It is unlikely China will be able to maintain foreign currency reserves large enough to defend its economic model. Instead, managing capital flows will become increasingly important. By easing restrictions on the capital account, foreign capital would be able to enter the country’s financial system and help make up for the outflow of capital from a capital account in deficit.
Secondly, increases in outbound investment by Chinese companies and their need for external financing have reversed the pattern of China’s investment of the last 40 years. Traditionally, foreign direct investment (FDI) was funneled into manufacturing, while Chinese companies invested little beyond China’s borders, resulting in a net inflow of capital.
This began to change around 2010 as the Chinese leadership set out more global ambitions for the country and its companies. Outbound investment surged, driven by rising cross-border mergers and acquisitions (M&A) by Chinese companies. In 2016, there was a net outflow of capital as Chinese companies acquired a string of technology assets around the globe.
Despite recent efforts by the EU and the USA to screen Chinese overseas investments, Chinese companies are set to continue their global expansion. The ambitious Belt and Road Initiative (BRI), for one, will need considerable capital outflow to finance overseas infrastructure. Also, wealthy private individuals will increasingly demand to diversify their investments internationally – and their spending on foreign travel will also continue to rise.
Crucially, limits on capital movements have resulted in routine illegality as investors exploit loopholes to move money abroad, for example, by mis-invoicing imports. To make up for an increasing outflow of capital, China will need to open up more legal channels connecting its economy to global capital markets, both to legalize outflows and encourage more inflows.
Thirdly, capital account liberalization would subject China’s financial system to increased scrutiny from global investors. This could potentially spur China’s financial system to become more sophisticated, with more efficient capital allocation. The current regime favors bank lending to SOEs through state banks, while financing through bonds and stocks is less developed. But state banks are failing to lend sufficiently to the private sector, although it makes up more than half of China’s economy. Institutional arrangements and state influence have also contributed to a massive build-up of debt.
Capital account opening could see the private sector’s needs better met, helping China’s transition to a more sustainable growth model. Far-reaching economic effects mean capital account opening could act as a catalyst for deeper economic reforms. Much like China’s WTO entry in 2001, a reduction of restrictions on capital flows and a liberalization of the financial system could reduce the influence of vested interests in the state-dominated sector.
Lastly, although shielding its financial system and controlling its capital account has served the CCPs domestic agenda well, the present arrangement will limit China’s global leadership role.
Liberalization would stimulate the international use of the CNY, a key step for expanding China’s currently under-leveraged position in global finance. Internationalization of its currency would also spur foreign demand for a wider range and scope of CNY-denominated financial products. A bigger role for the CNY and for China in international finance would provide the foundation for eventually challenging the dominance of the US and its USD.
It gives the US control of global financial flows and power beyond the realm of economics. With over 40 percent of international payments conducted in USD, the currency and its financial infrastructure are also used for transactions between non-American partners. This allows the US to use sanctions or disrupting financial flows to project power globally.
Capital account opening would eventually give China equivalent reach. With the CNY as an alternative reserve currency to the USD, China’s leaders could limit the United States’ ability to affect China economically while increasing its ability to project financial power. To develop in economic and geopolitical terms, China needs to integrate further into the global financial system.