Implications of Chinese Capital Account Liberalisation

If China does liberalise, few other events over the next decade are likely to have more impact on the shape of the global financial system. This also sets out a conceptual framework, identifying three separate factors which help explain why the scale of the subsequent movements in capital flows — both into and out of China — could be very large relative to the size of the world economy:

(i) ‘Closing the openness gap’- There is a large gap between China’s current level of openness and that of advanced economies. Liberalisation will lead this gap to close, generating large flows in the process.

(ii) ‘Catch-up growth’- China’s economic growth is expected to be relatively high over the next decade. So even if China’s capital flows do not increase relative to its own economy, they will relative to the world economy.

(iii)‘Declining home bias’- Prior to the recent crisis, the global financial system became increasingly integrated. A resumption of these trends over coming decades would lead capital flows to increase both in China and globally.

Summary chart Potential impact of capital account liberalisation on China’s international investment position

Based on these three factors and some simple but plausible assumptions, the summary chart shows a hypothetical scenario for China’s global financial integration in 2025. It shows that China’s gross international investment position could increase from around 5% to over 30% of world GDP.

The global financial integration of China has the potential to be a force for economic growth and financial stability not just in China but also globally.

Global implications of Chinese capital account liberalisation

The potential changes in both the magnitude and composition of capital flows outlined in the previous section would dramatically alter the financial landscape both in China and globally. In principle, capital account liberalisation in China could be a powerful force that enables the Chinese and global Implications for China

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For China, there are several potential benefits of liberalisation which can all be viewed through the broader lens of contributing to economic rebalancing. The Chinese economy is now starting to transition to a new model of growth, away from reliance on exports and investment as the key sources of demand. The new model of growth will therefore place a greater emphasis on consumption as a source of demand and an increase in the production of services relative to exportable manufactures. This is a challenging task and will require an ambitious agenda of structural reforms. Among these reforms, capital account liberalisation will play a key role.

A removal of restrictions on outflows, for example, will allow Chinese companies and households to diversify their large pools of savings by investing in overseas assets. This should help to spread risk, reducing the need for precautionary saving and hence free up income for current spending. And it may also boost household income if returns earned on overseas assets are higher than on domestic assets (which is likely given that real deposit rates in China are currently negative due to regulatory caps). China has the biggest banking system in the world by total assets but it is very domestically focused. If China’s banks were to diversify their balance sheets by expanding abroad — either directly through cross-border bank lending, or indirectly through lending to foreign affiliates — they may become more resilient to an adverse shock in their home market and so be better able to maintain lending to domestic companies and households in China.

Allowing more channels for inflows, on the other hand, will help to deepen and diversify China’s financial system, providing alternative sources of capital for Chinese borrowers. Should liberalisation also lead to lower reserve accumulation, it could lead to an improvement in China’s fiscal balance since the return on its FX reserves is lower than the cost of sterilising those purchases. And if it were accompanied by a more flexible exchange rate regime (as was suggested by the Third Plenum), it could allow China to operate a more effective monetary policy, increasing its ability to respond to domestic shocks. All of these factors should promote China’s rebalancing and its transition towards a new model of growth. But there are also risks. There are several notable examples where capital account liberalisation has resulted in instability. The most recent, perhaps, was the Eastern European countries where large capital inflows contributed to unsustainably rapid credit growth that ultimately culminated in economic and financial crisis in 2008 (Bakker and Gulde (2010)). Chinese policymakers will need to ensure they have sufficient scope to set policy to offset shocks that could pose risks to economic and financial stability. It will be particularly important to sequence carefully external liberalisation with appropriate domestic macroprudential and microprudential policies to mitigate risks from excessive credit growth and asset price volatility. One concern is that by opening the financial gates, some banks and, ultimately, borrowers in the Chinese real economy may find themselves faced with a shortage of liquidity. China’s banking system is heavily reliant on domestic deposits for its funding, which account for around two thirds of total liabilities. A reallocation overseas of even a small share of these deposits could therefore cause funding difficulties. By enabling higher real returns for Chinese domestic savers, however, domestic interest rate liberalisation could help to reduce these risks.

Another set of risks are related to inflows. In the short run, there could be indigestion in China’s asset markets, which are still small relative to potentially large inflows of capital. And over a longer time period, inflows could lead to an unsustainable build-up of maturity and currency mismatches in national balance sheets (for example, long-term domestic investment funded by short-term overseas FX-denominated borrowing). Large mismatches are susceptible to unwind in a disorderly way, as was the case for some Asian economies in 1997–98. Finally, the risks arising from a more flexible — and potentially more volatile — exchange rate would need to be effectively managed.

Which of these outcomes — more sustainable growth or a rise in instability — would dominate will depend on the accompanying policy framework. The empirical evidence on the costs and benefits of financial openness tends to suggest that countries benefit most when certain threshold conditions — such as a well-developed and supervised financial sector and sound institutions and macroeconomic policies — are in place before opening up to large-scale flows of capital (Kose et al (2006)). This underscores the importance in China of careful sequencing of capital account liberalisation alongside other domestic reforms such as domestic interest rate liberalisation, development of effective hedging instruments and enhancing the microprudential and macroprudential regimes.

