Abstract: There are four major preconditions for capital account liberalization, namely, a free-floating exchange rate, clearly defined property rights, an advanced government bond market, and restrictions on short-term capital flows. Currently, capital account liberalization is not the highest priority for China as the preconditions are not in place yet. China should first accelerate reform of its exchange rate mechanism to transition toward a free-floating regime before liberalizing its capital account.
I. Two changes in external environment and six issues associated with Sino-US financial conflict
The main point of the research paper “The Choice of China’s Exchange Rate Policy and the Development of Foreign Exchange Derivatives Market amid Changing External Environment” is that amid a changing external environment, it is necessary for China to adopt a flexible exchange rate regime, develop its foreign exchange derivatives market and continue to promote the use of domestic currency in international transactions so as to cope with various international challenges. The basic proposition of the research paper—that China should achieve a clean float as soon as possible—is absolutely correct and has my full support.
Arguments on this issue in this paper are developed mainly based on four key points:
First, only with a flexible exchange rate system which can play a buffering role can China respond to various external shocks in a timely manner.
Second, only with the development of foreign exchange derivatives market can enterprises effectively control risks and seek advantages while avoiding disadvantages under a flexible exchange rate system, and can a flexible exchange rate system be maintained in China.
Third, only by lifting foreign exchange controls can China further develop the onshore international financial market and get off the dependence on the offshore market, thereby realizing the dual circulation.
Fourth, liberalize capital account as soon as possible. What the research team emphasizes is to gradually open up and eventually liberalize the capital account. But in my view, capital account liberalization should be pursued in a gradual manner based on actual situations, so as to eventually realize the use of domestic currency in international transactions.
It is logical for the research to argue that transitioning toward a clean float should follow the four steps. I totally agree with the first two points, and the third and fourth points also make sense. But the problem is that we are not yet at a point when foreign exchange control can be completely lifted (that is, the complete convertibility of RMB under capital account).
For instance, in 2015-16, without capital control, China would have lost more than $1 trillion foreign exchange reserves. I doubt a clean float alone can curb massive capital flight. Without capital control, the exchange rate of yuan against the US dollar would have dropped below 7 under a free-floating regime.
Moreover, cross-border flows of short-term hot money do far more harm than good. Why should we not intervene just because textbooks tell us not to? I'm afraid there will always be interventions in cross-border flows of short-term capital.
This research suggests to promote capital account liberalization gradually and marginally, which I agree. What’s important is to analyze problems on a case-by-case basis.
For example, should we raise the quota of $50,000 for foreign exchange purchase by individuals? And to what extent? Is it possible to increase the quota for foreign exchange purchases of different "channels"? Can new “channels” be developed? All of these issues are not only open to discussion, but should be discussed.
The prerequisite of the use of RMB in international transactions is capital account liberalization, without which the former can only achieve partial and piecemeal progress, and it will be impossible to fundamentally open the channels for the international use of RMB. Because some of the necessary conditions are still immature, capital account cannot be liberalized immediately, which, therefore, means that the internationalization of RMB must be done in a gradual way.
Of course, the reason for the gradual promotion of the international use of RMB is not just that China has not yet fully opened up its capital account. The capital account of the Hong Kong Special Administrative Region of China is fully liberalized, but the Hong Kong dollar is not an international currency. Japan's capital account is also liberalized, which, however, does not necessarily lead to the use of yen in international transactions. In fact, Japan voluntarily abandoned its policy to promote the internationalization of yen.
Given the recklessness of the Trump administration, I am more positive about promoting the international use of RMB now than in the past when the main purpose to promote RMB internationalization was to break the old international monetary pattern in which one nation’s currency served as an international reserve currency, and to reduce the chance for the US to export crisis and take advantage of other countries. Now there is a new dimension to the motivation behind promoting the international use of RMB, that is, reducing the probability of the seizure of financial assets by other countries.
One flaw of this research, if there’s any, is that while the precondition of the research is the "changing external environment", it was not fully combined with the discussion of the reform of China’s exchange rate system. It gives the impression that the research has not adequately explained how China’s exchange rate reform in the context of a changing external environment is significantly different from one in a normal context.
In my opinion, there are two main changes in the external environment currently.
