The broad narrative of a coming capital account liberalisation in China has always bugged us. The main reason being that we couldn’t see how China, in its current state, was going to start letting money flow (easily) out as well as in.
But before we get into that we should note, somewhat counterintuitively, that China’s capital account is already fairly liberalised.
As Gavekal’s Chen Long says:
It is not at all easy to specify just how open a country’s capital account might be. The well-known Chinn-Ito Index shows that China’s capital account is among the most closed in the world, and has not opened at all in recent years. Yet this is difficult to square with the fact that total crossborder capital flows have increased by ten times over the past decade to US$1.5trn. China has a low level of de jure openness but a higher level of de facto openness. Very few types of capital flows are completely free of government control, but the partial controls still allow for a good deal of flexibility. Foreign direct investment has been largely open for decades, though there is still an approval process as well as restrictions on many sectors. Trade credit and offshore borrowing are subject to controls for prudential reasons, but they are relatively accessible for many companies. More recently, China has also simplified foreign exchange regulations to give companies more freedom in dealing with their foreign currency assets. According to the IMF’s classification, 35 out of 40 capital account items are already fully or partly convertible in China, leaving only five inconvertible.
The biggest remaining restrictions on capital flows today are on foreign currency exchange for individuals, and inward and outward portfolio investment. But there has already been fairly substantial change on this front. Today every Chinese individual is allowed to buy no more than US$50,000 worth of foreign currency from banks each year. But that limit was lifted from US$20,000 in 2007, and it is also not that hard for the more savvy to get around it.
Indeed. And if you are a less than savvy individual you might want to look into hard-to-value assets (such as art work), insurers, equity deals, Macau, brokerages, underground banks, cruise lines, and… er, “ants moving houses”. To savvy up, that is, even if we’d suggest our list is almost certainly lagging Chinese innovation where this is concerned.
Where the portfolio investment channels are concerned — mostly quota-based via the Qualified Domestic Institutional Investor and (RMB) Qualified Foreign Institutional Investor routes — suffice to say for now, as Long does, that it’s “a more nuanced tool than an on-off switch, as the quota can be increased over time as regulators get more comfortable with capital flows. Indeed, since 2012 China has significantly increased the size of the quotas for each of the channels”, including the recent Shanghai-Hong Kong Stock Connect which doesn’t apply a quota to individuals as do the QDII/ QFII and RQDII.
So we’re in a situation where China’s capital account is more open than it has been before and recent relaxations of control have increased the size and volatility of flows. Including, obviously but crucially, outflows. That makes China’s leaders v nervous and restricts policy options.
In fact, suggests Long, that’s one of the main, again counterintuitive, arguments for liberalisiation:
In fact one of the stronger arguments for further liberalization of capital flows is that the current situation is an unhappy halfway house: capital flows have become much larger, but are not very transparent. With some channels quite open but others still closed, there is much illicit use of the more open channels to disguise capital flows. For instance, companies can falsify export and import invoices, or trade finance documents, in order to move money in and out of the country. Reformers argue that it would be better for these capital flows to happen out in the open rather than underground. So the debate is not about whether or not to open the capital account, because it is in fact already partially open. The question is where to go from here.
We really like this way of looking at the issue. It’s not naive, for one.
The naive approach sees China marching towards actual capital account liberalisation. But, seriously, who thinks that is on the cards in the near term? (Or even, depending on your level of pessimism about China’s economic future, in the longer term?)
To re-re-re-iterate, this is a system that needs external capital very badly. It is happy to welcome it in, vastly less happy to see it (now internal capital?) leave. More so, it doesn’t take much to draw a lesson about attitudes to control and stability from China’s reaction to the recent stock market puke.
Long argues that the issue of CA convertibility is high on the politically important list, for both Xi and PBoC governor Zhou. And that it’s one way for the leadership to demonstrate reform. Damp squibs elsewhere need to be covered up after all.
Then there’s the SDR angle. The idea of SDR inclusion has been held up as a status thing in China and for the RMB to included in the IMF’s currency basket it has to be “freely usable”.
The reality is the decision will be more about politics and the US’s opinion on the matter — as the IMF noted previously, “there is no Board-approved set of indicators for such an assessment, nor a formal limit on the number of currencies that can be considered freely usable” and that decisions about the basket “would require judgement framed by the definition of a freely usable currency” — but here’s a chart from Cap Econ attempting to summarise China’s current position from a purely economic standpoint:
And an extra large chart covering RMB promotion from Xi et al from Deutsche for those who can be bothered clicking:
The more important political stuff is trickier to read but do remember that Jack Lew said, per Cap Econ again, on 31st March that further reforms were needed for the renminbi to qualify to be part of the SDR basket. So this could well be pushed out either way. Fwiw, Deutsche see a 40 per cent probability that the RMB will become an SDR currency in 2015, and a 70 per cent probability that this will happen by the end of 2016. We shall see.
