China & Asia-Pacific Insights: Antoine Martin comments on recent monetary talks involving IMF Director Christine Lagarde and Central Bank Governor Kuroda regarding capital controls in China.
[ By Antoine Martin ]
Capital controls are amongst the early 2016 burning political economy trends, with China and international leaders such as Japan’s Central Bank Governor Haruhiko Kuroda and IMF Managing Director Christine Lagarde being at the forefront of a polemical debate on interventionism.
Not so long ago, China was monopolizing headlines because the country’s currency – the Renminbi (RMB) – had just been included into the International Monetary Fund’s Special Drawing Right, a pool of major international currencies (U.S. dollar, Euro, Japanese yen, and pound sterling) selected because of their weight in terms of foreign exchange reserves and international trade but also because they can be traded freely.
Amongst the requirements to join the club, in particular, was the development of significant reforms by Beijing to liberalize the country’s capital account (defined as the balance between international capital transactions moving in and out of the economy). Or, in plain English, to facilitate the use of the renminbi on international markets.
But China might somehow be moving backward.
Recent developments, Kuroda & Lagarde
Problematically, significant financial flows have fled the country over the past months with investors facing uncertainty as to the country’s future growth prospects, a risk of significant currency depreciation on international markets and, more generally, a similar trend spreading over most developing economies.
The amounts tend to vary depending on the sources but, in the main, between 700 billion (Financial Times), 840 billion (Bloomberg) or 900 billion (Forbes) might have left the Chinese markets in 2015. Not to forget an additional 110 billion for January 2016 only according to the FT.
But there is more. The Shanghai Index has dropped by nearly 50 per cent from its highest level about 7 months ago and China’s foreign exchange reserve has reached their lowest level in four years with Beijing spending more than 90 billion last month (FT) to limit RMB devaluation on international markets followed by a massive USD 48 billion cash injection into the Chinese banking system in early February (Reuters).
The Chinese situation has thus become a concern to other countries and, at Davos in late January Japan’s Central Bank Governor Haruhiko Kuroda suggested that Beijing – instead of putting massive amounts of exchange reserves in the balance – considered taking measures to control outbound capital movements, fuel national demand and preserve its exchange rate on international markets. IMF Director Christine Lagarde, in turn, merely reacted by saying that China’s current ‘massive use of reserves’ to try and compensate exchange rate movements was ‘not a good idea’ but failed to reject and condemn the possibility of using capital controls.
The end of a Taboo?
Some have thus started talking about the end of a taboo – as if the non-rejection of capital controls was all new and perfectly unforeseen. There is hardly any taboo here, though.
First, the idea of applying capital controls is far from being recent. As of 2013, for instance, The Economist was already discussing the fact that various countries were putting capital control policies into place, starting with Iceland trying in 2008 to limit outward capital movements after three of the country’s largest commercial banks had defaulted and left the banking sector traumatized. For currency preservation purposes, other countries such as Brazil, India, Indonesia, South Korea or Thailand followed the same path until 2011.
Second, capital controls have been on the IMF’s mind for a long time now. For Forbes, ‘Lagarde’s failure to quash Kuroda’s regressive-sounding plan tells us she is extremely concerned about China’ whereas for the FT her answer marks the end of a taboo. In reality however, the very idea of applying controls to cross-border capital movements has been acknowledged in IMF policymaking for quite some time now, so that Lagarde’s (non-)reaction to Kuroda’s suggestion is no real surprise.
In fact, the IMF’s Director is simply in line with recent policies put in place as part of the Fund’s Institutional View which – since 2012 – has accepted the idea formulated by its Member countries that cross-border capital flows can ‘pose important risks’ since ‘they can lead to booms and busts in credit or asset prices, and [make] countries more vulnerable to contagion from global instability’ because ‘they are volatile and can be large relative to the size of a country’s financial markets or economy’ .
From ‘trade-financing finance’ to ‘self-financing finance’
The idea that capitals should flow freely (or not) is a modern consideration. Originally, the decision to ease financial movements related to the necessity to finance free trade – as permitted by the increasing trade liberalization efforts undertaken through the World Trade Organization. At the time, in other words, controls were about restricting particular types of trade-related transactions (tariffs, quotas, profit repatriation, etc.) and the suppression of these controls was aimed at easing trade on a global scale. Controls on capitals, however, were not considered as a burning issue and were left aside.
The issue of easing capital flows eventually followed in the late 1990s with the idea that foreign capitals – taking the shape of foreign investment – were key to development-funding in developing economies where the public funding capacity was poor. The need to liberalize the countries’ ‘capital account’ – i.e. the balance of public and private international investments flowing in and out of a country – was thus promoted together with the idea that, if trade liberalization required facilitated payment possibilities, development-funding capitals also required a form of capital flow facilitation scheme.
The recent acceptance by the IMF that cross-border financial flows may have an impact on economies translates this major shift in international financial relations: it admits that financial flows have largely evolved from trade-financing tool into a self-standing financial sector which, thanks to major improvements in information and communications technologies, is nowadays capable of generating its own booms and bubbles when cash flows in as well as its own crises when things turn bad and the cash flows out.
As far as Lagarde is concerned …
Commentators over-react on the fact that IMF Director Christine Lagarde – by not rejecting Kuroda’s suggestion that China ought to consider taking control steps – somehow approved it: capital controls, as mentioned before, have been acknowledged by the IMF since 2012 and, for good or worse, now make part of the IMF toolbox.