First, world economy has fallen into recession. The world economy was already showing signs of recession before the COVID-19 outbreak, which was basically a cyclical outcome. Yet, this year's COVID-19 outbreak has added to the woes of the world economy. The uncertainty of the pandemic has greatly increased the uncertainty of the world economic environment.
Second, trade and financial conflicts between China and the US, which concern at least six issues:
First, the US financial extortion of China. In fact, earlier in 2016 and 2017, the US had extorted Chinese financial institutions such as the Bank of China and the Agricultural Bank of China. Now it is extorting TikTok.
Second, the US is now pushing for capital flow reversals, calling for US multinational companies to withdraw capital and come back to the US. At the same time, the US is abusing its national security laws and regulations, setting barriers to Chinese investments in the US high-tech sector, driving out Chinese companies in the US and threatening Chinese companies listed in the US.
Third, short China and drive capital flight. China experienced severe capital flight in 2014 and 2015, when domestic problems were the main cause of capital outflows and flight. But looking ahead, as part of its financial war against China, will the US start an attack similar to that against the Thai baht and Hong Kong dollar in 1997-1998? The possibility that the US could short China and trigger massive capital flight should not be ruled out.
Fourth, as China is the largest foreign creditor of the US, the US may dilute China's claims on the US Treasuries through the depreciation of the US dollar, thereby transferring the burden to China. The Federal Reserve has been on a money printing spree, and the exit from its unconventional monetary policy looks elusive. Unless the US can exit from such unconventional monetary policy, it is bound to shift debt crisis to its creditors.
Fifth, kicking the Chinese financial institutions out of SWIFT and CHIPS under various pretexts, so that they could no longer conduct US dollar transactions for Chinese firms.
Sixth, as the Sino-US conflict intensifies, the US may seize China's overseas assets. This is a real danger.
In summary, how the changes in world economic situation and Sino-US relations will affect China’s choice of exchange rate policy and its exchange rate reform is worthy of more research. It should also be noted that even without the above-mentioned deteriorations of the external environment, China must vigorously promote the reform of its exchange rate system, and the external environment changes have given us a better understanding of the necessity of such reform.
II. Exchange rate should be allowed clean floating given how costly foreign exchange intervention could be
The research points out that foreign exchange intervention is not conducive to the timely adjustment of balance of payments and can cause large fluctuations in foreign exchange reserves. From 2003 to 2014, the RMB exchange rate failed to appreciate in time, so the imbalance of international payments could not be corrected. From 2015 to 2016, exchange rate intervention caused China to lose foreign exchange reserves of one trillion USD. These facts show that foreign exchange intervention can bring huge costs.
The research points out that foreign exchange intervention under the pressure of appreciation can have an adverse effect on external investment income. This is true. The net income of China’s foreign exchange investment has been in a negative range for a long time, and the phenomenon that net creditors pay interest to debtors should have ended long ago. A core reason for this phenomenon is China’s intervention in the foreign exchange market. As a result of the intervention, China has formed an unreasonable structure of international investment position featuring low-yield assets and high-cost debt. If we haven’t intervened in the foreign exchange market, this phenomenon would not have occurred. Therefore, in order to solve this problem as soon as possible, China must have its exchange rate realize free floating.
According to the research, the imbalance of international payments was an important trigger of the Sino-US trade conflict. If the RMB exchange rate was flexible enough a decade ago, there would not have been trade surplus of more than 200 billion or even 300 billion USD with the US every year. Such a huge trade surplus is actually not good for China, while the US gets the benefit yet still complains. In terms of exchange rate policy, the huge trade surplus between China and the US was caused by China’s long-term intervention in the RMB exchange rate in the past.
The research points out that the conflict between China and the US has intensified. That China's foreign exchange assets are largely concentrated in US Treasury bonds puts us at a passive position in the negotiations between the two countries.
Lord Keynes had a famous saying: “If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy.” I have always worried that the US will seize China’s dollar assets at some point. Martin Wolf clearly pointed this threat out in an article published on the Financial Times at the end of 2013. This is a real danger, if the growing clamor among US politicians for the seizure of Chinese assets as reparation for the country’s pandemic-related losses is any indication.
It must be said that the passive situation currently facing China is directly related to the exchange rate policy we adopted in the past.