Implications for the rest of the world

From the perspective of policymakers outside of China, it is important to understand how capital account liberalisation might ‘spill over’ to affect other economies. Four such channels are discussed below, although there are undoubtedly others. Greater exposure to the Chinese financial system If liberalisation has a large impact on the Chinese economy or financial system, it is also likely to have a significant impact in other countries as well. Although China’s economy is already considered able to generate material spillovers onto other economies (International Monetary Fund (2011b)), the process of capital account liberalisation will likely increase its systemic importance even further, by magnifying existing transmission channels, while also creating new ones. Foreign households, businesses and financial institutions will increase the amount and the number of their claims on China, while those in China will do the same with respect to the outside world, thereby deepening the complex web of financial interconnectedness.

If China does hard-wire itself into the global financial system, it will bring important benefits in terms of risk-sharing. Households that purchase Chinese assets whose returns are not perfectly correlated with their own income would be better able to smooth consumption. And foreign banks that expand in China would diversify their earnings base and potentially enhance their resilience.

The flipside of increased interconnectedness, however, is that the global financial system will be more sensitive to shocks originating in China. Increased holdings of Chinese assets, for example, would imply greater exposure to fluctuations in their price. Greater reliance of global banks on Chinese banks for funding, in turn, would bring about the possibility of a liquidity shortage if those banks were to repatriate funds in response to balance sheet pressures back home.(1)

Increase in global liquidity

If China’s financial walls are lifted, some of its vast pool of domestic savings will migrate into global capital markets, providing a significant boost to liquidity. The illustrative scenario in Chart 5 suggests that these flows could amount to a substantial share of world GDP. A new source of global liquidity from China could lead to several beneficial effects, particularly during a period where the world’s financial system is becoming increasingly fragmented and retreating into national borders (Carney (2013b)). As well as providing a new source of finance for borrowers, it could lead to a more diversified and more stable global investor base. At the same time, however, a rapid increase in liquidity from China could lead to absorption pressures in some asset markets in the short run, which could lead to a mispricing of risk with adverse consequences for financial stability.

Increased global role of the renminbi

Greater international use of the renminbi would add another dimension to the global impact of capital account liberalisation. Potential benefits include lower transaction costs and a reduced risk of currency mismatches. But it may also amplify the international transmission of Chinese policy and domestic shocks, of which policymakers around the world will need to take into account. Take the following hypothetical case: a country purchases a large proportion of its imports from China and its currency depreciates against the renminbi. If the prices of those imports are set and invoiced in the domestic currency of that country, the depreciation would not automatically lead to an increase in their price and hence no response in domestic monetary and fiscal policy would be needed.(2) If, however, the imports were invoiced in RMB, then their price would increase in line with the exchange rate depreciation, leading to domestic inflation. Moreover, a country that had no trade with China but whose imports were set and invoiced in RMB — such that the RMB would be a ‘vehicle currency’ — would need to respond to macroeconomic or policy fluctuations in China that affect the exchange rate and feed through into domestic prices of that country. There is a body of literature which finds evidence of these invoicing effects for the US dollar, as the world’s most international currency. Goldberg (2010) finds that for non-US economies, large use of the US dollar in reserves and in international transactions is typically associated with greater sensitivity of trade, inflation and asset values to movements in the value of the dollar relative to the domestic currency. However, as discussed above, it would likely take much longer than a decade for the renminbi to take on a similar role to that of the US dollar today.

Global imbalances

The literature on the causes and consequences of global imbalances is as vast as it is inconclusive. According to one influential perspective, the large imbalances in current account positions that accumulated over the past decade partly originated in high net saving rates in developing Asian countries (Bernanke (2005). If true, capital account liberalisation in China could potentially help to alleviate these imbalances to the extent that it leads to a reduction in China’s net savings and correspondingly its current account surplus (although clearly the impact of this on overall imbalances

would depend on the corresponding adjustment in other countries). This may occur either because liberalisation lowers the incentives for precautionary saving or because it leads to a more flexible and higher exchange rate. But even if Chinese capital account liberalisation were to lead to no reduction in global imbalances, it could still help to lessen some of the adverse consequences relating to these imbalances. There is evidence that reserve accumulation by foreign governments can materially depress the risk-free interest rate in the United States (Warnock and Warnock (2009)) which, in turn, may encourage excessive risk-taking behaviour globally. So to the extent that Chinese capital account liberalisation were to result in a switch in the composition of outflows, away from reserve accumulation by the central bank and towards overseas investment in riskier assets by other Chinese residents, this may reduce some of the downward pressure on government bond yields and related rates in the United States and globally. Of course, this would bring other challenges. But in the longer term, it could be beneficial for the stability of the international monetary and financial system as a whole.

Conclusion

If China continues to liberalize its capital account over the next decade or so, it is likely to be a force for development and constancy not just in China but also for the international monetary and financial system. While this process will be companied by new and important risks, it falls to international bodies and national authorities to monitor and take appropriate policy actions to mitigate such risks. This will not be a petty task. As we already know Chinese capital account liberalisation could lead to striking changes in the global financial landscape, policymakers will be facing uncharted territory. In order to succeed, policy cooperation between national authorities is necessary, both to increase understanding of the risks and to develop common policy approaches. Currently the Bank of England is working intimately with the People’s Bank of China regarding the development of offshore renminbi activity in the United Kingdom and will continue to seek other ways to support a successful integration of China into the global financial system.