Time for cautious easing of capital account limits
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Shanghai Daily, December 2, 2011
A closed capital account has long thwarted Shanghai's ambition to develop itself into a global financial center.
Time is now ripe for China to relax its capital account restriction. Of course, this process is not without risks and any reform will have to proceed cautiously, with schemes implemented to cope with possible crisis.
Scholars disagree over whether it pays to open up a country's capital account. Some say it's good for it finances growth with foreign savings, others say it may cause short-term economic upheavals.
Despite the academic differences, China's Securities Regulatory Commission and People's Bank of China (PBOC), the central bank, began to loosen the capital account as early as November 2002, with the launching of the Qualified Foreign Institutional Investor (QFII) scheme. This scheme afforded foreign investors a foothold in China's stock market.
In 2006 came another breakthrough, the Qualified Domestic Institutional Investor (QDII) initiative, a channel for outbound investment by Chinese households.
Combined, the twin cross-border investment vehicles regulate the inflows and outflows of capital. Their adoption marks a milestone in China's journey to open up its capital account.
In August 2007, China's State Administration of Foreign Exchange announced that domestic businesses could retain the forex revenues obtained under their current accounts, as opposed to the past, when they were ordered to convert into yuan the amount of forex in excess of what they were legally allowed to keep. This officially signaled the end of the mandatory forex conversion regime that lasted 13 years.
One year later, Shanghai and Beijing led the pilot program in granting permission to non-financial enterprises to engage in franchised individual forex conversion business. Later in 2009 the scope of the scheme was expanded to include another 17 provinces, municipalities and autonomous regions.
It was then that the yuan's internationalization emerged as a matter of formal discussion.
As its economy keeps growing, China has been struggling to insulate its wealth from vagaries of the global economy. And internationalization of its currency pays off not just in the form of "seigniorage" - the profit from printing the anchor currency- but also in the mitigation of risks for export and import businesses. In addition, having a reserve currency reduces the need for a large forex reserve.
In 2009, state authorities enacted a set of regulations to enhance the efficiency of forex use among domestic firms and to broaden the follow-up financing options for overseas companies.
Meanwhile, to encourage two-way capital flows across the border in a cautiously opening market, Beijing raised in September 2009 the cash ceiling of single QFII projects to US$1 billion, with a lock-up period of three months for shares purchased by open-ended Chinese funds and one year for other institutional investors. Investors are free to trade their shares monthly for capital gains after the lock-up's expiration.
Moreover, since 2004 control over derivatives and personal capital flow has been somewhat relaxed.
Offshore markets
The liberalization of China's capital account coincided with elevation of the yuan as a global currency. To safeguard its hard-won wealth, Beijing has long contemplated establishing two offshore financial hubs, Shanghai and Hong Kong.
It spelled out that vision in an announcement on March 25, 2009, that Shanghai is to become such a hub by 2020. This is a sign of China's resolve to accelerate the opening up of its capital account, a goal consonant with its financial aspirations.
Thanks to a free capital account, Hong Kong went ahead with the experiment in yuan trade resettlement. This development has gained momentum since June 19, 2010, when the PBOC announced deeper reforms of the yuan's exchange rate policy to lift its flexibility.
This was followed by a landmark deal on yuan settlement signed between PBOC and the Hong Kong branch of the Bank of China to enlarge the business.
Of course, caution is the linchpin in liberalizing China's capital account. The state forex watchdog made clear in November 2010 that it would beef up supervision of speculative capital. Banks, joint ventures with foreign stakes, export and import companies and overseas listed firms are among the most closely monitored. These measures will heighten the cost for refugee capital to move across borders, thereby hampering its activity.
There are also decrees barring foreigners from owning more than one home - an attempt to rein in speculation in the overheated property sector amid the yuan's appreciation and resulting hot money influx.
Besides, Japan's "lost decade" has shown the bitter results of recklessly liberalizing capital account.
Japan's industry hollowed out as factories moved abroad, fleeing higher production costs brought about by a stronger yen.
Another complication was a capital exodus following Japan's adoption of a zero interest rate.
Relaxed financial oversight enabled Japanese corporations to fund their operations through IPOs. Banks thus lost their premium customers and resorted to lending heavily to real estate. After the housing bubbles burst, the banking sector crashed.
Cushion pool
An important procedure in liberalizing China's capital account is to create a figurative "pool," to quote PBOC chief Zhou Xiaochuan, that absorbs sloshing liquidity and cushions its impact on the overall economy.
For instance, with its infusion of US$40 million, George Soros's Quantum Fund recently became the biggest cornerstone investor in Hainan-based Sihuan Pharmaceutical Co. One of the deal's terms is that shares held by Quantum will stay frozen for up to a year before they can be traded.
Generally speaking, hedge funds won't have the patience to wait that long for investment to yield returns if a target company doesn't show considerable growth potential.
This case highlights the necessity to channel hot money to the real economy and make it contribute to China's long-term economic health, instead of making quick bucks and heading for the exit.
That's also a reason to build two offshore markets.
Above all, China should seize the external opportunity to make a timely push toward the yuan's internationalization and cautiously open up its capital account.
Of course, realization of its financial dream entails the step-by-step formulation of a financial culture. Culture attracts talent.
They combine to inspire financial innovation, which in turn boosts society's wealth and consumption. This is a positive cycle.
The author is director of the Research Center for Modern Finance at the Shanghai University of Finance and Economics. The article is adapted from his speech at the 9th Shanghai Social Sciences Annual Conference on November 27. Shanghai Daily reporter Ni Tao translated his article from Chinese.
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