Moreover, as the research notes, foreign exchange intervention is not conducive to the development of foreign exchange derivatives market and the implementation of monetary policy. For a long time, the development of China’s foreign exchange derivatives market has been slow, which has been a result of China’s exchange rate policy. Since the Chinese central bank directly intervenes in the foreign exchange market to ensure exchange rate stability, all risks have been transferred to the state, and the corporate sector does not need to bear any risk. Therefore, companies have no interest to buy foreign exchange products, and no one is willing to develop foreign exchange derivatives products.
Therefore, it is necessary to accelerate the reform of the foreign exchange market to achieve a clean floating of the RMB exchange rate. In this way, market players will have the motivation to develop foreign exchange derivatives market, which in turn will promote flexible exchange rates.
The research believes that foreign exchange intervention also weakens the independence of monetary policy. This is very obvious. For example, from 2005 to 2008, China's inflationary pressure was relatively high, and China’s policy of pegging to the US dollar hindered the implementation of a tight monetary policy to a certain extent. Foreign exchange intervention is effective in stabilizing the nominal exchange rate, but has limited effects on stabilizing the real exchange rate. The real exchange rate usually rises due to the fact that deflation happens faster than the adjustment of nominal interest rates.
We can understand the mechanism of real exchange rate increase in the following ways. When external demand suddenly decreases, China’s trade deficit will increase due to such external shocks, and the pressure of RMB devaluation will follow. In order to prevent RMB devaluation, China will sell US dollars to buy RMB, which tightens RMB supply and could count as a contractionary monetary policy if no countermeasure is adopted. As a result, the interest rate rises. This may be a possible transmission channel.
Another possible explanation is that because of China’s intervention in the foreign exchange market and selling US dollars to buy RMB, commodity prices fall as a consequence. Falling prices also mean that real interest rates will rise. In other words, foreign exchange intervention can affect monetary policy through many channels.
This research provides very enlightening views on overshooting, and China's experience is enough for us to develop a theoretical model with Chinese characteristics that is as constructive as the Dornbusch Overshooting Model.
The research team believes that foreign exchange intervention will slow down the realization of the expected RMB depreciation, prolong the time for arbitrage, and aggravate capital outflow. This is in line with China's actual situation. In 2003, there was a popular saying that we should break the irrational expectation of appreciation through slow appreciation or no appreciation. However, ten years later, China still saw slow appreciation of RMB and continuous influx of hot money, which to a large extent has caused China’s asset bubble.
On the other hand, after the “August 11 Reform” of RMB exchange rate in 2015, RMB showed a depreciation trend (in fact, this trend had emerged before the exchange rate reform), but because China refused to let RMB depreciate, and the central bank kept intervening in the foreign exchange market, China suffered a loss of foreign exchange reserves of one trillion USD. Some people believe that the exchange rate has stabilized because of intervention. This view is untenable. After 2018, the US dollar has ceased to appreciate and the currencies of all developing countries have stabilized and rebounded. The stability of RMB exchange rate is not the result of intervention. On the contrary, intervention has not eased the pressure of capital outflow, but increased it.
Some say that the RMB exchange rate should not be allowed to fluctuate freely as demands and supplies change. But this viewpoint has been proven wrong. The best proof against it is the debate as to whether RMB exchange rate should be allowed to breach the critical level of 7 against USD. This issue sparked controversy in the middle of last year. One view was that once the RMB exchange rate breaks the 7 threshold, it will enter a freefall, spiraling down by as much as 20% or even 30%, which should not be allowed to happen. However, it was proven totally wrong. Facing the critical juncture, the PBC remained calm and patient and did not intervene. It turned out that RMB did not end up in a crash as expected; instead, its exchange rate gradually stabilized. There are lessons to learn in that.
Next let’s consider the macro- and micro-economic conditions required to put RMB closer to a free float. The research team suggests that there are three major vulnerabilities in China’s macroeconomy and financial system that have the biggest impacts on RMB exchange rate: imbalance in the external sector, fiscal imbalance, and imbalance between the financial and business sector. But I don’t think these imbalances are very important. Of course, we should try to achieve balances in these areas because that would cushion the impacts of China’s exchange rate reform, but this is not necessary for RMB exchange rate to float freely. Actually, a lot of countries, including Thailand, Argentina and Australia, turned to free floating exactly because they faced so severe imbalances in the above-mentioned aspects that they could not maintain their fixed exchange rate regimes any longer. Therefore, although it’s meaningful to discuss these issues, they are not really of much significance.
