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China’s impressive record of economic reform over the past four decades has been implemented slowly and deliberately. Key to the Chinese strategy also has been to absorb lessons from the experience of other countries. It is widely agreed that reform of the financial system has lagged behind reforms in the rest of the economy. The reasons have been a mix of ideology and complexity. In recent years, the pace of financial reform has picked up. The recent market turbulence and the uneven Chinese policy responses to it raise serious questions about the pace and content of financial reform in China.
Over the past several years, China’s financial reforms have been driven by Governor Zhou Xiaochuan of the People’s Bank of China (PBoC) and encouraged by the International Monetary Fund (IMF) and the US Treasury. To achieve his objectives, Governor Zhou has made a Faustian bargain with the Chinese political leadership: If they agree to accelerate the process of liberalization of China international financial accounts, China will be rewarded by the inclusion of the renminbi (RMB) in the basket of currencies that establishes the valuation of the IMF’s special drawing rights (SDR). The RMB will vault overnight into the ranks of the major global currencies.
At this point, it is unclear whether Governor Zhou will be able to deliver the SDR side of the bargain. Time is running out and the recent volatility of Chinese financial markets may lead the Chinese authorities to delay the necessary additional liberalization steps to qualify the RMB by November 2015 when the IMF executive board must make its decision.
One necessary step, in my view, is to demonstrate that reserve managers in other countries not only have unimpeded access to investment opportunities for their RMB holdings in the domestic market, but also are taking advantage of those opportunities. To date, the Chinese approach has revealed an inherent tension between the desire of the authorities to control the internationalization of the RMB and reality that such control is inconsistent with its status as a freely usable currency, with the emphasis on freely. One can doubt whether the arrangements that the PBoC have put in place to date will meet the test of unimpeded access. First, they have linked primary market offshore trading of RMB with the establishment of Chinese-government owned banks as clearing banks and with the local central bank signing a swap agreement with the PBoC. Second, they have required foreign official investors in domestic RMB assets to register with the PBoC thereby giving the Chinese authorities de facto control over such investment, and disinvestment, activities. One can also doubt whether a responsible reserve manager, unconstrained by international political pressures, would increase his country’s holdings of RMB assets today. Of course, international politics may overwhelm both doubts.
A second necessary step, in my view, is for the Chinese authorities to fulfill their commitment to adhere to the IMF Special Data Dissemination Standard (SDDS).[1] The Template on International Reserves and Foreign Currency Liquidity (Reserves Template), which is a key element of the SDDS, will pose a particular challenge to the Chinese penchant for non-transparency. The Reserves Template requires the PBoC to reveal where and in what form its reserves are invested. For example, how much is invested in domestic financial institutions that are at risk of failing, is being used to backstop those institutions in supporting Chinese equity markets, and is invested in forward operations designed to resist the RMB’s weakness and discourage domestic capital flight. In principle, China will not only have to promise that it will meet that requirement but to demonstrate that it is doing so. Time is running out to do so. Again, international politics may give China a bye on this aspect as well.
The central issue for the Chinese authorities and the world, however, is not whether China is deemed to have satisfied these and other related tests. The issue is whether in the process of pushing international recognition of the RMB the Chinese authorities have put the external financial liberalization cart before the horses of domestic financial liberalization and associated supervision and regulation. The principal lesson of the past several decades from experience of other countries with financial liberalization is that the domestic reforms should be accomplished first. Inexplicably for a country that prides itself in learning from the experience of others, Governor Zhou and the Chinese authorities appear to have ignored that lesson. The consequences for China and, as we have seen from recent evidence in international financial markets, for global economic and financial stability could be most unfortunate. Moreover, the IMF and the US authorities that have been pressing the Chinese authorities to accelerate the process of external financial reform will deserve some of the blame if the worse-case scenario materializes.
In addition, Governor Zhou’s Faustian bargain may turn out not to be a bargain that produces any magical powers for China in the form of instant rewards. If other IMF members defer to political pressures and agree to degrade the SDR by prematurely admitting the RMB to the SDR basket, the Chinese authorities may discover that they have achieved nothing. Like those euro area authorities, who before the turn of the century eagerly anticipated that the euro would emerge to challenge the US dollar as the dominant international currency and would shower great economic, financial, and political benefits and prestige on Europe, the Chinese authorities are likely to be disappointed. As long as they insist on controlling the international use of the RMB and exerting strong influence over financial markets in RMB-denominated assets, the RMB will remain an also-ran among international currencies, well behind both the euro and the dollar. The Chinese authorities would be well advised to slow the process before it is too late.
[1] The Chinese authorities are moving in that direction. On September 9, the National Bureau of Statistics announced that it was altering the way it was reporting China’s GDP to conform to international standards by providing on a quarterly basis not only the growth rate over the quarter but the value of GDP achieved. See http://www.bloomberg.com/news/articles/2015-09-09/china-is-changing-how-it-reports-gdp-to-meet-imf-s-standard
