The People’s Money

IN MAY 2012, I took part in a private dinner in Shanghai’s financial district. Shanghai, authorities had recently announced, was to become China’s international financial center by 2020. This investiture had sparked great excitement and a fierce debate. Which policies needed to be put in place in order to develop Shanghai’s financial business? How could the best talent be attracted and nurtured—especially when the main competitor, Hong Kong, offered a particularly favorable tax regime? And, above all, how fast could the capital account be liberalized to facilitate the free circulation of capital from and to the overseas markets—a key requisite for an international financial center?

Although the central government in Beijing had not given the details of its development plan for Shanghai, many believed that a fully functioning financial center in mainland China needed a fully convertible currency and an open capital account. This was consistent with the plan for the development and reform of the financial industry that the People’s Bank of China (PBoC) published in 2012 for the Twelfth Five-Year Plan (2011–2015).¹ The stated goal was to achieve “basic” convertibility of the capital account by 2015, with restrictions limited to short-term flows and the exchange rate regime fully flexible.

Therefore, 2020 became the implicit deadline for the renminbi to be a fully convertible international currency. In those days, many economists and policy makers in Shanghai had no doubt that the liberalization of China’s capital account and the internationalization of the currency had to go hand in hand. For Shanghai economist Ya Fu, for instance, it was not possible to turn the renminbi into a full-fledged international currency without opening China’s capital market and allowing the currency to become fully convertible under the capital account. A similar view was expressed by Arthur Kroeber, an analyst based in the United States; although he acknowledged the potential of the Chinese currency to see increased international use, he deemed it “extremely unlikely” that “the yuan will be anywhere close to achieving the status of a principal global reserve currency (like the US dollar or Euro).”² And Japanese scholar Takatoshi Ito stressed that China must “lift capital controls completely” for the renminbi “to become a genuine international currency.”³

During that dinner in Shanghai, a former deputy governor of the PBoC made it clear that, along with opening the capital account, China needed to accelerate the reform of its banking and financial sector and bring it in line with international market practice. Letting money flow in and out of the domestic market was seen not only as a natural outcome of the policy of opening up but also as a way to force Chinese banks and financial organizations to reform in order to be able to compete in international financial markets. It was a case of sink or swim. China’s accession to the World Trade Organization (WTO) and the notion that Zhu Rongji had used it to force reforms were brought up several times in the conversation. I continued to hear this parallel later in other discussions. As part of the WTO accession requirements, state-owned enterprises were transformed into publicly owned companies with shares tradable on the equity market, an example of how positive incentives can drive reforms.

Critics of this accelerated approach, on the other hand, argued that the opening of China’s capital account needed to be gradual and sequenced. Their reasoning was that the financial sector was not ready and the reforms that would allow banks and other financial organizations to survive in the new environment would take years.⁴

In any case, both schools of thought were careful to stress the importance of the financial sector serving the real economy, and not vice versa.⁵ Partly for historical reasons—the early reformers adopted financial reforms along with fundamental changes to the real economy—and partly as a reaction to recent financial crises, Chinese leaders have often stressed that finance should have no purpose other than to support investment and therefore economic growth. Thus, speculative finance, with short-term goals and complex instruments that risk distorting economic activity and creating instability, allegedly has no role in the development of China’s financial sector.

Fast-forward to 2015, the year when China’s capital account was expected to be fully open, and the debate had changed tone and priorities. According to Han Zheng, Shanghai Communist Party secretary and one of the twenty-five members of China’s Communist Party Politburo: “Convertibility under the capital account does not equate to full convertibility under the capital account. These are different concepts.”⁶ This is no longer a case of sinking or swimming but of managed convertibility, as I discuss in the next section, or capital account liberalization “Chinese style.” The monetary authorities can facilitate and make these movements easier while also monitoring inflows and outflows and ultimately intervening to curb undesired and excessive activity. In April 2015, PBoC Governor Zhou stated: “As suggested by the [International Monetary] Fund after the global financial crisis, countries may adopt temporary capital control measures when there are abnormal fluctuations in the international markets, or there are balance of payments problems.”⁷

Unlike in the early days of China’s renminbi strategy, allowing capital to freely move into and out of the Chinese market no longer seems to be part of the authorities’ plans. They seem more cautious and more aware that China cannot achieve the full liberalization of the capital account without changing the exchange rate arrangements and switching from the current managed float to a fully floating exchange rate; otherwise, money inflows and outflows would force the PBoC to intervene even more massively to buy or sell dollars in the foreign exchanges to stabilize the exchange rate.

