By Xie Fang
With the removal of the restrictions on foreign investments in China's banking, securities and insurance industries in recent months, China has been taking big steps to further open up its financial sector.
Nonetheless, as part of China's financial opening-up, the liberalization of China's capital account is a contentious issue that has been discussed by government officials as well as scholars for years.
At this year's Lujiazui Forum held in Shanghai in mid-June, Yi Gang, governor of the People's Bank of China (PBC), reaffirmed the central bank's commitment to the opening-up of China's capital account, but he also cautioned that it would be an incremental process that would not be accomplished any time soon.
Yi took the financial crisis breaking out in Southeast Asian countries in 1998 as an example to illustrate the potential risk posed by the abrupt liberalization of a country's capital account.
Yi's opinion was shared by some economists who attended the China International Conference in Macroeconomics held by the PBC School of Finance, Tsinghua University last weekend.
In his presentation, Liu Zheng, senior research advisor of the Federal Reserve Bank of San Francisco, argued that given the current state of China's financial system, the benefit of the capital account liberalization was not as clear as in more developed financial systems.
Liu pointed out that China's financial market is currently distorted to some degree due to what he called financial repression, in which domestic banks are required to extend loans to state-owned enterprises (SOEs) at a below-market interest rate.
Also, the distortion of the financial market is compounded by the implementation of what he called the two-way capital controls, in which domestic investors are restricted from investing abroad, and foreign investors are also restricted from investing in China.
Under this context, he concluded that the authorities should liberalize the financial repression and ease capital controls before opening up China's capital account.
Vivian Zhanwei Yue, associate professor of economics at Emory University, also shared her study on the optimal pace of the capital account liberalization for China in her presentation.
"Free capital mobility is optimal in a frictionless world," noted Yue. "But when the world is not frictionless then free capital mobility may not be optimal."
From her perspective, the ease of capital control faces a tradeoff. "On the one hand, liberalizing capital outflows improves consumption-saving but exacerbates misallocations across sectors because it raises the funding costs for productive private firms," said Xue. "On the other hand, liberalizing capital inflows increases the share of private sector activities but generates borrowing spillovers."
When discussing the issue of financial repression, Xue pointed out that compared with the private sector, the SOE sector is less productive and monopolistically competitive, which can borrow working capital loan at below market interest rates. Hence, she argued that reducing the degree of financial repression required a reduction of the size of the SOE sector.
Therefore, she concluded that a rapid removal of the financial repression but a gradual liberalization of the capital account is the optimal approach under the current situation.
