international analysis and commentary

Long-term financial reforms: key to manage China’s imbalances


As China prepares for the 19th Congress of the Communist Party – a tightly controlled and close event to be held later this year – many China-watchers have been wondering whether the country’s leadership can continue to stir the economy without triggering any instability. Will the Chinese leaders be able to deliver economic growth in line with the annual GDP target of 6.5% while changing gear and shifting the model of growth – from exports and investment to consumption as the main driver of growth? Above all, can they keep the many imbalances under control and avert instability?

Whether China is on the verge of economic and financial collapse – a ‘hard landing’ – has been a recurring question over the past fifteen years. Strong GDP growth has been the necessary component of the country’s economic development in order to lift per capita income and reduce the number of the very poor – indeed, between 1990 and 2015 GDP in real terms expanded, on average, by almost 10% a year. Per capita income is now just over US$ 8,000 in nominal terms – it was approximately US$ 350 in 1990 – and about 500 million people, over the same period, were lifted from extreme poverty. Over the space of a generation China has managed to move from abject poverty and isolation to become a key economic player.

Today China is the world’s second largest economy – or even the first, depending on how we measure GDP – and the largest exporter – having overtaken Japan in 2010. This extraordinary development coincided with the globalisation of the world economy in the early 1990s that created the perfect setting for Deng Xiaoping’s ‘opening up’ of China and the promotion of a market-based system ‘with Chinese characteristics’ – i.e. a system where the political leadership retains control of key parts of the economy such as large enterprises, large banks and financial institutions, and sets up key economic targets.

How weaknesses and imbalances reflect on the renminbi

But this extraordinary development has also resulted in a system mired down in many weaknesses – inequalities, environmental degradation, excessive capacity, deflationary pressures, financial imbalances. ‘Financial repression’, in particular, is a trademark of the Chinese system where the savings of many individuals and households –  about 38% of the household disposable income – provide loans, at favourable rates, for state-owned companies and provincial governments.

The imbalances in China’s development are somehow epitomised by the currency – the renminbi or ‘the people’s money’.  Despite significant progress since 2009 when policy measures to internationalise the renminbi were put in place, it remains limited as an international currency – i.e. a currency used to invoice and settle international trade, and to be held as an asset – with limited international demand and circulation. Unlike other trading nations, notably Britain and the US, that managed to develop their economies while, at the same time, establishing their currencies as key international money, China’s monetary and financial development has been trailing behind that of the real economy. To paraphrase Robert Mundell, China is a great country without a great currency. Great currencies, it should be added, are fully convertible – unlike the renminbi.

China’s system, instead, is one of ‘managed convertibility’ or capital account liberalization ‘Chinese style’ where financial opening is achieved through quotas and licenses. The idea is to calibrate capital movements and so to control the impact of capital outflows and inflows on the exchange rate. But throughout 2015 and 2016 ‘managed convertibility’ proved not to be so effective, and sustained intervention was required, with the consequent depletion of foreign exchange reserves. This was exactly the case that ‘managed convertibility’ intended to avoid. ‘Explicit’ capital controls were introduced in late 2016 to discourage transactions and curb the outflows.

Why financial reforms are critical

Domestic financial reforms to strengthen the financial system and enable it to withstand capital movements are essential for the renminbi to be fully convertible. In practice, however, China remains tangled in a system of financial repression and murky governance that requires controls to be in place – or to have a system of quotas – and affects the exchange rate. Outflows and the investments in the so-called ‘shadow banking’ are consequences of this system. Having the option, many Chinese wound take some of their savings elsewhere – i.e. away from the ‘official’ banks and/or abroad.

Financial reforms have been a priority since 2013 when Xi Jinping took over the country’s  leadership, a priority that was reiterated in the 13th Five-year Plan that covers the period 2016-2020. In recent years, as part of the policy framework to internationalise the renminbi, the pace of financial reforms has accelerated. Interest rates have been liberalised and the exchange rate has been made more flexible and more market-oriented, and the scope for ‘financial repression’ has been reduced. Even so, reforms have not dented yet in the link between state-owned enterprises and the big banks. Vested interests and political tangles continue to hinder transparency, governance and independence, thus the reforms aimed at improving them.

Even if the leadership has been clear about the importance of structural reforms for China’s future, China will continue with its slow and gradual approach to financial reforms, and will continue to muddle through control and openness.

The difficult balancing act of control and openness

‘Capitalism with Chinese characteristics’, or the predicament that markets should, and can, be managed, remains as elusive today as it was in Deng Xiaoping’s day. As former Chinese president Jiang Zemin told Henry Kissinger, for “those accustomed to the West […] the market is nothing strange”. But markets continue to be a source of risk and instability in China, and instability has been exacerbated by the authorities’ attempt to rein in ‘market exuberance’.

There is a seemingly irreconcilable dilemma here, between continuing to manage the economy or  planning to build a more market-oriented system. To some extent the inability of the People’s Bank of China (PBoC) – China’s central bank – to let the exchange rate be set by the interaction between supply and demand reflects this dilemma. Up to now, and despite measures to limit the scope for policy intervention, the exchange rate remains a target of policy intervention.

The bottom line is that managing the economy without improving transparency and governance undermines investors’ confidence and, at the same time, the authorities’ ability to manage short-term volatility and anchor market confidence with transparent, consistent and credible action.

Recently the Chinese leadership has been clear about the scope of international economic ambitions and the role that China should be playing in development finance and in the international monetary system. In 2015 two largely symbolic milestones made these ambitions apparent: the launch of the Asian Infrastructure Investment Bank and the inclusion of the renminbi among the currencies that determine the value of the IMF’s special drawing rights. How these ambitions will play out remains to be seen, but there is no doubt that financial reforms will be the area where the leadership will have to focus even if only to strengthen control while working towards mitigating instability.