China's Capital Controls and the Exchange Rate Regime
When the Chinese government wanted to damn the great Yangtze River, it moved more than a million people. When it wanted ring roads running through the 20 million people of Beijing, China built 270 miles in less than 30 years. So, when Chinese leaders say that they want Shanghai to be a global financial center and their currency the renminbi (RMB) to be an international leader, it’s natural to ask how, when, and at what cost.
In a recent post, we concluded that vast, politically sensitive reforms would be needed to make the RMB a key currency for global finance and central bank reserves. We see the goal of internationalizing the RMB and turning Shanghai into a financial center as incompatible with shielding the Chinese economy from financial and other shocks coming from abroad. Put simply, some of the reforms needed to make the RMB attractive for international use – namely, an elimination of capital controls – will increase China’s exposure to external disturbances. Building a global financial center and making one’s currency a key player in international finance depend on the world outside one’s borders in a way that domestic infrastructure projects do not.
Capital controls have helped insulate the Chinese economy for decades. When the Asian financial crisis hit in the 1990s, investors (both residents and nonresidents) ran from every Asian country they could. Capital flowed out and currencies collapsed. The movement of the Korean won from roughly 850 to the dollar at the beginning of 1997 to 1700 by early 1998 is just one example. Not so the RMB exchange rate, which was fixed. Residents of China faced limits on transfers abroad, while nonresidents required government permission to invest onshore. Despite some modest relaxation of the capital account over time, the situation in China was largely the same during the global financial crisis that began in 2007. Again, the economy was shielded from the brunt of the trauma abroad.
It is these “capital flows management policies” (as they are now euphemistically called in international policy circles) that have made it feasible for China to manage its exchange rate, controlling the gradual appreciation of the RMB while enjoying great discretion over monetary policy. In the absence of capital controls, a fixed exchange rate regime would eventually require the sacrifice of such discretion. The “impossible trinity” of fixed exchange rates, free movement of capital, and discretionary control of money and interest rates, arises from the fact that, when a central bank commits to buy or sell its currency to maintain a pegged exchange rate (even an adjustable one like China’s), it is the public not policymakers that determines the size of the central bank’s balance sheet. Capital controls throw a wrench in this process by limiting the public’s ability to buy or sell foreign exchange, allowing the central bank to retain a degree of monetary control.
A careful review of history since the late 19th century confirms that the “impossible trinity” is a binding constraint on economic policy. Countries that have tried to maintain all three parts – like the United Kingdom in the run-up to the 1992 crisis of the European Exchange Rate Mechanism (ERM) – have repeatedly been blown out of the water by speculative attacks. Here’s one employee recently describing how George Soros broke the Bank of England on September 16, 1992, when the pound was forced out of the ERM.
Giving up either direct control over the exchange rate or discretionary control over the size of the central bank’s balance sheet and interest rates seems to be anathema for Chinese policymakers. But would China move to the now common configuration of an open capital account, a floating exchange rate, and domestic monetary control? Large emerging market economies that have taken this road have not always been happy. Brazil is the most recent example, where volatile exchange rates and capital flows have been met with a combination of accusations and attempts at control.
In China, exporters, including many large and powerful state-owned enterprises (SOEs), may be particularly unhappy with such a system. That said, the willingness of Chinese authorities to revalue the RMB over time, and to widen its daily floating range, suggests a slow move in this direction.
Giving up capital controls also creates risks of financial instability independent of the currency regime itself. China’s financial markets in RMB are less deep and liquid than those of other international currencies. And, while the financial system is very large – especially for an economy at China’s level of development – it remains inefficient and fragile. The big banks, which are effectively state controlled and shielded from market forces, continue to funnel an outsized share of loans to SOEs despite higher productivity elsewhere. At the same time, deposit rate caps and restrictions on local government bond issuance have fueled a rapid rise of shadow banking, some of which finances unproductive spending by municipalities and adds to speculative fervor in real estate markets. The resulting financial system allocates resources ineffectively and may already suffer from a large (but unrecognized) capital shortfall. (The NYU Stern Volatility Lab currently estimates systemic risk in China at more than $500 billion, second only to Japan.)
Against this background, a sudden relaxation of capital controls could trigger large capital inflows from abroad to Chinese intermediaries supporting unproductive activities, adding to the potential for a financial crisis. [Think of the crisis now facing the euro area’s peripheral economies, which initially benefited from massive capital inflows from Germany, France, and others when EMU began.] At the same time, removal of controls could prompt residents to rush abroad to put savings where their property rights are more secure. It is hard to know whether the capital inflow or outflow will dominate, so it will be difficult to predict which way the RMB will move, if at all.
Unsurprisingly, the dismantling of extensive capital account restrictions remains a gradual and tentative process in which the Chinese government is carefully widening the radius of transaction freedom, waiting at each step to see if the system remains stable. During this guarded transition, obstacles to cross-border capital flow mean that there are still two very different RMB: call them onshore and offshore. The latter is primarily used and traded in Hong Kong, but with financial centers elsewhere (like London and Singapore) now vying for a piece of the action.
The chart below shows three-month RMB deposit rates onshore (labeled CNY) and in Hong Kong (labeled CNH) where banks began accepting RMB deposits in 2010. Two features are striking. First, the series are not converging, as would have been expected if short-term capital flows had been significantly liberalized. Indeed, the daily correlation is slightly negative (-0.11)! Second, the onshore deposit rate is persistently higher, likely a consequence of the combination of a preference by residents for keeping funds abroad (when they can), and the fact that nonresidents can’t get permission to move them onshore.
Three-month RMB Deposit Rates: Onshore (CNY) and Hong Kong (CNH)
Source: Bloomberg (codes CCDRC and CGDRC)
Eliminating capital controls probably would eliminate this interest rate differential, but at what cost? Exchange rate and capital flow volatility would inevitably rise, and could put the Chinese financial system at risk, at least in the short run. But removal of capital controls is just one (albeit important) aspect of China’s larger need for economic and financial reform. In a future post, we will look more closely at the financial fragilities that the government must address to reduce the risks from liberalizing capital flows and get closer to realizing their goal of being one of the preeminent players in global finance.