Last week, the People’s Bank of China (PBOC) announced a series of measures aimed at further liberalizing China’s capital account and hinted that there is more to come. While the timing of the recent announcement is likely related to the ongoing US-China trade dispute, the substance of these reforms has been in the works for years. Were it not for the surge in capital outflows from the Chinese economy in 2015 and 2016, some of these measures might have been already implemented by now.
And this begs the question: at a time when market liberalization is not high on the reform agenda for most other parts of the Chinese government, why is the PBOC so committed to opening up China’s financial system now? Part of the reason is the fact that the PBOC has always had a more liberal bent within the Chinese bureaucracy, being culturally predisposed toward modernizing China’s financial system and importing global best practices.
But that’s only a partial answer at best. The less obvious, but perhaps more important, reason is that a more open capital account will potentially result in less government meddling in monetary policy, thereby giving the PBOC greater autonomy in its operations. In China, it’s usually easier to deal with politics by circumventing it through other means rather than taking it on directly. And capital account liberalization appears, for the moment, to be the central bank’s “other means” for creating more breathing space between itself and political influence.
Of course, vying for more PBOC independence has been a war of attrition—one that clearly has gnawed the former and longest-serving central bank Governor Zhou Xiaochuan, who even went so far as saying publicly in a 2016 IMF speech that the bank should be more independent. As a student of economic history, Zhou would certainly know that history has shown time and again that letting politicians exert influence over monetary policy and the credit supply can lead to disastrous results, including high inflation and economic recession. This is a key reason why a majority of advanced countries maintain independent central banks.
That is not to say the PBOC hasn’t won a few pitched battles along the way. For instance, local governments are no longer able to interfere in the central bank’s operations as they once did. But compared to its international peers, the PBOC is still less independent than it would like to be. Under China’s current political configuration, the PBOC is part of the cabinet, reporting to the State Council, and doesn’t have independence in setting monetary policy. In other words, in addition to conventional central bank mandates like controlling inflation, the PBOC also has to meet certain political mandates.
Still, with the Communist Party expanding its authority throughout the economy and across the landscape of government institutions under the State Council, directly shielding the PBOC from political meddling would seem like an exercise in futility, at least in the near term. Even so, the PBOC’s latest quest for less political interference is not hopeless. Reducing political meddling in monetary policy—and in particular reducing the Chinese government’s inclination to stimulate the economy through monetary expansion—can be achieved by making it less appealing. And that makes capital account liberalization the newest front.
Here is why. First of all, China’s capital account is actually already quite open. Thanks to China’s gradual opening over the past four decades, China’s capital account is leaky enough—and will continue to get leakier—that it is now nearly impossible to isolate China from the global financial system. In the past three years, annual undocumented net capital outflows have all been over $200 billion (equal to roughly 2% of China’s GDP). In other words, every year $200 billion of capital moved out of China that cannot be accounted for by trade or approved capital transactions. Moreover, that has occurred during a period of enhanced regulation and monitoring of capital outflows.
By combining a liberalized capital account with a closely managed currency, the famous trilemma idea suggests that China will lose, at least partially, the freedom to set domestic monetary policy as it wishes. Put another way, having those two conditions in place limits the flexibility of monetary policy and can help deter politically-motivated monetary stimulus.
Although China’s currency is not fixed, the exchange rate is currently only allowed to float within a narrow range, and this is highly unlikely to change. In early 2016, Governor Zhou unambiguously told media that a free-floating exchange rate will not be China’s objective, even in the long run. Furthermore, China’s recent experience with volatile capital outflows has made Beijing to become even more anathema to the idea of a floating exchange rate. If Beijing were forced to make a choice between currency depreciation or reducing money supply, it is very likely to opt for the latter.
And so, with the currency regime the way it is, the PBOC is making moves to meet the second condition of a more liberal capital account. That’s because when countries that have an open capital account—like the United States or Japan—expand their money supply, ceteris paribus, their currencies typically depreciate. The logic is that increasing money supply, or loose monetary policy, would erode the purchasing power of the domestic currency, thereby making domestic assets less attractive to local and foreign investors alike. This reduced demand for domestic assets will in turn put further downward pressure on the domestic currency. Under an open capital account, to prevent domestic currency from depreciating drastically, monetary authorities have to tighten monetary policy.
In fact, Beijing’s intolerance of exchange rate fluctuations, combined with a leaky capital account, is already acting as a constraint on politically-motivated monetary stimulus. Despite its wish to support growth in the year ahead of the 19th Party Congress in October 2017, Beijing had to tighten the credit supply in the fourth quarter of 2016 to tame capital outflows (see Figure 1).
Figure 1. Tightening of Domestic Credit Supply Alleviates Capital Outflow Pressure
Note: Net private non-FDI capital flow is the sum of net private capital flow plus net errors & omissions, minus net FDI flow. FDI is excluded because recent shift in policy resulted in a sharp change in outward FDI. Capital flow is calculated as a four-quarter moving average.
Sources: National Interbank Funding Center and State Administration of Foreign Exchange.
So, should Beijing decide to pursue future monetary stimulus, the resulting pressure on the exchange rate and on capital outflows could potentially be significantly larger than what China experienced in 2015 and 2016. Moreover, capital outflows dilute the effectiveness of stimulus, as funds that would otherwise be used to generate economic activity at home move abroad instead to seek better assets and higher returns. Therefore, as the capital account becomes more liberalized, the short-term stimulus benefits from loose monetary policy will be diminished, while the need to defend the exchange rate with foreign exchange reserves increases the cost of monetary stimulus.
Of course, while capital account liberalization can potentially act as an effective check on politically-motivated monetary stimulus, in practice the effectiveness of such an arrangement is not certain.
The idea of using an open capital account and managed exchange rate to discipline domestic monetary and fiscal policy is not a new one. Many countries have tried this approach but failed. Despite the harsh built-in punishment for imprudent macroeconomic policy, frequently governments still cannot resist the short-term temptation to run large fiscal deficits or credit expansions.
Take Argentina for example. After repeated economic crises, the Argentine government adopted a currency board in 1991 to impose discipline on government finances. Nonetheless, the Argentine government still ran persistently large deficits in the late 1990s, which required the central bank to expand credit supply to accommodate. In hindsight, the monetization of the country’s fiscal deficit proved to be a main cause of the collapse of its currency peg and the ensuing economic crisis. And it took Argentina six years to fully recover from the crisis.
China’s record of economic management has been much better than Argentina’s so far. The PBOC may be making a calculated bet that by moving toward greater capital account liberalization, it can constrain politicians’ short-term inclination to run the money printing presses, and instead leave monetary policy in the hands of the PBOC. Nevertheless, the Argentina lesson still has relevance for China, as it remains to be seen whether PBOC can fend off the political pressure when state firms and local governments are again in distress, begging and lobbying for more stimulus.
The trilemma idea is that any country can only achieve at most two out of the three policy objectives of independent monetary policy: an open capital account and a fixed exchange rate.