Anyway, on we go, as this isn’t all about SDR inclusion and China needs inflows to help with its fiscal problems. Deutsche estimated in April that the size of the central government’s financing gap may be 3.7 per cent, and, to give one example, it could do with generating external demand as it launches its local government debt swap plans in ever greater style. For those keeping count, another RMB1tn is on the cards.
So, via Long, to the notion that while Zhou pledged to achieve “capital account liberalization,” he did not promise full capital account convertibility. Expect a future of monitored flows and capital controls where necessary even as China says it has opened the CA. Which should surprise nobody, tbh. Per Deutsche, “capital account openness is not a bipolar choice. Instead, it is a spectrum.”
So, as Long says, “managed convertibility” is the more appropriate likely term — and it’s not as if the world’s orthodox economic institutions, like the IMF, disagree with a cautious approach:
So what will China’s capital account look like under the future of “managed convertibility”? We think there will be three themes in the coming reforms.
First, access to domestic capital markets will be greatly increased, as separate small quotas for each investor are replaced with large quotas for all foreign investors in aggregate. The Shanghai-Hong Kong Stock Connect program marks the first step in this direction. Previously, foreign investors only had access to the Chinese financial market through an individual QFII quota. Although these quotas have been increased quite a bit, they are still not large and investors complain that the approval process is quite cumbersome. The Stock Connect program instead has a RMB250bn quota for everyone, requiring no prior approval—and the quota can be easily lifted when desired. A complementary Shenzhen-Hong Kong Stock Connect program will also be launched later this year, and we expect more such measures in the future. And in talks with the US in June, China said it would create a similar program for the interbank bond market, offering foreign investors an aggregate quota without individual limits.
Second, as China liberalizes it will try give to preference to longer-term investors who can be a stabilizing influence. A good example of this is its strategy for the bond market. We expect the domestic government bond market will grow rapidly in the coming years as fiscal deficits expand and more local government debt is restructured… This gives the government an incentive to open up of the bond market in order to find new marginal buyers of bonds. The potential is clearly very large: currently foreign investors hold just 2% of China’s onshore bond market. By comparison, India allows foreign investors to hold as much as 12% of its bond market. The People’s Bank of China said this week that central banks, sovereign wealth funds and international organizations can invest in the interbank bond market with no quota restriction, but shorter-term investors did not get the same treatment. The recent stock market crash may also lead regulators to restrict short selling and margin financing by foreign investors.
Third, restrictions on Chinese people moving their money outside the country will be relaxed, but such flows will still be closely monitored. We expect the government will lift or remove the US$50,000 annual cap on foreign-currency exchange by households. Instead the central bank will monitor the overall direction of flows and reserve the right to put on more controls when necessary. There are domestic media reports that the central bank will start pilot programs to test a removal of this limit in a few cities. In its June report on renminbi internationalization, the central bank pledged to provide an expanded channel for households to invest in overseas securities, dubbed “QDII2.” Though details are scarce, it will be easy to improve on the current QDII program which limits investors to a few Chinese funds and has not been very popular.
Taken together, these changes have major implications for financial markets: there is no question that capital flows into and out of China will substantially increase. But there is also no question that China will declare that it has achieved capital-account liberalization while retaining more restrictions on capital flows than other major economies, and that it will not meet the definition of full capital-account convertibility. This is not a criticism: we think a headlong rush to a completely open capital account would be pointlessly risky. And this “managed” approach will still get China what it wants: recognition that the renminbi is a major global currency and that Chinese financial markets are of global significance
This is all obviously educated guesswork from Long but, even if he is potentially being a bit optimistic, the broad strokes feel right.
China will want to bring money in for the reasons outlined above — and as Pettis has said it will probably succeed in doing so as yield hungry investors are attracted to RMB debt with the SDR push being used as potential cover — but it will be far more reluctant to let it leave. Really reluctant, (really) hypothetically.
Of course it remains to be seen how China’s recent attempt to save/ destroy its equity market will hit demand more broadly, but why anyone would expect any other form of liberalisation from China is somewhat beyond us.
Related links:
China’s holy trinity and the need for RMB stability – FT Alphaville
China widens foreign access to bond markets – FT
China’s plan to deal with its debt mountain – FT Alphaville
China and a friendly reminder to keep watching those capital outflows – FT Alphaville
