The Chinese financial game-changer still to come

By Michael Casey

Think of it as the financial-market equivalent of the collapse of the Berlin Wall.

When China’s government eventually fulfills its pledge to lift restrictions on international fund flows into and out of its financial system, the Chinese economy will undergo profound changes — with global implications.

Chinese producers will lose access to a source of abundant, artificially cheap credit that fueled two decades of prodigious growth. In China itself, the dismantling of capital controls will test the profitability of state-owned enterprises and thus challenge the financial foundations of the Communist Party. And for the global economy, it will reshape the geographic balance between savers and spenders.

Chinese leaders may speed up the removal of capital controls, which have fueled the country’s speculative credit bubble.
If we’re to take China’s top central banker at his word, this paradigm shift will come faster than many have assumed. People’s Bank of China Gov. Zhou Xiaochuan said Friday that the government intends to accelerate its program for stripping back capital controls. Those controls, among many other restrictions, block Chinese citizens from sending more than $50,000 a year offshore for anything other than to fulfill an import contract.

Zhou’s comment failed to garner much attention. Investors were more obsessed with his assessment of the turmoil in Chinese money markets, where a credit crunch had pushed rates sharply higher. But if Zhou is to be believed, they should start paying attention.

With 102 trillion yuan, or $16 trillion, sitting in deposits at China’s tightly controlled banks, there’s enormous potential for the relaxation of capital account rules to drive dormant Chinese money into investments overseas. A mere 10% of that total is almost equivalent to the gross domestic product of Canada.

Then there’s the prospect for money flows into China. A total $636 billion in international portfolio investments went to emerging markets in 2012, according to the Institute of International Finance. Opening up access to yuan-denominated Chinese assets would likely draw a major portion of those funds.

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People’s Bank of China Gov. Zhou Xiaochuan
What’s more, removing capital controls would create pressure for liberalizing the financial sector, setting up a possible bonanza for foreign banks, insurers and investment firms. Their CEOs salivate at the idea of hundreds of millions of new customers.

Yet the risks, both to China and its trading partners, are daunting.

If the country’s biggest savers used their newfound freedom to seek higher returns in foreign currencies, the outflow would force the PBOC to ratchet up or abandon its mandated “ceiling” on deposit rates so as to repair banks’ deposit balances. This in turn would force banks to drive up the rates they charge for loans to stay profitable.

Higher borrowing costs would leave Chinese exporters — already struggling with higher wages and a stronger yuan — unable to compete with cheaper competitors from around Asia. It could mean massive job losses.

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And they would pose a threat to many of China’s 100,000 or so state-owned enterprises, an integral feature of the country’s political structure. SOEs now average a return on assets of less than 5%, which is already below their cost of capital, says Nicholas Lardy, a China specialist at the Peterson Institute for International Economics. Lardy expects the government to remove the cap on interest rates before it lifts capital controls, so as to gradually ease into the change. Such a move, he says, will force many SOEs to sell assets or shut down.

These firms’ problems will in turn hurt commodity producers in places such Australia or Brazil, which have plied Chinese industry with raw materials.

Despite these risks, the Chinese government says it’s moving ahead with capital liberalization. Zhou’s comment left it unclear whether a previously set 2015 deadline had now been brought forward. Nonetheless, his statement underscores a determination to deliver a substantially more open financial system in relatively short order, even if many economists expect some degree of capital control to remain for many years after that.

One reason for the urgency: Chinese leaders, who’ve already taken numerous measures to increase offshore transactions in yuan, want it to become an internationalized currency, giving them more clout on the world stage. This is impossible while the yuan remains “nonconvertible” on the capital account.

Just as importantly, Zhou and others also know capital controls are at the root of many of the country’s newest ills, including the surge in debt that’s now feeding fears of a U.S.-style credit bubble. The controls have fostered a system of financial repression that exploits China’s famously frugal households and companies, whose combined savings rate stands at a world-beating 50% of GDP. They also create vast distortions in the economy.

Capital controls left savers no option but to park their money in domestic bank accounts at punitive rates. (For many years, the ceiling deposit rate was fixed below inflation.) In so doing, they provided a giant, guaranteed pool of low-cost funding for Chinese banks, which could profitably re-lend the funds at or above a mandated “floor” lending rate. The result: a river of low-cost credit, funneled relentlessly to state-owned enterprises, private merchandise exporters, and infrastructure and property developers. Those borrowers’ debts, now worth close to 200% of GDP, have financed a nationwide network of unoccupied buildings, underutilized toll roads and cavernous, empty train terminals.

With foreign demand for its exports waning, China’s leaders know they must get off this treadmill. They must transform a saver-subsidized investment-dependent system into a more sustainable, consumer-led economy. Indeed, the entire world needs them to succeed at this. Sooner or later, that means China’s capital account must be opened.

So, buckle up.

Michael Casey is managing editor for the Americas at DJ FX Trader, a foreign-exchange news service from Dow Jones Newswires and The Wall Street Journal. Follow him on Twitter @mikejcasey.

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