When China’s policymakers launched the internationalization of the renminbi against the backdrop of the Global Financial Crisis, their initiative was greeted with great hype even though China’s insulated and underdeveloped financial system meant that the country lacked an important basis for the development of a truly international currency. However, a little more than a decade later, the internationalization of China’s financial system is gaining pace, and Beijing appears to be turning into a force to be reckoned with in global finance.
The most striking development has been the increase in cross-border portfolio capital flows into China. At the end of 2020, foreign holdings of Chinese portfolio investments amounted to $2 trillion, five times as much as in 2009 when China began to promote the renminbi’s use in international trade. This development has been facilitated by a further opening of China’s capital account that has improved access to China’s financial markets. In 2014, China launched the Stock Connect Program to increase cross-border equity investment, followed in 2017 by the Bond Connect Program aimed at channeling foreign capital into Chinese debt securities. Improved access to China’s financial markets has allowed for the inclusion of Chinese stocks and bonds into global indices – such as the MSCI Emerging Markets Index and the Bloomberg Barclays Global Aggregate Index – which has increased passive portfolio investment flows into China.
China’s relaxation of capital controls has reflected shifting economic and financial priorities. Beijing has long relied on a system of financial repression to provide cheap loans for investment in infrastructure and industry. To subsidize these loans, interest rates on deposits had to be kept at artificially low levels, and capital controls were needed to prevent savers from searching for higher returns in foreign financial markets. While this system succeeded in supporting China’s investment- and export-led growth model, it is no longer suitable for an economy that needs to increase efficiency and strengthen the role of consumption. The accelerated pace of China’s financial opening can therefore be understood as an effort to improve capital allocation to allow for growth in a structurally challenging situation characterized by decreasing investment efficiency, declining productivity growth, and a shrinking working age population.
A look at China’s current account balance provides another way to understand the economic motives for opening up China’s financial system. After China’s accession to the World Trade Organization, its current account surplus reached unprecedented levels, peaking at 10 percent of GDP in 2007. However, before the outbreak of the COVID-19 pandemic, its surplus had shrunk to just 1 percent of GDP. (Due to the effects of the COVID-19 crisis, it rose again in 2020, but this did not indicate a reversal of the general downward trend.) The current account balance corresponds to the difference between savings and investment, and in China’s case, the shrinking surplus can be attributed to a falling savings rate – a trend that is bound to intensify due to the country’s aging population. If the fall in China’s savings rate continues without being matched by a fall in the investment rate, it will lead to a current account deficit. Since current account deficits are financed by the inflow of foreign funds, China needs to prepare for this shift by providing better access to its financial markets and making them more attractive to foreign investors.
However, even though China’s changing economic fundamentals provide a powerful rationale for increasing financial integration, the Chinese Communist Party’s penchant for stability and control stands in the way of China’s rise in global finance. In recent years, there has been plenty of evidence suggesting that especially in the face of acute crises, China’s financial policymakers continue to display a fondness for interventions that is not compatible with a liberalized financial system. China’s interest rate reform is a case in point: With the removal of the ceiling on deposit rates, China officially completed interest rate liberalization in 2015. However, banks remained subject to policy guidance regarding interest rates and credit allocation. During the COVID-19 crisis, this guidance gained in importance when the authorities mandated the banks to increase cheap lending to soften the economic blow of the pandemic.
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A similar story can be told about China’s exchange rate reform: In 2015, China’s central bank announced that it would allow markets to play a bigger role in the renminbi’s exchange rate formation, but it continued its interventions to prevent substantial movements of the exchange rate in either direction. Policy interventions regarding the exchange rate also seem to have increased during the COVID-19 crisis. Despite a substantial current account surplus and strong capital inflows, the renminbi appreciated only modestly in 2020. At the same time, foreign currency assets in the banking system increased significantly, suggesting that China’s commercial banks were mandated to mitigate the renminbi’s appreciation.
As long as China’s policymakers are unwilling to stop the political steering of interest rates and the exchange rate, strict limits regarding capital inflows and – more importantly – outflows will need to be maintained. Those limits will prevent the country from playing a major role in global finance. If the CCP were to put an end to political interventions in the financial system, this would have ramifications that would go far beyond crisis management. In an economy that has become ever more politicized since Xi Jinping took over as head of the CCP, political control over the financial system remains indispensable for the support of state-owned enterprises and the advance of industrial policy objectives. A complete removal of capital controls would therefore require a fundamental overhaul of the CCP’s most basic economic doctrines.
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Moreover, a degree of financial integration that would allow China’s financial markets to compete with their U.S. counterparts would also necessitate a strong protection of property rights, which would go against the grain of Xi’s disdain for the rule of law and be irreconcilable with an increasingly totalitarian political system. Last but not least, rising tensions between China and the United States might even derail more modest goals of financial integration. The damage that the U.S. could do to the internationalization of China’s financial markets became evident when global index providers, responding to an executive order by the Trump administration banning U.S. investors from holding stakes in companies with alleged links to the Chinese military, removed the stocks of a number of Chinese firms from their indices.
None of this bodes well for the renminbi’s prospect of turning into a truly global currency. And despite what excited fund managers would have us believe, the introduction of a digital renminbi is not going to change this outlook, given that the digital version will be subject to the same constraints as the old-fashioned one. If the CCP were to embark on a path of economic and political liberalization, it would stand a good chance of turning China into a global financial powerhouse. But as long as the party subordinates economic efficiency to political control, China will not be able to challenge U.S. dominance of the global financial system.