China’s Rocky Road Ahead, Financial Liberalization versus Financial Stability

A summary of the 3rd annual joint conference of the People’s Bank of China and the International Monetary Fund offers a snapshot of the state of debate.  So-called “renminbi internationalization” has been official policy since 2009.  By the end of this year, expect to see the launch of a new “China International Payments System” to facilitate use of RMB as a settlement currency, and perhaps also inclusion of the RMB in the official definition of the SDR.  But these are small steps, and the eventual ambition is much bigger.

Among the foreign guests, Eswar Prasad and Louis Kuijs stake out the most optimistic and most pessimistic positions.

Prasad:  “The renminbi is already well on its way to becoming a widely used currency in international trade and finance.  It is likely that the renminbi will become a competitive reserve currency within the next decade, eroding but not replacing the dollar’s dominance” (p. 14).

Kuijs:  “RMB internationalization—which calls for more capital account opening to facilitate access by foreign residents to China’s financial markets and onshore RMB-denominated assets—complicates financial and monetary reform, and increases the risks involved. Policymakers will have to prioritize economic and financial objectives. In the bigger scheme, compared with objectives such as economic growth and social and financial stability, RMB internationalization should probably not be a key objective” (p. 104).

Who is right?

Summaries of the experience of financial liberalization in Australia, Korea, and Thailand provide cautionary lessons.  It’s a rocky road, requiring transformation of the financial industry, regulatory apparatus, and macroeconomic management, all three.  Boom-bust, with the bust involving collapse of significant chunks of existing financial infrastructure, is to be expected.  All three reflect retrospectively that it was ultimately worth it, but definitely hard going.  But of course none of these three ever aspired to reserve currency status, as China apparently does!

Australia perhaps comes closest, and it is therefore significant that their biggest challenge proved to be the move to a flexible exchange rate, involving the development of deep and liquid forward and futures markets, integrated with domestic money markets.  Something like that is beginning to develop in offshore RMB markets in Hong Kong, but really quite small and quite separate from onshore RMB markets.

Onshore, interest rate liberalization has come a long way; deposit rate caps are soon to be gone, deposit insurance soon to be introduced, and the PBoC is working toward greater reliance on the interest rate as a policy tool (Jun MA).  But monetary transmission to the real economy is a problem, given legacy banking institutions and underdeveloped domestic bond markets.  Further, it is not at all clear that legacy institutions could survive a big-bang liberalization, and it seems excessively optimistic to suppose (as does MK Tang of Goldman Sachs) that openness to international capital markets could facilitate smooth transition within China from the current shadow banking system to a proper private bond market.

Against this background, the keynote of Lars Svensson on “Monetary Stability and Financial Stability” seems at first to come from a different planet entirely.  Indeed, his main beef is with the Bank for International Settlements.  In their 2014 Annual Report (reiterated in their 2015 Report issued just last week) the BIS is concerned about the way that monetary policy regimes that focus narrowly on inflation targets can wind up fueling financial instability.  Svensson argues contrariwise, based on the experience of Sweden, that tight monetary policy directed toward combating an incipient bubble sacrifices significant current output to very little gain.

Svensson:  “Price stability does not lead to financial stability. Interest policy is not sufficient to maintain financial stability.” (p. 46)  “Importantly, price stability does not lead to financial stability. Monetary policy can achieve price stability, but it cannot achieve financial stability.” (p. 48)  These are statements about the model that Svensson uses to think about the economy.  In the type of models that Svensson relies on, financial instability arises from exogenous shocks, not endogenously from within the operations of the credit system itself.  The right policy response is therefore micro and macroprudential, directed toward enhancing the resilience of the system to these external shocks.

For China, the issue at stake in Svensson v. BIS is central.  The main challenge China faces is reform of its financial services industry, and opening up to the outside is explicitly part of the strategy for producing that needed reform, “inviting outsiders in and allowing domestic businesses to go global” (p. 20).   The problem is how to use openness to stimulate reform without importing also financial instability.  Professor HUANG says it best:

“Financial instability could worsen in the coming years because of slowing economic growth and liberalization of the financial system. Financial risks were not low in the past, but three key factors kept such risks from exploding: a closed financial market, rapid economic growth, and the government’s strong balance sheet, including its enormous foreign reserves. However, all these factors will change in the coming years. Can China remain the only major economy to escape a major financial crisis? The answer is uncertain” (p. 95)