Far more relevant when trying to show that the IMF is not opposed to capital controls anymore, in fact, would have been to mention Lagarde’s last month intervention (Paris, January 12, 2016) acknowledging the necessity to regulate capital flows while distinguishing blunt capital controls from smart capital flow management opportunities. In contrast with sudden regulatory moves aimed at restraining very volatile short-term flows as currently witnessed, that is, the IMF Director clearly favours the possibility for host countries to control cross-border capital flows by encouraging long-term equity investments. Selected quote:
‘Even so, emerging and developing economies are now receiving up to $1.5 trillion of capital inflows per year. And it has become more difficult to prevent liquidity shocks from doing serious harm to an economy […] In addition to an adequate safety net, a stronger international monetary system should include a framework for safer capital flows.’
‘There is a growing recognition that the short-term nature and inherent volatility of global capital flows are part of the problem affecting emerging economies today. There is also an inherent debt bias embedded in the global tax system.’
‘In source countries, the supervisory framework may need to be adjusted to ensure that prudent levels of capital are held behind short-term debt creating flows.
Recipient countries may consider policies to enhance the resilience of their financial systems to capital flows. Both Prudential and tax policies can play a useful role here. For example, the tax system could be structured to provide incentives to rely less on debt and more on direct investment and equity financing.
Overall, a global shift toward more long-term, equity-based capital flows would alleviate concerns about reversals, and lessen the need for insurance. It would also reduce the size of financial buffers that emerging and developing countries need to maintain.’
As far as Christine Lagarde and the IMF are concerned, in other words, the issue is not whether countries should refrain from applying capital controls, it is about controlling capitals in a sound and sustainable manner by ensuring that the financial markets evolve from a large amount of highly indebted individuals short-term dabbling on the stock market and creating a ready-to-burst bubble into a long-term source of financing.
Can China reasonably move on with capital controls then?
There are (at least) three aspects to consider here.
One is the fact that China is facing a major issue (capitals are moving away) which certainly needs to be solved. In fact, other developing economies are currently facing it too and the Financial Times for instance reported recently about the Governor of Mexico’s Central Bank Agustín Carstens suggesting that it might be time for emerging market central banks ‘to become unconventional’ when dealing with capital flows management.
Another is the type and impact of potential capital control measures aiming at preventing foreign (and domestic) capitals from leaving the Chinese market. For instance, the increase of a tax on foreign financial transactions by Brazil in the years 2010 aimed at managing capital movements but led to a massive leak of foreign capitals which eventually had consequences on the country’s currency valuation. The issue, of course, would be to determine whether outflows would have been greater if no tax had then been set up but there is hardly a simple answer to this.
A third aspect lies with the consequences of blunt capital controls in terms of China’s international legal and political obligations, particularly as far as trade and finance liberalization are concerned. On the one hand, Beijing has made tremendous efforts over the last 15 years to join the WTO and benefit from easier international trade flows, as an exporter but also as an importer. On the other hand, the country also made significant efforts to reform and ease access to its financial markets, culminating in the Renminbi’s inclusion into the IMF’s Special Drawing Rights pool as mentioned before.
These efforts, clearly, have all been about opening the country’s capital account – i.e. improving the balance of international capital movements flowing in and out its economy – by (i) adapting to international trade rules and (ii) making the RMB fully convertible on international markets and, without doubt, any form of control aiming at preventing foreign capital owners from freely using their cash would have important consequences.
Investors could interpret sudden control mechanisms as an alarm message saying that overall, China has no way to mitigate capital outflows & volatility but remains free to interfere with foreign capitals in last resort, for good or worse. In January, in fact, China already had a hard time putting in place, operating and eventually suspending its ‘circuit breaker’ mechanism aimed at temporarily interrupting market operations to avoid panic depreciations, thus sending an additional ‘lack of experience’ signal. Controls, in this situation, might thus give investors an additional reason to take their cash away, as a preventive move.
Beijing’s state counterparts, alternatively, could approve a control action or consider it as a major step back in terms of market access and liberalization commitments. Capital controls, simply put, could make the country look like it never intended to play by the rules. The point is important because, while China joined the WTO fifteen year ago and increasingly pushes towards the development of further trade liberalization agreements, its trade partners – individually but also through the WTO itself – will soon have to decide whether China is to be given a ‘market economy status’ by the end of 2016. Of course, the issue of capital controls does not directly relate to this tariff dumping issue but, considering that developed economies already blame China for dumping prices on the trade markets, imposing controls on foreign capitals would suggest that Beijing will not allow free capital movements either, even though it committed to do so. As far as China’s international trade and finance liberalization efforts are concerned, in short, capital controls would send the unreasonable message that Beijing is not ready to play the full market economy game.
[Edit 15/02/2016 – According to the Financial Times, a recent comment by Zhou Xiao Chuan (Governor of China’s Central Bank) drew a line between capital outflows and capital flights and, considering that ‘the level of cross-border capital flows is within the normal region’ rejected the possibility of Beijing tightening capital controls. See Patti Waldmeir, ‘PBoC governor plays down forex feras, FT 15/02/16]
Insights by Dr Antoine Martin
Dr Antoine Martin is the Head of Insights of The Asia-Pacific Circle, which he co-founded in 2016. Antoine follows analyzes and comments on developments in international trade, investment, and finance, with a particular focus on Asia-Pacific relations. He is also a scholar at The Chinese University of Hong Kong, Faculty of Law, a leading academic institution in Asia.
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