Chinese authorities have beenmaking efforts to liberalize the country’s financial systems. Thishas been witnessed in the continued efforts to open China’s capitalaccount. The shortage and enhanced instability of major currenciesduring the 2008 financial crisis resulted in an international rise inthe demand for Chinese currency. Since then, China realizes theadvantages of capital account liberalization as important towards thecountry’s development.
The research paper brieflysummarizes Chinese authorities’ efforts in opening up its capitalaccount and their impact on capital account liberalization, the prosand cons of capital account liberalization for China’s financialsystem, and the potential impact of RMB inclusion into the SDR basketon the development of China’s financial markets.
Chinese Authorities Efforts
A number of efforts have beenmade by Chinese authorities towards opening up the country’scapital account. These include the implementation of a Pilot FreeTrade Zone (FTZ) in China. The FTZ was established in 2013 andadvanced in 2015 to incorporate Lujiazui, which is China’sfinancial district (Prasad 19). The purpose of the zones involvesallowing for an enhanced level of capital account openness, though ina regulated manner by restricting FTZ to particular geographicregions. Despite having free trade zone policies, China limited freetrade to specific industries. However, in 2015, the restrictions wereremoved in industries like mining, technology, logistics, finance andtransport (Prasad 20). The impact of FTZs on capital accountliberalization is that using zones provides China’s government witha regulated approach towards capital account opening. This reducesrisks associated with full opening of the capital account.
Chinese authorities have madeefforts to continuously open “Q” programs. The Chineseadministration has formed various schemes, which allow for regulatedas well as calibrated opening of their capital account to inflows inaddition to outflows. The schemes have been planned to create thecollateral advantages that derive from financial openness whenforming freer capital movement. An illustration is the 2002,Qualified ForeignInstitutional Investor,a scheme that makes it possible for overseas institutional investorsto convert their currency into Chinese currency, and further investin shares that are listed on Shenzen and Shanghai stock exchanges,and in different RMB financial products that have received approvalfrom the ChinaSecurities Regulatory Commission (Prasad15). In 2004, the government allowed domestic financial institutionsto make investments in offshore monetary products. The impact of suchschemes on capital account liberalization is that they result in thefull liberalization of interest rates, which enhances reforms towardsopening China’s capital account.
China has made significantdevelopments towards the liberalization of its capital accountthrough its dual-track interest rates (He and Wang 930). As early as1996, Chinese authorities liberalized “wholesale transactions amongfinancial institutions in money and bond markets as well as interestrates on foreign currency denominated instruments” (He and Wang930). In 2004, the country removed its deposit-rate floor as well aslending ceiling that were apparent in deposit markets and retailloans (He, Wang and Yu 3). The impact on capital accountliberalization is that China has been able to reduce regulation oninterest rates within its banking system, which opens its bondmarkets to all investors.
Pros of Capital AccountLiberalization for China’s Financial System
Capital accountliberalization is likely to create several collateral advantages forChina’s domestic economy, specifically in regards to domesticfinancial market advancement, which as a result, may ease more stabledevelopment (Prasad 9).
Liberalization of outflowscreates opportunities for Chinese households to broaden their savingsportfolios globally, as well as encouragement of domestic monetaryreforms through the formation of competition for domestic banks,which presently rely on confined domestic sources of money.Initiatives that motivate corporate outflows have concentrated onhuge government owned companies and some sectors like naturalresources. In order for the RMB to become stronger internationally,the portfolios as well as foreign direct investment outflows arerequired to include enhanced participation from the private sector(Prasad 9).
By liberalizing inflows, itbecomes possible for China to attain its collateral gains of capitalaccount liberalization. This is because liberalization has made itpossible for foreign investors to play a crucial role towards thedevelopment as well as widening of the country’s financial markets(Prasad 9). For example, there is evidence to demonstrate thatliberalization of portfolio inflows assists in the enhancement ofliquidity within the domestic equity markets of upcoming economies.This, coupled with overseas banks entry, is likely to enhancecompetition within the banking industry, which would be advantageousto borrowers as well as savers. Different sectors of China’smonetary sector such as insurance have relied on capital controls aswell as different entry limitations to continue being competitive.The segments are likely to face increased competition once inflowsare opened (Prasad 9). Effective regulation will result in importantefficiency benefits for China’s financial system.
