Asia Economics Comment

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1 June 6, 13 Goldman Sachs Global Economics, Commodities and Strategy Research Li Cui, MK Tang, Fiona Lake Research Report Gao Hua Economics Research at China: Capital account reforms charting a roadmap Bottom line: China has pledged to accelerate capital account liberalization. This is likely to be pursued alongside interest rate and exchange rate reforms. Capital controls have been effective in maintaining a wedge between the onshore and offshore interest rate. A normalization of global rates will provide a catalyst for faster reforms in our view. In the near term, allowing greater FX volatility (including band widening), expanding outflow channels to offset inflow pressures, and further developing the offshore CNY markets are likely to be priorities. China has indicated its intention of putting together a blueprint this year towards a more coherent strategy of capital account liberalization. This is the first time such a clear policy directive is given, after years of very cautious dealings with capital flows. Although some of the controls have been progressively eased, the legal basis has remained "prohibition in principle" rather than "permission in principle". Within different categories of the capital account, direct investment is the most open, followed by bank flows ( other investment in balance of payment statistics). On the other hand, portfolio investment has remained very limited (Exhibit 1). Exhibit 1: China s portfolio flows limited but bank flows were volatile % share of GDP % share of GDP 1 China's balance of payment: other investment portfolio investment direct investment current account Source: CEIC, Haver. Why the determination to speed up capital account reforms? Across emerging markets (EM), capital flows have been managed cautiously in recent years. Some EMs have in fact resurrected capital controls to moderate the inflows stemming from the low global rates, and the IMF, for instance, has called for a more prudent approach towards capital account openings. In China s case, however, there are a number of arguments in support of an accelerated pace towards opening up the capital account. Important disclosures appear at the back of this document

2 Capital controls increasingly porous and not effective in stopping flows into or out of the currency. Capital flows have been volatile in recent years, putting pressure on the People s Bank of China (PBOC) to sterilize the impact. This suggests that capital controls have become porous. In addition, as highlighted previously, the foreign currency position of residents can bring about a large shift of flows into the domestic currency as well, an area that the recent regulations have targeted (see Emerging Markets Macro Daily: China: Recent capital inflows and SAFE s new regulations, May 7, 13). The PBOC still maintains a wedge between the onshore and offshore short-term interest rates (see Emerging Markets Macro Daily: China: The PBOC's monetary policy: Still in control, March 21, 13), but this is managed through substantial foreign exchange and domestic money market operations. Rising need to support an international currency and diversify foreign currency risks. China is an international creditor with a net international investment position of about 21% of GDP, with the foreign assets mostly denominated in foreign currencies. This subjects China to a valuation loss in case of US dollar (USD) depreciation. Moreover, the private sector maintains a short foreign currency position, suggesting that the private sector could suffer a loss in case of USD appreciation. The renminbi (CNY) internationalization initiative was partly to reduce the FX risks arising from such currency mismatches. But a bigger offshore CNY market can only be achieved if it is linked to the onshore CNY market. Urgency to diversifying domestic savings. The large domestic savings and the limited channels of domestic investment have added to the overheating of the Chinese property market. A gradual relaxation of outflows could usefully divert domestic savings to overseas markets, achieving better risk diversification and easing domestic property price pressure. Approach towards capital account reforms interactive with domestic reforms without strong sequencing While we expect priority areas to be identified in the government s plan of capital account reforms and the pace may accelerate, the sequencing of reforms may still be kept vague. So far, the PBOC has pushed back in particular the conventional wisdom that the interest rate and exchange rate systems need to be liberalized first before more substantial steps of capital account reforms are taken. Instead, the government has pursued simultaneous reforms incrementally. The potential risks of capital flows need to be weighed against the benefits of better price signals through liberalization, in their view. Moreover, given the economy s size and available tools to manage the monetary condition, China's domestic interest rate won't be overwhelmed by global liquidity even with more liberal capital flows, and the strength of China's financial positions (including the external surpluses and FX reserves) offers sufficient cushion to manage downside risks. The debate about sequencing is likely to continue; meanwhile, we believe the reform agenda in the near term is likely to feature continued progression on several fronts. We group the areas of reforms into four areas, and lay out the inherent connections of these reforms in Exhibit 2. Exhibit 3 summarizes recent achievements and highlights possible next steps. Exhibit 2: China s reform map: A cobweb rather than a line (arrows indicate influence) Exchange rate reforms increase scope of short rate setting Interest rate liberalization Exchange rate reforms Onshore and offshore CNY interest rate convergence Capital flows affecting onshore rates Exchange rate volatility reduces capital flow pressure CNY internationalization Less currency mismatch reduces risks from capital flows Capital account liberalization Capital account liberalization needed for international currency Source: GS Global ECS Research estimates. 2

