China’s capital controls: here to stay?

Capital controls are critical to China and have formed the basis of its remarkable economic development over the past 40 years. 

While domestic households are restricted from investing abroad and foreign investors are restricted from accessing financial markets, funds are kept safe within China’s borders. 

During times of stress, capital controls have helped Chinese policy-makers maintain financial stability. But, as the global financial system becomes ever-more interconnected, heightened by the Covid-19 pandemic, the need for capital control relaxation has become more urgent.  

“As long as there is capital control, there will be severe hindrance for the currency to be accepted by the international market,” says Hui Feng, senior research fellow at Griffith Asia Institute. “There will be no global status for the currency. For a currency to become a true international currency, it has to be accepted by the market.”

Prior to the inclusion of the renminbi (RMB) in the special drawing rights (SDR) basket, Chinese policy-makers had signalled their intention to liberalise the country’s capital account. One of the most successful initiatives has been the opening of the Chinese domestic bond market, which started cautiously with bank-by-bank quotas in 2002, but subsequently dropped limits and eased currency hedging from 2016. Central banks worldwide have been able to invest a proportion of their foreign exchange reserves in Chinese government bonds as a result.

Meanwhile, the world’s bond investment managers have been moving a sizeable amount of money into the Chinese domestic bond market. “China has gone from very little to a double-digit share of the domestic central government bond market, [which is] now owned by the rest of the world,” says Robert McCauley, non-resident senior fellow at the Global Development Policy Center at Boston University.

While the share might not yet be up to par with that of the US Treasury market, it is a noticeable change in just a few short years. Chinese government bonds are also being included in various global government bond indexes. 

The biggest milestone, however, came in 2015 when the International Monetary Fund (IMF) decided to include RMB in its SDR basket of currencies. The move signalled China’s growing prominence within the global economy, and has helped grow its status among global reserves. 

But the pace of China’s capital account liberalisation has slowed, following a change in focus from the government. Feng says the government’s priorities have changed from actively promoting the use of RMB internationally to attracting international investment to boost economic growth. 

 “[The government’s] priority at the moment is not on RMB, but the economy,” he says. “Its priority has changed since the time it actively promoted RMB in 2015. Beijing is not actively promoting RMB now, and that is reflected in the market.”

Control measures 

Since the mid-1990s, China has embarked on a number of initiatives to relax elements of its capital control regime. However, the 2015–16 Chinese stock market turbulence –which led to a stock market meltdown and subsequent capital flight – marked the beginning of stricter capital controls. 

While Feng notes there have been a number of major changes, he stresses the majority of controls remain largely intact as the economy remains “shaky”. 

“The control measures seek to prevent currency and capital outflow. China still needs investment; it does not want capital to leave the country,” Feng says. 

Unless China’s economy begins to show strong signs of recovery, Chinese policy-makers will not consider relaxing its capital control regime, he adds. Covid‑19 will also need to be well contained. 

A legacy of strong growth 

China’s growth model is arguably reliant on the government’s capital control regime, and is built on what Feng describes as “financial repression”. This is where the government exerts control over the entire banking system, including larger banks. 

“China’s growth model relies on state investment,” he says. “By implementing capital controls, you put all domestic savings within the borders, and savings have to be placed with banks. Because the government controls the banks, they can channel the savings to the industries that they want to develop.”

As a result, abolishing capital controls will involve a fundamental shift in China’s growth model. Currently, China is integrated within the global economy as a low-value-added manufacturer. But, as higher wages and tariffs make Chinese goods more expensive, it is becoming harder for policy-makers to justify this growth policy.  

Over the past decade, Chinese policy-makers have started to consider whether a model reliant on domestic consumption – the dual circulation model, as named by President Xi Jinping in May 2020 – might be an alternative. 

The new model is a simple one: focus on the domestic market, or internal circulation, to continue to grow without overreliance on international trade or external circulation. Chinese authorities have been quick to stress this does not mean a period of isolation, rather external circulation will not be the main driver of growth moving forward. 

Feng argues this shift in policy is “long overdue”. “China should have done this after the global financial crisis [that began in 2007–08] but, because of the factors affecting the economy, Beijing has been hesitant.” 

Barry Eichengreen, George C Pardee and Helen N Pardee professor of economics and political science at the University of California, says China will gradually open its capital account. 

“The authorities realise they erred in the years leading up to the 2015–16 ‘mini-crisis’ in Chinese financial markets by opening the capital account more quickly than warranted by the pace of financial reform and financial market strengthening,” he says. 

