Cap­i­tal con­trols aren’t the an­swer for China

The Pak Banker - - OPINION - Christo­pher Bald­ing

CHI­NESE lead­ers could be for­given for find­ing Western pun­dits and cen­tral bankers a tad hyp­o­crit­i­cal. Af­ter years of preach­ing the virtues of fi­nan­cial lib­er­al­iza­tion, the lat­ter have sud­denly taken up the cry for China to im­pose "tem­po­rary" cap­i­tal con­trols in or­der to stem record-set­ting out­flows -- an es­ti­mated $1 tril­lion in 2015 alone. The govern­ment has al­ready be­gun sub­tly tight­en­ing con­trols. The ar­gu­ments for go­ing fur­ther, how­ever, are mis­guided.

For awhile now, China has been strug­gling with the so-called im­pos­si­ble trin­ity, which says that a coun­try can have any two, but not all three, of the fol­low­ing: free cap­i­tal flows, a fixed ex­change rate or sov­er­eign mon­e­tary pol­icy. Chi­nese lead­ers claim to want to in­ter­na­tion­al­ize their cur­rency, the yuan, and to open up the coun­try's closed fi­nan­cial sys­tem. But for a lit­tle more than a year, de­clin­ing in­ter­est rates and a lack of good in­vest­ment op­tions have en­cour­aged Chi­nese to ship their as­sets out of the coun­try. In­vestors com­par­ing shaky Chi­nese pro­vin­cial bonds to U.S. Trea­suries with sim­i­lar yields don't need to con­tem­plate the trade­off long.

A sur­prise de­val­u­a­tion in Au­gust in­ten­si­fied the out­flow, as in­vestors sought to avoid fur­ther de­pre­ci­a­tion by mov­ing their money off­shore. Mean­while, the govern­ment's at­tempts to prop up the cur­rency are drain­ing China's for­eign-ex­change re­serves at an choose be­tween float­ing the yuan and im­pos­ing strict cap­i­tal con­trols is ap­proach­ing faster than many are will­ing to ad­mit.

To as­sess the vi­a­bil­ity of cap­i­tal con­trols, one needs to judge what they might ac­com­plish and how and when they might be lifted. Pro­po­nents ar­gue that they'd at least give Chi­nese lead­ers more room to juice their slug­gish econ­omy. No less than Bank of Ja­pan Gov­er­nor Haruhiko Kuroda re­cently sug­gested that af­ter im­pos­ing con­trols, China could safely ease "do­mes­tic mon­e­tary pol­icy to stim­u­late con­sump­tion at home."

True, out­put and retail sales are grow­ing much more slowly than the 11 per­cent topline rate might sug­gest. Out­flows, in fact, re­flect a lack of con­fi­dence among Chi­nese cit­i­zens and com­pa­nies about the Chi­nese econ­omy. But boost­ing de­mand will re­quire fun­da­men­tal eco­nomic re­struc­tur­ing, in­clud­ing low­er­ing hous­ing and busi­ness costs. Cap­i­tal con­trols by them­selves won't do much to help. In the mean­time, fur­ther eas­ing would place even more down­ward pres­sure on the yuan and on the con­trols them­selves. The Peo­ple's Bank of China clearly rec­og­nizes this dilemma: A leaked week­end memo quoted as­sis­tant gov­er­nor Zhang Xiao­hui as say­ing, "A too-loose liq­uid­ity sit­u­a­tion may re­sult in rel­a­tively big pres­sure on the yuan ex­change rate."

Oth­ers say that con­trols would af­ford China the time it needs to clean up the bank- ing sys­tem, which is groan­ing un­der a moun­tain of debt. But those prob­lems are the prod­uct of of­fi­cial pol­icy, which for years in­volved run­ning large bal­ance-of-trade sur­pluses and im­port­ing cap­i­tal to drive rapid in­vest­ment, chan­neled by the govern­ment. Even now, de­spite declar­ing the need to delever­age in 2016, Chi­nese lead­ers are still al­low­ing credit to grow ap­prox­i­mately twice as fast as GDP. It's un­clear what cap­i­tal con­trols can ac­com­plish if pol­i­cy­mak­ers re­main un­will­ing to ad­dress un­der­ly­ing prob­lems.

More likely, such mea­sures would en­cour­age con­tin­ued over­in­vest­ment and a buildup in debt, mark­ing a fi­nal break with any at­tempt at re­form­ing the Chi­nese econ­omy. The mea­sures al­most cer­tainly wouldn't be "tem­po­rary." As one pa­per noted, cap­i­tal con­trols have his­tor­i­cally been "as­so­ci­ated with poor gov­er­nance" and in most cases stud­ied, "did not sup­port fi­nan­cial sta­bil­ity." Even pro­po­nents ad­mit they'll take sev­eral years at least to un­wind. While Malaysia's ex­pe­ri­ence with cap­i­tal con­trols af­ter the 1998 Asian fi­nan­cial cri­sis is of­ten cited as a suc­cess, its prob­lems were tem­po­rary and due to an ex­oge­nous shock; nei­ther is true of China's chal­lenges. That means China's so­lu­tions must be dif­fer­ent, too. The first thing pol­i­cy­mak­ers have to un­der­stand is that cur­rent out­flows are driven by fear.

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