In early 2012, the People’s Bank of China (PBoC) took advantage of what
it viewed as a “strategic opportunity” to accelerate capital-account
liberalisation, which has been underway since 2009. The renminbi, it was
expected, would be “basically” convertible by the end of 2015, and
fully convertible by the end of 2020. But things haven’t worked out as
expected.
Problems began in 2014, when China’s capital account, which had been in
surplus since the 1990s, swung into deficit. By the end of the next
year, the deficit had grown so large that China’s overall balance of
payments (BOP), too, turned negative, even as China’s current-account
surplus remained above $300bn. Last year, China’s capital-account
deficit amounted to some $200bn.
To protect the renminbi, the PBoC intervened heavily – a process that
proved costly. In less than two years, China’s foreign-exchange reserves
fell from their peak of $4tn in mid-2014 to just below $3tn.
At first, many were indifferent to the losses. Some even argued that
there were no losses at all, but rather a positive shift in resource
allocation, with official reserves becoming privately held foreign
assets. After all, they pointed out, as China’s foreign-exchange
reserves fell by $1tn from the second quarter of 2014 to the end of
2016, holdings of foreign assets by the private sector increased by
$900bn.
But this argument failed to recognise that, during the same period,
China’s cumulative current-account surplus was $750bn. By definition, a
country’s current-account surplus should be equal to the increase in the
country’s net foreign assets. So what really happened was that $850bn
of China’s foreign-exchange reserves had gone missing.
And, in fact, this process had begun much earlier. From the first
quarter of 2011 to the third quarter of 2016, while China’s cumulative
current-account surplus was $1.28tn, its net foreign assets fell by
$12.4bn. In other words, since 2011, some $1.3tn of China’s foreign
assets has disappeared. Recognising this dangerous trend, the PBoC
abruptly hit the brakes on capital-account liberalisation last year,
tightening capital controls to a degree not seen since the Asian
financial crisis of the late 1990s.
The gap between changes in a country’s current account and its
net-foreign-asset position partly reflects “net errors and omissions” in
the BOP calculations. When capital flows out of a country, the
transactions are supposed to be reflected in the BOP table. But in a
country like China, where capital flight is illegal and investors
attempt to evade capital controls, transactions might not be recorded at
all. Instead, they show up in net errors and omissions, which in China
have turned strongly negative in recent years, owing, in my view, to
accelerating capital flight.
Some in China have argued that the negative trend for net errors and
omissions is simply the result of statistical mistakes. But when the
shortfall amounts to $1.3tn, such claims can hardly be taken seriously.
Nor can they account for the fact that, over the last six years, China’s
net errors and omissions have moved in just one direction, always
contributing to the BOP deficit.
Although China’s net errors and omissions must be linked to capital
flight, the figures do not have to line up exactly; net errors and
omissions can be either larger or smaller than the actual figure. In
China’s case, the latter seems to be true, for a simple reason: capital
flight may also be recorded as regular capital outflows that do not
affect errors and omissions.
For example, as they pursue overseas mergers and acquisitions, some
Chinese corporations have taken large amounts of capital out of China
legally. But no one knows whether those outflows will translate into net
foreign assets owned by Chinese residents. That is why, to gauge the
scale of capital flight, one must also consider the difference between
year-end investment positions, net of “financial transactions” and
“other changes in position.”
Doing so leads to a stark conclusion. Since 2012, and especially since
2014, China has experienced massive capital flight. If the government
had not taken action to slow, if not halt, the process of
capital-account liberalisation in 2016, the results could have been
truly devastating.
In the past, the key challenge facing China was to stop importing “dark
matter”: as one of the world’s largest net creditors, China needed to
stop running an investment-income deficit. Today’s challenge is to avoid
“matter annihilation”: China must prevent its net foreign assets from
disappearing.
In early 2013, when capital-account liberalisation was in full swing, I
wrote that, “with China’s financial system too fragile to withstand
external shocks, and the global economy mired in turmoil, the PBoC would
be unwise to gamble on the ability of rapid capital-account
liberalisation to generate a healthier and more robust financial
system.” In fact, I continued, “Given China’s extensive reform agenda,
further opening of the capital account can wait; and, in view of
liberalisation’s ambiguous benefits and significant risks, it should.”
Four years later, this advice is worth reiterating. – Project Syndicate
* Yu Yongding, a former president of the China Society of World
Economics and director of the Institute of World Economics and Politics
at the Chinese Academy of Social Sciences, served on the Monetary Policy
Committee of the People’s Bank of China from 2004 to 2006.
The People’s Bank of China: tightening capital controls