“They are unlikely to repeat that mistake. “[This] suggests that the course of RMB internationalisation will be correspondingly gradual and incremental,” he adds. 

Some have argued the removal of capital controls would force the People’s Bank of China to let RMB operate under a free-floating exchange rate. 

The People’s Bank of China sets a daily midpoint fix for onshore RMB, based on its previous day closing level and quotes taken from interbank dealers. If the rate deviates more than 2% from the midpoint, the People’s Bank of China buys or sells RMB to stem volatility.

For offshore RMB, market supply and demand influence the exchange rate. However, the People’s Bank of China ensures the spread between the two rates remains narrow by intervening with its FX reserves, State-owned banks are also expected to enter the offshore market and swap USD for RMB.

Eichengreen does not think that is necessary, although the relaxation of controls is likely to require a “somewhat free float with less intervention to stabilise the rates”, he says. 

Feng, however, thinks that the free float of RMB is a longer-term plan for the Chinese government. 

Capital control-less 

One of the biggest benefits to lifting capital controls would be a greater use of RMB internationally, which has slowed in recent years. McCauley points to offshore RMB deposits, offshore RMB (‘dim sum’) bonds and offshore RMB FX trading, all of which indicated a slowdown in momentum in internationalising the currency in recent years. 

“The trading of RMB FX market has continued to grow faster than foreign trading in general. The flows into the Chinese bond market are sizeable and sustained,” he says. “Other indicators have plateaued and a few show declines. In general, progress is mixed compared to the years before 2015, but still, on balance to my eyes, RMB has become more international.”

While the inclusion of RMB in the IMF’s SDR helped to raise the currency’s status, the currency is yet to be widely accepted by the international markets. According to global payment service provider Swift’s RMB Tracker 2021, while central banks have marginally increased their holdings, RMB has no substantial impact at the market level. 

This is made evident by the fact 90% of global trades are settled in US dollars, compared with just over 1% settled in RMB. Nearly 60% of the global reserves are in dollar-denominated assets, according to Swift. 

Eichengreen believes the low usage of RMB – the currency accounts for just 2% of cross-border financial transfers across Swift’s network – is indicative of multiple challenges. 

“The [US] dollar and euro have had a considerable head start,” he says. “Investors worry, not unreasonably, about China abruptly changing the rules of the game governing access to and use of its currency.”  

Eichengreen cited recent moves against payment giant Alibaba and technology firm Didi as evidence Chinese policy-makers are looking to clamp down. 

McCauley notes an obvious “unevenness” of RMB’s internationalisation. Investors worldwide look to hold RMB assets but few borrowers are takers of RMB loans, he says. 

For instance, an Australian energy company selling coal to China might be a borrower of RMB, as its sales would provide a natural hedge for its borrowings. But such borrowers have been few over the years, McCauley says. 

Even the China Development Bank and China Export‑Import Bank have few loans to emerging market sovereigns denominated in RMB, according to a recent paper by Anna Gelpern and others. 

“In sum there has been much progress, but the progress has been one-sided, with the rest of the world bringing RMB to their asset portfolios but not to their liability portfolios,” McCauley says. 

Reviewing weights

RMB accounts for just 2% of cross-border financial transfers through Swift’s network. Such a low number – which is disproportionate to China’s weight in the global economy – is indicative of the market not yet accepting RMB. 

In March 2021, the IMF’s executive board announced an extension of the current SDR valuation basket until July 31, 2022. A review had been expected in September of this year, with some observers predicting an increase in RMB’s weight. 

An increase in RMB’s weighting would undoubtedly boost its usage as a reserve asset globally and bolster confidence among global investors. But Feng is not convinced the currency should be included in the basket at all.

“It is contradictory to the original purpose of SDR; it’s not freely accessible. The value of the currency is not free. If you include RMB in the SDR, that means the value of the SDR would also be distorted,” he says. 

Eichengreen is also sceptical as to whether the inclusion of RMB in the SDR will bolster its usage. “Adding RMB to the basket lends a bit of additional legitimacy to the SDR as an official unit of account, insofar as the basket better reflects the composition of the global economy,” he says. 

However, he stresses the SDR is not used in “actual transactions” and therefore commercial usage is unlikely to be bolstered as a result of its inclusion, or indeed, a change in RMB’s weighting. 

“The commercial use of RMB is precisely what China is seeking to promote,” he says. 

This feature forms part of the Central Banking focus report, The renminbi’s rise to prominence