Why China’s capital-account liberalisation has stalled

In early 2012, the People’s Bank of China (PBoC) took advantage of whatit viewed as a “strategic opportunity” to accelerate capital-accountliberalisation, which has been underway since 2009. The renminbi, it wasexpected, would be “basically” convertible by the end of 2015, andfully convertible by the end of 2020. But things haven’t worked out asexpected.Problems began in 2014, when China’s capital account, which had been insurplus since the 1990s, swung into deficit. By the end of the nextyear, the deficit had grown so large that China’s overall balance ofpayments (BOP), too, turned negative, even as China’s current-accountsurplus remained above $300bn. Last year, China’s capital-accountdeficit amounted to some $200bn.To protect the renminbi, the PBoC intervened heavily – a process thatproved costly. In less than two years, China’s foreign-exchange reservesfell from their peak of $4tn in mid-2014 to just below $3tn.At first, many were indifferent to the losses. Some even argued thatthere were no losses at all, but rather a positive shift in resourceallocation, with official reserves becoming privately held foreignassets. After all, they pointed out, as China’s foreign-exchangereserves fell by $1tn from the second quarter of 2014 to the end of2016, 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, acountry’s current-account surplus should be equal to the increase in thecountry’s net foreign assets. So what really happened was that $850bnof China’s foreign-exchange reserves had gone missing.And, in fact, this process had begun much earlier. From the firstquarter of 2011 to the third quarter of 2016, while China’s cumulativecurrent-account surplus was $1.28tn, its net foreign assets fell by$12.4bn. In other words, since 2011, some $1.3tn of China’s foreignassets has disappeared. Recognising this dangerous trend, the PBoCabruptly hit the brakes on capital-account liberalisation last year,tightening capital controls to a degree not seen since the Asianfinancial crisis of the late 1990s.The gap between changes in a country’s current account and itsnet-foreign-asset position partly reflects “net errors and omissions” inthe BOP calculations. When capital flows out of a country, thetransactions are supposed to be reflected in the BOP table. But in acountry like China, where capital flight is illegal and investorsattempt to evade capital controls, transactions might not be recorded atall. Instead, they show up in net errors and omissions, which in Chinahave turned strongly negative in recent years, owing, in my view, toaccelerating capital flight.Some in China have argued that the negative trend for net errors andomissions is simply the result of statistical mistakes. But when theshortfall 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’snet errors and omissions have moved in just one direction, alwayscontributing to the BOP deficit.Although China’s net errors and omissions must be linked to capitalflight, the figures do not have to line up exactly; net errors andomissions can be either larger or smaller than the actual figure. InChina’s case, the latter seems to be true, for a simple reason: capitalflight may also be recorded as regular capital outflows that do notaffect errors and omissions.For example, as they pursue overseas mergers and acquisitions, someChinese corporations have taken large amounts of capital out of Chinalegally. But no one knows whether those outflows will translate into netforeign assets owned by Chinese residents. That is why, to gauge thescale of capital flight, one must also consider the difference betweenyear-end investment positions, net of “financial transactions” and“other changes in position.”Doing so leads to a stark conclusion. Since 2012, and especially since2014, China has experienced massive capital flight. If the governmenthad not taken action to slow, if not halt, the process ofcapital-account liberalisation in 2016, the results could have beentruly devastating.In the past, the key challenge facing China was to stop importing “darkmatter”: as one of the world’s largest net creditors, China needed tostop running an investment-income deficit. Today’s challenge is to avoid“matter annihilation”: China must prevent its net foreign assets fromdisappearing.In early 2013, when capital-account liberalisation was in full swing, Iwrote that, “with China’s financial system too fragile to withstandexternal shocks, and the global economy mired in turmoil, the PBoC wouldbe unwise to gamble on the ability of rapid capital-accountliberalisation to generate a healthier and more robust financialsystem.” In fact, I continued, “Given China’s extensive reform agenda,further opening of the capital account can wait; and, in view ofliberalisation’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 WorldEconomics and director of the Institute of World Economics and Politicsat the Chinese Academy of Social Sciences, served on the Monetary PolicyCommittee of the People’s Bank of China from 2004 to 2006.