CHINA REWRITES RULEBOOK ON CAPITAL FLOWS AFTER CRISIS LESSONS

Since global capital was set free following the end of the Bretton Woods system in the 1970s, countries have struggled to tame the consequences of unbridled money flows without walling off their economies.

Now China is trying to crack that code by essentially establishing two separate checkpoints for flows: one for foreigners and one for residents. It’s a big difference from the all-in capitalaccount liberalisation that rich nations began embracing four decades ago and which later badly tripped up emerging markets — as in the Asian financial crisis in the late 1990s.

China’s thinking is seen most clearly in the “bond connect” that opened on July 3, which lets global investors buy Chinese bonds through Hong Kong, but as yet bars Chinese from buying in the Hong Kong market. The Communist Party leadership has similarly taken a number of other steps to open markets to foreign participation, while steadily tightening supervision of what domestic actors can do to take money abroad.

“China has been encouraging capital inflows but not really encouraging outflows — fundamentally it’s a direction that policymakers in China would like to see,” said Chi Lo, senior economist for Greater China at BNP Paribas in Hong Kong. He says there is no precedent for such an “asymmetric capital account opening”.

The immediate benefit of the lopsided approach is that it should help avoid the kind of sudden capital outflows that hobbled the likes of Mexico and Thailand in the 1990s or Brazil in the 2000s. What’s less clear is whether foreign investors will be comfortable enough with the arrangement to commit portfolio investment commensurate with China’s economic importance. And without steady inflows, pressure may remain on the yuan to depreciate.

The approach under President Xi Jinping has only become clear over the past year or so, after policymakers previously followed a course of gradual opening on both sides of the account. The country had stepped up reform in the middle of the last decade, when it ended a 10-year fixed peg to the dollar in 2005, then in 2006 gave permission to households to take as much as $50,000 a year abroad, more than double the previous limit.

In the wake of the 2007-09 crisis that exposed the dangers of the global financial system’s reliance on the dollar, China began elevating the role of its own currency. It pushed the establishment of offshore yuan trading centres. Officials widened the band for the yuan’s fluctuation against the dollar. By 2012, HSBC analysts were predicting full convertibility for the yuan by 2017.

Things went wrong in 2015, ironically just as China was securing International Monetary Fund approval for the yuan as an official reserve currency. In its efforts to reduce links between the yuan and the dollar, policymakers contributed to a sea-change in investors’ longer-term expectations.

While an inexorable strengthening in the yuan had for years been the assumption — much like the decades of appreciation by the yen — expectations were turned on their head. The new narrative was that with the Federal Reserve preparing to kick off a US monetary tightening cycle, and estimates of more than $2 trillion worth of pent-up money in China looking to diversify abroad, the yuan faced years of decline.

“The outflow pressure is very real,” says Zhao Yang, chief China economist at Nomura Holdings in Hong Kong. The new one-way capital flow strategy that started in 2016 will remain for years to come, and “China doesn’t want hot money”.

While countries such as Japan faced strong post-Bretton Woods pressures that prompted them to dismantle capital regulations, China’s single-party government has demonstrated the ability to maintain controls over a wide range of areas across both the economy and society.

Some see the measures taken to curb outflows since late 2015 as part of a long-standing pattern of two-stepsforward, one-step-back liberalisation. They predict policymakers will again embrace outflows as they did last decade.

There’s no evidence of that now, however, with China’s banking regulator recently looking into the financing of overseas acquisitions by private domestic companies.

While China has emphasised that foreign investors won’t have trouble withdrawing money, capital controls give some pause. And while economists once projected up to $1 trillion of foreign funds pouring into China’s bond market over a five-year period, estimates have been scaled back now.

China ultimately must embrace twoway liberalisation, according to George Wu, who spent 12 years working at the People’s Bank of China before joining Huarong Securities in Beijing as chief economist last year.

“In the long run, as China is already a middle-income country, and residents as well as companies have strong incentives to diversify their assets globally, the controls will hamper the economy’s long-term growth and vitality,” he said.

Christopher Anstey and Xiaoqing Pi are correspondents with Bloomberg News.