Risks and politics in capital account liberalization

Various talking heads, including yours truly, are quoted in this Bloomberg piece about the risks to China’s decision to step up the pace of capital-account liberalization in recent months. Here are some indicative comments:

“History shows that if China prematurely opens the capital account before properly sequencing in other reforms the results could be disastrous for financial stability and longer-run growth prospects,” said Kevin Gallagher, an associate professor of international relations at Boston University who co-wrote a paper on China’s cross-border capital deregulation. “I worry that they are forgetting the past.”

The best sequencing would have China first free up its domestic financial sector and shift to using interest rates as the major tool to affect credit, according to Louis Kuijs, Royal Bank of Scotland Group Plc’s chief China economist. Next, policy makers should allow greater currency flexibility, and then open the borders to capital flows, said Kuijs, who previously served as the World Bank’s senior economist in Beijing.

Why all the hand-wringing? In April, central bank governor Zhou Xiaochuan made a surprisingly public and specific pledge to complete some additional opening of the capital account during 2015–a timetable explicitly driven by the goal having the renminbi blessed by inclusion in the IMF’s currency basket for the SDR, whose quinquennial review begins in November. The IMF has made very positive noises in response, so it is looking like a done deal. The symbolism of having the renminbi recognized as a reserve currency is obviously very important to China. Or, what I think is more likely, the symbolism is politically useful for Zhou. An issue of national prestige is a much better way to convince the rest of the government of the merits of additional capital account opening than a technical economic argument. In any case, it seems pretty clear that the decision to open up more to capital flows (through measures like the trading link between the Shanghai and Hong Kong stock markets) is not being driven by technocratic concerns about sequencing, but by political opportunity.

It’s reasonable to worry about the potential consequences of this opportunistic strategy. I have a lot of respect for Louis Kuijs and do not quibble with his preferred sequencing. And there are definitely a number of Chinese economists who think opening the capital account should be a relatively low priority, undertaken only after more liberalization of the domestic economy. However if we are describing what is actually going on in China, rather than prescribing what it should be doing, I think it is pretty clear that the proper sequencing of reforms is not the big priority.

Does this make sense? If you think about how governments actually work, it does. Policy changes tend not to happen at the exact moment that the eggheads think is optimal, but when there is a political opportunity to get agreement on them. Proposals can sit on the shelf for years until the right political moment arrives. It looks like Zhou has decided to seize the moment to push through some additional opening of the capital account, without worrying too much about whether it is exactly the right time to do so. Sure, some people may quibble about the sequencing of reforms, and there may be some messes to clean up later. But getting the sequence wrong may be less of a risk than missing a political window of opportunity that may re-open for years. At least, that is the apparent calculation.

The politics of capital-account liberalization are a useful reminder that China’s economic reforms do not, despite how it may sometimes seem to outsiders, proceed according to a detailed top-down plan made long in advance.

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