A Capital Problem

March 23, 2006 • Commentary
This article appeared in The Wall Street Journal Asia on March 23, 2006.

Capitol Hill is growing impatient again with China’s exchange‐​rate regime, threatening protectionist tariffs, and more. Three U.S. Senators even flew to Beijing this week to vent their frustrations. But they’re missing the point. Banging away on the narrow issue of the renminbi’s value diverts attention away from a more pressing problem: China’s long‐​standing repression of its capital markets.

Of the world’s top 10 biggest trading nations, only China has extensive capital controls. Sure, current‐​account transactions, or trading in goods and services, are liberalized. But Chinese citizens are barred from investing overseas, interest rates are heavily regulated and domestic stock markets are limited mostly to state‐​owned enterprises.

China pays a high price for such controls, which distort investment decisions and misallocate capital. Ordinary Chinese suffer too. Denied the right to seek higher returns overseas for their hard‐​earned savings, they have no choice but to take their chances with poorly regulated domestic investments. And that, in turn, helps explain why China’s savings are so high — and why the much‐​discussed U.S.-China trade deficit remains intact.

Ending draconian capital controls and allowing widespread privatization — a necessary condition for the existence of competitive capital markets and efficient pricing — would have many benefits. It would transform China’s socialist system into genuine markets with real owners who would be responsible for their decisions. It would steer capital to its most productive uses. It would also attract foreign investments and help revalue the renminbi, also called the yuan, and rebalance the U.S.-Sino trade relationship.

All the more reason, then, for Congress to shift its focus away from the exchange rate. Since Beijing revalued its currency by 2.1% last June and switched to a basket of currencies approach, the renminbi has moved less than 1% against the greenback. So, Senators Charles Schumer and Lindsay Graham, have proposed a bill to impose prohibitively high tariffs on Chinese imports unless Beijing moves rapidly toward a more substantial revaluation. Along with Senator Tom Coburn, the three told their Chinese hosts on Monday that U.S.-Sino trade relations “are getting worse.”

Rather than resorting to damaging protectionist measures, the senators would be better advised to help China move toward capital freedom. That means pointing out how China risks falling behind India, where Prime Minister Manmohan Singh recently put capital‐​account convertibility firmly back on the agenda. And it means supporting reformers such as Zhou Xiaochuan, the head of China’s central bank, who recently committed his country to move in the same direction.

There have been other encouraging signs. The central bank’s Monetary Policy Committee said in September that the market should “play its role in economic restructuring,” including further interest‐ and exchange‐​rate reforms, and that “efforts should be made to advance financial reform” in order “to enhance the effectiveness of monetary policy.”

But the real question is how quickly China will act. Most critics argue that capital controls cannot be relaxed until the banking sector is fully reformed. That argument suggests that if Beijing let the money flow out, it wouldn’t flow back to China again, and domestic Chinese banks’ balance sheets would suffer. Not only is that unlikely, but it ignores the important role that competition plays in fostering the most efficient use of capital.

The Chinese Communist Party itself may also put up strong resistance to giving up its control over the financial sector. Once Chinese citizens had a taste of controlling their own capital and private property became protected under the law — as promised in the recently amended Chinese Constitution — the last visage of central planning would disappear and the Party’s power would fade.

That is why the Party failed to adopt the draft civil code — designed to protect private property rights — earlier this month at the National People’s Congress. Indeed, Gong Xiantian, a law professor at Beijing University, strongly criticized the draft civil law because it fails to declare that “socialist property is inviolable.” That mentality explains why China has been so slow in making the transition from financial repression and state ownership to capital freedom and private rights.

A modest proposal to allow some Chinese pension funds and insurance companies to invest overseas, known as the Qualified Domestic Institutional Investors scheme, is still not in place, five years after it was first mooted. However, Hu Xiaolian, head of China’s State Administration of Foreign Exchange, said in February that Beijing would move ahead with capital account liberalization and encourage capital outflows. In reality, however, the amounts will be small.

Another much‐​hyped scheme to allow selected foreign investors to buy domestically traded stocks and bonds, known as the Qualified Foreign Institutional Investor scheme, is highly restrictive. Most fund managers don’t want to tie up their client’s capital in state‐​owned companies. Consequently, foreign investors still play only a minor role in China’s casino‐​like stock markets.

China’s top policymakers realize what needs to be done to improve the country’s financial architecture. But we must be patient. It will take time for China to liberalize its exchange rate regime, open its capital markets, allow full convertibility of the renminbi, liberalize interest rates and use domestic monetary policy to achieve long‐​run price stability. Even more difficult will be the crucial task of privatizing China’s stock markets, banks and state‐​owned enterprises.

As Senators Schumer, Graham and Coburn are discovering, the path ahead will not necessarily be an easy one, particularly if Congress focuses narrowly on the exchange rate. It’s time to broaden the discussion — and encourage capital freedom.

About the Author
James A. Dorn

Vice President for Monetary Studies, Senior Fellow, and Editor of Cato Journal