In addition, it’s critical for China to step up the introduction of high-quality foreign exchange and futures products. This is the most pressing task right now.
III. Discussions of RMB exchange rate should keep pace with national strategy adjustments
First, theoretical research needs to be more detailed and in-depth. For example, further research needs to be done on the expectations theory. Before 2005, even a slight rise in RMB exchange rate would stir up market expectations that the currency’s value would continue to ascend, which caused appreciation pressure that later gave rise to calls for reverse operations to devalue RMB. At that time, some of the media spoke highly of the PBC for “dealing huge blows to short-sellers” and breaking their expectations. But this coping strategy was actually problematic. We should do more in-depth research on the expectations theory.
Second, China’s exchange rate policies are closely associated with the country’s economic development and strategies. In the late 1970s, Chinese scholars started to discuss comparative interests and whether we should borrow from abroad or introduce foreign capitals. Based on these explorations, we gradually formed a set of development theories and export-oriented strategies, such as adopting mercantilist trade policies, and accumulating foreign exchange reserves. These fundamental discussions and policies have had direct influences on China’s exchange rate policies.
The Chinese government has put forward the “dual circulation” strategy. Its core concept is that China’s economic growth should rely more on the domestic market, which I believe is totally correct. Does this mean that the economy should rely more on domestic investments now that it’s harder to attract foreign investments and invest abroad?
In fact, the contribution of trade to GDP in China dropped from 64% in 2006 to 32% in 2019, while the proportion of net imports in GDP fell from 9% in 2006 to less than 0.8% in 2018; likewise, the percentage of exports in GDP also declined from the 2006 high of 35% to the current level of 17%.
Against this backdrop, the Chinese government has released a clear signal that the national development strategies may undergo significant changes or adjustments when it says that the economy should rely more on the domestic circulation. It does not mean that China will steer away from the general direction of reform and opening-up, but that the economy needs to be responsive to changes in the environment and development strategies need to keep updated. This is the necessary and correct thing to do. Discussions of the exchange rate issue need to keep pace with the big adjustments in the country’s development strategies.
Third, there should be more discussions on some of the technical details. For example, the formation mechanism of the central parity rate of RMB against the USD that came into being in early 2016, which was based on both the closing rate and the exchange rate movements of a basket of currencies, embodied a lot of complicated concepts; later the countercyclical factor was also incorporated into it. Behind this is the PBC’s progressive efforts to transform the fixed exchange rate mechanism into a floating regime before realizing free floating.
Fourth, related discussions need to be grounded on data.
Last, the Sino-US trade war has provided a new dimension for the research on exchange rates, and it needs to be fully studied.
IV. Capital account liberalization is not an urgent task at the moment, and it requires four conditions
We need to have more in-depth discussions on the details of the liberalization of China’s capital account. It’s important to carefully prioritize the opening of various items under the capital account, hammer out a proper roadmap, and plan ahead for operational details. I believe four things need to be done before liberalizing China’s capital account:
First, float the RMB exchange rate. Generally speaking, this is a must before China steps up its opening-up of the capital account. But of course, we need to leave some flexibilities for different items under the account.
Second, clearly define and strictly protect property rights. Economists are usually disinclined to talk about institutional economic problems, but such discussions are inevitable. It would be hard to stop capital flight and dangerous to open up the capital account hastily if property rights are ill-defined and protected.
Third, fully develop the government bond market. Although China’s bond market already ranks the second in the world, its government bond market remains underdeveloped, which has hindered the liberalization of its capital account.
Last, flows of hot money, which do no good to the recipient country, must be restrained in any case, though the exact measures can be discussed separately.
In summary, liberalization of the capital account is not a pressing task at the moment. Preconditions, including a floating exchange rate regime, must be met before the capital account can be opened up. Meanwhile, China needs to fix related vulnerabilities and put in place concrete measures to promote the liberalization process. This would tell the world that it has no intention to isolate itself, but is dedicated to opening up and liberalizing cross-border capital flows.
In one word, I endorse the research team’s idea that China needs to step up reform of the exchange rate regime to achieve free floating of the RMB exchange rate.