Capital outflows, which until recently the authorities mildly encouraged in order to release pressure on the exchange rate, are potentially more problematic than capital inflows—as the rapid depreciation of the renminbi in the second half of 2015 and early 2016 showed—because of China’s huge household saving deposits, estimated at more than 40 trillion renminbi, or more than 75 percent of gross domestic product. If full liberalization was achieved, the impact of depositors moving a relatively small percentage of their saving overseas because they were able to find better returns in international markets would be significant. In addition, it could trigger more capital flight, which, in turn, could lead to a large devaluation—triggering further capital flight.

Yet it’s clear that something must be done and that the costs of financial repression and exchange rate management outweigh the benefits.⁸ Bank dominance, state intervention, and financial repression distort the allocation of financial resources and generate risks and imbalances.⁹ Savings are mobilized and capital allocated to sectors and industries that the leadership has deemed essential to China’s development—regardless of whether they are the most profitable. Savers are presented with limited investment options in the domestic stock and bond markets and are offered poor returns on bank deposits, whereas financial resources are allocated to projects with no profitability.

Not only do the existing distortions in China’s banking and financial sector hamper the development of the renminbi as an international currency, but also they hinder the leadership’s ambition to turn China into a harmonious, high-income society. As President Xi Jinping said at the Third Plenum of the Eighteenth Communist Party Congress in November 2013, when he unveiled an ambitious and far-reaching reform agenda to improve the country’s economic performance during the next decade, “To boost the economy we must enhance the efficiency of the allocation of resources…. We should work harder to address the problem of market imperfection, too much government interference and lack of oversight.”¹⁰

The Chinese leadership has concluded that the process of capital account liberalization needs to be gradual and carefully calibrated by policy (the recent episodes of high volatility, such as the “tapering tantrum” in 2013 and the turmoil in the stock market in the summer of 2015 and in early 2016, have made the Chinese authorities even more cautious), whereas the domestic banking and financial sector has to be reformed to become stronger, more diversified, and more resilient. The Twelfth Five-Year Plan highlights that China needs to “steadily proceed with the market-oriented interest rate reform, improve the managed floating exchange rate system to be based on demand and supply, reform the management of foreign exchange reserves, and gradually accomplish the convertibility of the RMB for capital account transactions.”¹¹ This concept is reiterated in the Thirteenth Five-Year Plan.

The list of necessary reforms is long and detailed—the World Bank suggests, among others, to further liberalize the interest rate, deepen the capital market, strengthen the regulatory and legal framework, and build a financial safety net.¹² In this chapter, I will focus on the interest rates and the exchange rate—the two areas that are critical for the development of the renminbi as an international currency. Reforms are complex to implement, and financial repression is difficult to dismantle. Untangling the complicated web of vested interests that resist significant financial and monetary reforms—which includes powerful groups within the Chinese leadership itself as well as large state-owned companies—is challenging. And it is not clear how committed the authorities really are to dismantling a system that for many years has served them well and protected many of their interests. As economic and monetary considerations overlap with political concerns, the result is procrastination and “stickiness.” The pace of reforms, as a result, has been very slow.

Just a few years ago, the dominant thinking, even among the Chinese authorities themselves, was that the country had to fully liberalize capital movements in order to turn the renminbi into a full-fledged international currency and to drive financial reforms at a faster pace and force them on various interest groups. The example of China joining the WTO is often cited in Beijing: the stakes were high enough to drive a series of reforms.

However, in the case of the banking and financial sector, forcing reforms through the liberalization of the capital account is illusory and risky. There are so many intertwined and overlapping interests between state commercial banks and other organizations—from state-owned enterprises to provincial governments—that it is difficult to implement a unified model of reforms from the top, as Governor Zhou had called for in a speech in 2010.¹³ Unlike the reforms in the years when China was preparing for WTO accession, financial reforms are unsuitable for a “one size fits all,” top-down approach.

It has become clear therefore that domestic reforms must come before the opening of the capital account—thus, the timing of the latter depends on the pace of the former. And the so-called internationalization of the renminbi is wrapped up with both of these, so it is one of the elements of China’s complex process of financial reforms—but not its main drive. Given this situation, understanding the web of reforms is the best way to understand the future of the renminbi as an international currency. And, because the reform of the domestic banking and financial sector will take a long time to fully implement, understanding the pace of these reforms gives an indication of the speed at which the renminbi will develop into a full-fledged international currency.

