Beware of capital account liberalization

From the domestic perspective, as China's economic growth potential declines, the financial risks are increasingly explicit. Against the background of weakened demand at home and abroad, the issue of seriously increasing overcapacity will result in the corporate sector deleveraging. Meanwhile, although the Chinese government has recently started to ease credit policies, it cannot reverse the trend of the real estate market's downward adjustment. The inevitable result is that China's non-performing loans in the banking system will be significantly increased in the years to come.

In addition, the Chinese government's plan to establish deposit insurance corporations this year will transform implicit insurance into explicit insurance for financial institutions, meaning some small and medium-sized financial institutions will be allowed to fail. With this is mind, confidence in the country's financial system will be reduced significantly.

For analysis it is not difficult to see China is facing a rising probability of capital outflow. If the government speeds up capital account liberalization, the economy is likely to face sustained, massive short-term capital outflows, which will have two negative impacts: Increased expectations that the renminbi falling in value, which will further deepen capital outflows and form a vicious circle, and tightened domestic liquidity. If the central bank cannot intervene in time, domestic interest rates will be raised significantly.

There are two schools of thought. One is that if there is sustained massive short-term capital outflow, the central bank may tighten capital controls again. However, that will not only damage the reputation of the central bank, but be costly and may cause turbulence in macroeconomic and financial markets.

The other is that China has nearly $4 trillion in foreign exchange reserves, enough to deal with massive capital outflows. Although China's M2 to GDP ratio is close to 200 percent, its foreign exchange reserves may shrink significantly, which will deepen investor concerns.

The internationalization of the renminbi should be a natural result of China's sustained and rapid economic growth and its financial market development and growth. Before achieving these goals, we should promote domestic structural reforms and avoid a systemic crisis.

Speeding up capital account liberalization has no real benefit for the policies of structural reform, such as domestic income redistribution and breaking the monopoly of State-owned enterprises. But an acceleration may set off a crisis. Further opening of the capital account should be done with caution.

The government should first accelerate the reform of the renminbi exchange rate and interest rate formation mechanism, and the establishment of the macro-prudential regulation framework. Otherwise, China risks going through what Russia went through last year: it had a spurt of capital outflows, and the rouble depreciated markedly against the US dollar, which forced its central bank to raise interest rates significantly.

The author is senior research fellow and head of the department of international investment at the Institute of World Economics and Politics, Chinese Academy of Social Sciences. The views do not necessarily reflect those of China Daily.