Beware of capital account liberalization

Haste is accompanied by a greater risk of unintended consequences

The International Monetary Fund is going to reevaluate the currency basket of Special Drawing Rights this year, and one of the options is to include the renminbi in the basket. Christine Lagarde, president of the IMF, says China should further speed up the capital account liberalization to achieve this goal.

In March, during the annual sessions of the National People's Congress, the State legislature, and the advisory Chinese People's Political Consultative Conference, a leader of the People's Bank of China reaffirmed that China would essentially realize the goal of the capital account liberalization by the end of this year.

It would be good if China could join the SDR club. It would mark the renminbi as an international currency, accepted by the IMF, an international multilateral financial institution. However, becoming an SDR member does not mean that significant achievements have been made in internationalizing the renminbi.

The SDR, established in the early 1970s, has played a limited role. It only applies to the official settlement between the IMF and member countries, and it is not widely used for pricing or settlement in the global financial market. In other words, even if the renminbi joins the SDR, the symbolic meaning is deeper than its practical implications.

A currency must meet two standards to qualify for the SDR. The first is that the issuing country occupies an important position in the global economy, which China has achieved by becoming the world's second-largest economy and the world's largest trading nation. The second is that the currency, in this case the renminbi, should be used widely and internationally. The definition of this is vague. The widespread use of the international currency does not necessarily mean the full liberalization of capital accounts, but in the eyes of the market and policymakers, the two things seem to amount to the same thing.

Since 2012, China has organized academic discussions on whether the government should speed up the liberalization of capital account. The main point is not whether it should be liberalized, but whether the process should be accelerated. At the Research Center for International Finance, part of the Chinese Academy of Social Sciences' Institute of World Economics and Politics, we hold a sharp negative attitude. We are concerned that an acceleration could lead to massive capital outflows, which could be detrimental to China's macroeconomic and financial market stability, and may even hamper or harm domestic structural reforms.

Several years on and the discussion on whether to speed up the process has already exerted a certain influence on some policies. Even the leader of the People's Bank of China declared that China will accelerate capital account convertibility, but at the same time he also reiterated the need to strengthen monitoring and management of short-term capital flows. In other words, speeding up does not mean completely abandoning control over short-term capital movement.

This stance is commendable. However, during the two sessions this year, the central bank's saying that the capital account will essentially be liberalized by the end of this year, and facilitate the renminbi joining the SDR basket by speeding up capital account liberalization once again gave cause for a great deal of concern.

Speeding up capital account liberalization may still lead to increased volatility of short-term international capital. Consequently, it may intensify domestic financial risks explicitly, even embedding hidden dangers. It would be handy to look at the consequences of speeding up capital account liberalization, from both an international and a domestic perspective.

From an international perspective, the European Central Bank introduced new quantitative easing monetary policies in March, and the Bank of Japan is maintaining the loosest monetary policy in its history, but the focus of the global policy is still normalization of US monetary policy. In October, the Federal Reserve had completely withdrawn from the quantitative easing monetary policy. From some time this year, the Fed is likely to enter a new round of the interest-rate rise cycle, which will dampen global investors' appetite for risk, causing global investors to increase their holding of dollar-denominated assets. As a result, huge sums of short-term international capital will flow from emerging market countries to the US and other developed countries.