authority to approve every currency trade when the number of cases is so huge.

 

A pragmatic choice is to stop administrative control over the capital account, which is both costly and inefficient, and turn to a market-orientated governance.

 

A good example can be found in Chile, where all commercial banks and financial institutions must hand in a percentage from their foreign debts as a non-remunerated reserve requirement. The shorter the debts, the higher the percentage.

 

Such a policy tool over capital inflow is based on the rule of the market, which is better than administrative control. And it is also more flexible because the rate of the reserve requirement can be adjusted according to actual needs.

 

A liberal capital account is one of the targets for financial reform. The key problem is timing the opening of the capital account, not whether or not it should be opened.

 

In my opinion, the capital account should be liberalized as soon as possible once the country is ready. And opening the account should be done gradually.

 

China is currently seeing sound economic growth, relatively low inflation, considerable surplus in foreign trade and fiscal budget, abundant reserves of foreign exchange and a currency with appreciating pressure.

 

China's financial reform has achieved remarkable progress. The State-owned commercial banks were financially restructured, the State-held shares in listed companies have been liquidized, a network of financial supervision has been established, and the marketization of the interest rate has been largely put in place.

 

All these conditions prove that now is a good time for China to ease administrative control on the capital account and actively move toward liberalizing it.

 

The author is a professor with the China Center for Economic Research, Peking University. The article was originally published in Economic Observer.

 

(China Daily June 22, 2007)