In addition, capital accountliberalization is likely to have enhanced benefits for the country’sfinancial structure because an open capital account could enhancegrowth towards the goal of ensuring Shanghai becomes a globalfinancial hub. Capital account opening, specifically when linked withenhanced flexibility in exchange rate, will improve china’sfinancial structure (Prasad 9). It would ease monetary sectorreforms, making it possible to rebalance development from adependence on exports as well as development based on investmenttowards a balanced growth model that is characterized by greaterprivate consumption.
Cons of Capital AccountLiberalization for China’s Financial System
The liberalization of capitalaccount through financial reforms may have a negative effect on thegeneral effectiveness of “financial resources allocation and thetransmission of monetary policy” (Qiao, Sun and Zhang 23). Thesemonetary reforms are hastened by liberalization through schemes likethe QualifiedDomestic Retail Investors,which result in faster integration of China into the internationalmarket. This poses problems for People’s Bank of China’s abilityto handle liquidity as well as secure financial security in avolatile global financial market (Qiao, Sun and Zhang 23). Inaddition, the opening of capital accounts and at the same timeholding on to fixed exchange rate, specifically in cases wheredomestic macroeconomic policies fail to be consistent with theprerequisites of a regime, has been accompanied by a financialcrisis.
Liberalization results inreduced regulation of deposits by banks. This results in enhancedcompetition amid banks for financing as well as a sharp decline innet interest margins. Such deregulation is less likely to affectmajor banks that have large networks and secure deposits. However,small banks are compelled to introduce advent financial instrumentsthat make it possible to draw retail funds (J.P.Morgan Asset Management16). The liberalization is also likely to enhance risks linked withimprudent fiscal policies through the provision of access toexcessive external borrowing. When capital accounts are openedprematurely they pose serious perils especially when financialcontrol and supervision is not adequate. In the case of weakregulations on bank systems and different distortions within domesticcapital markets, overseas capital inflows might be misallocated andresult in several problems.
Another disadvantage derivesfrom the risks associated with open financial markets. For instanceprivate growth outflows are likely to increase as compared toinflows. The liberalization of China’s account will result inreallocation from its public sector outflows towards private ones.This will result in increased development in the private outflows ascompared to the private inflows.
Potential Impact of RMBInclusion into the SDR Basket
The possible impact on thedevelopment of China’s financial markets is both positive andnegative. One of the positive impacts is improved financing for China(Hentov and Hoguet 2). The country will be able to borrow money inits own currency, whether globally or domestically. This eliminatesthe possible exchange rate risk, which is likely to result in acrisis when balancing of payments. Additionally, when industries areable to issue their liability in RMB, liquidity within the domesticmarkets rises. This leads to an array of financing alternatives atrates that are competitive. Second is seignorage, which is money,earned by China due to issuing its currency. RMB inclusion into theSDR basket leads to a positive impact on China’s financial marketsbecause the country is able to issue a non-interest liability, whichmakes it possible for foreigners to invest in the country’s bonds.As the RMB holdings increase in the global market, so does the profitfrom seignorage (Hentov and Hoguet 3). The third impact is thereduction of transaction costs for Chinese organizations. Thecompanies are able to buy goods and services in RMB, both globallyand domestically. This in turn reduces the transaction expensesincurred when using or converting currency. As more people use theRMB, Chinese companies use their currency to transact (Hentov andHoguet 3).
The negative impacts includean appreciation and unpredictability of exchange rate and loss ofmonetary policy independence (Hentov and Hoguet 3-4). When theexchange rate appreciates, it results in a drop in exportcompetitiveness. The demand for RMB could result in a rise in theexchange rate with other currencies. As a result, China’s exportslose their competitiveness as they are considered expensive whenbuying using other currencies. It is not possible to predict theexchange rate for RMB once it is included in the SDR basket. The ratemay increase, and in the process cause a decline to domestic activityor decrease and thus enhance the possibility of inflation. China willlose its independence regarding the monetary policies it implements.The policies will no longer affect the country, but the globalcommunity as well. This is because the currency is not only used inChina, but in other countries as well. China must ensure that anyfinancial policies it makes do not strain the country’s globalrelations with other countries, for instance via negative spillovers.
As the Chinese governmentcontinues to make efforts towards capital account liberalization, itshould put into consideration the pros and cons. There are morebenefits gained from liberalization and the country can work onreducing the negatives.
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