Capital Freedom for China

his article was published in the Asian Wall Street Journal, September 9, 2003.
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The growing chorus denouncing China’s “economic attack” on the U.S. manufacturing sector and demanding a revaluation of the renminbi to spur U.S. exports and narrow China’s bilateral trade surplus is misguided. Even if the yuan is allowed to appreciate by widening its band, China will still have a comparative advantage in textiles and some other manufactured goods. That reality should be accepted and attention should focus on normalizing China’s capital markets and abandoning the peg. If China continues to maintain an artificially low value for the yuan, the United States and others may retaliate.

The right to freely hold and invest foreign exchange is an important component of economic and personal freedom. If the Chinese Communist Party were to end capital controls and make the yuan fully convertible, the ossified system of state investment planning would end and China could move steadily toward a modern financial architecture. Private, market‐​directed, investment serving consumers’ — not planners’ — preferences would set a sound basis for future development.

Ending capital controls would force Beijing to abandon its schizophrenic monetary policy and choose between monetary independence and a hard peg. If policy makers opted to let market forces determine the foreign‐​exchange value of the yuan, monetary policy could be used to anchor the long‐​run purchasing power of the yuan. Capital freedom would complement and strengthen trade liberalization, and market discipline would thwart those policies that undermined property rights and freedom.

As long as China controls the ownership of capital, including foreign exchange, people will be subject to exploitation. As Sir Alan Walters, former economic adviser to Margaret Thatcher, noted with regard to transition economies, “Restricted capital convertibility ensures that it is still possible for the government to draw a ring fence around its subjects and expropriate them at will.”

Internationalizing China’s capital markets would normalize them and end one of the Party’s last vestiges of centralized planning. President Hu Jintao could learn a lesson from the experience of post‐​World War II Europe, which was subject to capital controls and used those controls to perpetuate national economic planning. Economist Barry Eichengreen, writing in the latest issue of Foreign Affairs, notes, “Controls on international capital flows, retention of which was permitted under the Bretton Woods settlement, gave each government the leeway to elaborate a national economic plan. But capital controls did nothing to rebuild Europe’s trade or to create confidence that Germany’s economic might would be funneled in productive directions.”

China’s current institutional arrangement — a pegged exchange‐​rate regime, a closed capital account, and a central bank that tries to use monetary policy to manage both the exchange rate and the price level — is untenable in the long run. Persistent current‐​account surpluses and growing capital inflows have increased foreign‐​exchange reserves at the People’s Bank of China (PBoC) to more than $350 billion. If capital inflows are allowed to expand the monetary base and state‐​directed investment continues at a rapid pace, excess growth of money (M2 has been growing at close to 21%, year on year) and credit will lead to mounting inflation.

Dai Genyou, head of the PBoC’s monetary department, has warned that rapid money growth is a threat to price stability. Although excess money growth has not yet shown up in the official consumer‐​price index, asset price inflation is clearly evident in the property sector. The PBoC’s recent announcement that it is increasing reserve requirements to 7% from 6%, as of Sept. 21, is an indicator that current monetary policy is too expansive.

Even if the PBoC increases reserve requirements, that move may not be sufficient to offset new capital inflows, motivated both by China’s entry to the World Trade Organization and by the expectation that the yuan will be revalued. The central bank would have to increase its open‐​market sales (it has sold more than $30 billion of securities in the past three months) to fully neutralize the effect of capital inflows on the monetary base. But that task becomes increasingly difficult for an emerging‐​market country with thin capital markets.

If the PBoC fails to stem inflation, a rising real exchange rate would depress the growth of China’s exports and increase imports. That method of adjusting the trade balance, however, would be costly and slow compared to allowing the yuan to float, promoting capital freedom, and concentrating domestic monetary policy on price stability. Schizophrenic monetary policy aimed at pegging the nominal exchange rate and controlling inflation is not a long‐​run option, if China wants free capital markets.

When the Party forces individuals to sell most of their foreign exchange to the PBoC in order to maintain the nominal peg of about 8.28 yuan to the dollar, those individuals lose the opportunity to invest in foreign capital markets. That “backdoor nationalization,” as John Greenwood, chief economist at Invesco Asia, Ltd., has called it, is inconsistent with economic freedom and misallocates capital.

Strengthening property rights in China by normalizing capital markets would let capital flow to its highest valued uses, as determined by private investors rather than Party officials. Stronger property rights for all investors, domestic and foreign, would attract new capital. With a flexible exchange rate and sound government policy, the yuan would appreciate and help normalize the balance of payments.

According to Mr. Greenwood, “If China’s capital markets and its industries were normalized (through deregulation, proper implementation of the rule of law, the encouragement of private markets, and extensive private ownership), then China’s balance of payments would no doubt undergo a major transformation.”

It is in China’s interest not to delay moving to a freely floating exchange rate and opening its capital account. Although those reforms are not sufficient to avoid a banking crisis, they can put added pressure on Beijing to restructure state‐​owned banks and allow greater competition. Moreover, experience has shown that a misaligned currency and capital controls are costly and unsustainable ways to promote development. Delaying real reform is apt to deepen, not prevent, a future financial breakdown.

Depoliticizing China’s capital markets would give Chinese investment funds the opportunity to diversify their portfolios. Capital would be allocated more efficiently and steps could be taken to privatize China’s pension system. Moreover, capital freedom would allow Hong Kong to develop an offshore yuan center that would further enhance efficiency.

The U.S. should stop worrying about its large trade deficit with Beijing and begin to work with China to normalize capital markets just as the two countries have already normalized trade relations. By shifting the focus from the trade deficit to capital freedom, it will be doing the Chinese people a favor. Free trade and free capital flows are important human rights. If those rights can be secured, U.S.-China relations will also be more secure.