3 Exhibit 3: China s recent reform initiatives in financial markets and possible next steps Areas Recent initiatives Possible near-term reforms Reducing the influence of cap/floor on policy rates Developing the interbank market, using open Further decline of guaranteed bank margin Interest rate reforms market operations instead of reserve requirement ratio changes for monetary management Increasing the role of non-loan financing that uses market interest rate Further developing the interbank market Making monetary policy more price orientated rather than quantity orientated Exchange reforms Intra-day band of the exchange rate widened Widening the band again and tolerate more More intra-day volatility of the exchange rate volatility of the CNY exchange rate in both allowed directions Reducing the FX market intervention Greater market impact in the fixing Offshore RMB market Started CNY settlement and related trade financing. Offshore CNY bond issuance and developing inter-bank benchmark. Deepening offshore markets and expanding offshore centers Increase the volume of offshore CNY bonds Increasing offshore bank lending in CNY Expanding onshore and offshore CNY linkages. Capital account reforms Quota-based portfolio investment such as QFII, QDII, R-QFII, Expanding outward FDI. Expanding the quotas of existing schemes. Introducing individual overseas investment scheme Source: PBOC, GS Global ECS Research estimates. Looking through the lens of earlier experience, Japan's experience in the 198s offers the best comparable example. Like China, Japan faced persistent inflow pressures from its trade surpluses, and the FX intervention resulted in large foreign currency mismatches for the country s balance sheet. Meanwhile, domestic financial systems were still controlled with interest rate regulation and credit quotas. Unlike China, however, the Japanese approach followed a clearer sequencing liberating domestic interest rates and exchange rates first before more aggressive steps of capital account reforms, including yen internationalization. Such an approach, however, may not be suitable in the eyes of the Chinese authorities as the wait for necessary reforms may be too long. How fast can it happen? Rising global rates would provide catalysts for bigger steps, but we expect liberalization to be paced A more liberalized regime is likely to see potentially very large inflows and outflows for portfolio rebalancing by the domestic and international investors, challenging the capacity of liquidity management. This suggests a paced liberalization rather than a speedy removal of all controls will likely remain a preferred approach. Global liquidity conditions also matter. So far, despite the volatile cross-border bank flows, capital controls still draw a wedge between the onshore and offshore interest rates, not only at the short maturity reflecting monetary operations, but also at the longer maturity. Exhibit 4 shows the average share of non-resident holding of government papers vs. the change of the yield spread of 1-year government bonds over the US treasury after the global financial crisis. A negative relationship across EM countries suggests that the greater foreign purchases of domestic papers likely to have contributed to the declines of yield spreads of the long-dated securities in recent years. Compared to most major economies (except Thailand), where the long-term interest rate spreads over the US Treasury have come down, China s interest rate spread actually climbed in the last few years, suggesting capital controls are still effective keeping domestic cost of funding higher than otherwise. A decline of the long-term yield would have been unwelcome in light of the solid growth and the concerns about the leverage buildup. At the same time the positive interest rate gap has been a source of inflow pressures as well, putting upward pressure on the exchange rate, as argued before. 3

4 A gradual normalization of global liquidity conditions will be an important catalyst for more comprehensive steps in our view. Meanwhile the inflow pressures can also be offset by the diversification outflows under a more liberalized regime, and perceived currency risks from a more flexible CNY. The near-term priority of capital account reforms is likely to concentrate on technical steps to reform the FX system, expanding the scheme for outward investment to offset inflow pressures, and further developing the offshore CNY markets, as illustrated in Exhibit 3. Exhibit 4: China s onshore interest rates less affected by global rates due to capital controls Share of non-residents holding of government securities (average, %) Poland 4 Foreign purchases vs. change in bond yield spread* Indonesia 2 Mexico Korea 1 Thailand Brazil China Change in 1-year bond yield spread over US Treasury post GFC (bp) * Changes in yield spread between June 9 (or the earliest available data) and the latest Source: CEIC, Haver, Bloomberg. 4

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