Reforming the banking and financial system has always been an integral part of China’s transition from plan to market, although it has happened in fits and starts, not in a linear way. The key theme of the whole program of economic reforms from Deng Xiaoping onward has been the creation of a market for capital, and this is not only in purely development terms—how the efficient allocation of capital could support economic growth—but also, and very importantly, in ideological terms. The debate about the ownership and the use of capital indeed touches on fundamental tensions in the Chinese system: “command vs market, central control vs efficiency, state vs private ownership, egalitarianism vs growth, and Party vs government control.”¹⁴

Given the complexity of the whole reform process, policies that are easy to implement and that will bring concrete results in the short term—the so-called low-hanging fruit—have always been more attractive than policies that would be difficult to implement but more effective in the long run. The authorities have to pick their battles very carefully and are mindful to promote reforms that are more likely to deliver tangible results and thus win the political support to overhaul the system. As a former PBoC senior official told me in a private conversation, when the Chinese leaders, from Deng Xiaoping onward, and policy makers started to carry out market-oriented economic reforms, the focus was on policies that could be introduced and implemented in the short term and that would offer the best and quickest way to generate jobs and strong economic growth. Transforming China into a socialist market economy was bold, and bold action is not easy. “For those who are accustomed to the West, you think the market is nothing strange, but in 1992 to say ‘market’ here was a big risk,” remarked Jiang Zemin in a conversation with Henry Kissinger.¹⁵ As a result, it was critical to focus on making things happen and to respond to “concrete needs of the economy rather than to a master ideological blueprint.”¹⁶ This pragmatic approach to policy making is one common theme linking all the measures that have been introduced over more than three decades. Capital markets have developed in response to specific problems related to the allocation of capital: how to distribute profits, how to finance large infrastructure programs, and how to fine-tune monetary policy and control price increases.

However, this does not mean that individual policies are implemented in a haphazard, scattershot manner; rather, they follow the general vision and policy direction established by the leadership and expressed in the five-year plans—and, of course, the direction of institutional or policy reform, which is subject to change.¹⁷ The decision at the Fifteenth Congress of the Chinese Communist Party in 1997 to lift many legal and economic barriers to private-sector growth and allow banks to lend to private businesses is an example of a substantial change of direction and a key policy shift toward private capital. A few years later, in 2004, the National Congress approved a constitutional amendment to protect private property rights, granting “private property” a legal status equal to that of “public property.” This alignment of policies in a particular but shifting direction often means that reforms that have been brewing for years can get the green light and be implemented overnight. This is what happened, for example, in 1999, when during a visit to the United States Zhu Rongji announced China’s bid to enter the WTO on terms that Chinese negotiators had previously resisted.

The change in the approach toward private property rights epitomizes the shift, in both policy and ideological terms, from complete reliance on state-owned and collective enterprises to a mixed economy, or “socialist market economy,”¹⁸ in which private enterprises play a major role in promoting growth, innovation, and employment. This shift is evident, for instance, in the share of people employed in private firms—now approximately 80 percent of total employment, compared with 58 percent in 1998.¹⁹ In line with the policy of further contraction in the state sector, the private sector has been leading the transformation of banks and finance providers, which are gradually being emancipated from the obligation to supply policy loans to the ailing state-owned enterprises. For instance, Shenzhen has developed as a financial center to respond to the need of small and medium-sized enterprises,²⁰ especially those that operate in the manufacturing and high-tech industries, and to provide more financial diversification.

However, these measures have not substantially changed the way capital is allocated—and thus have not corrected distortions and imbalances. Above all, they have not yet severed the deep links among China’s political leadership, the state-owned enterprises, and the large banks, with the banks providing financial resources to the state-owner enterprises in order to address the government’s policy goals (as was discussed in chapter 3). Thus, they have not been able to redress the peculiar mix of opening and continued repression, of the encouragement of private initiative and the continuing ability of the state to direct and allocate financial resources through the banking and financial system. In this sense, these financial and banking reforms are much more complex than shifting the real economy from plan to market.

Nonetheless, removing the key distortions that exist in the banking and financial sector and curbing credit-driven, poorly profitable investments and loss-making investments are essential to China’s economic rebalancing—and, by implication, a critical step toward the development of the renminbi as a full-fledged international currency. The existing initiatives to reform the interest rate and improve the allocation of financial resources, as I explore further later in this chapter, are the most promising ways to achieve China’s goals and to rebalance the economy in line with President Xi’s objective. These are the reforms that the authorities are focusing on, albeit in a timid and cautious way.

As discussed in chapter 3, Chinese-style financial repression is both a cause and a consequence of interest rates that are being fixed by the monetary authorities to achieve policy objectives instead of being allowed to reflect the effective demand and supply of credit. This distorts the allocation of capital to state-owned enterprises and other entities that are politically connected but commercially unprofitable, making it more difficult for private firms to access financial resources. In addition, over the years, distorted capital allocation has favored investment over consumption and has resulted in an unbalanced growth model. Finally, savers (individuals and families, in particular) get poor returns for their money and are lured into making unregulated and more risky investments in shadow banking instruments, which promise higher returns.

Reforming the interest rate is therefore critical if China wants to improve the allocation of capital in the domestic market, to support the development of private enterprises, and to fairly remunerate savers—in other words, it is critical to the rebalancing of the Chinese economy. And it is an essential element in the transformation of the renminbi into an international currency. It is worth repeating here that a competitive, liquid, and well-diversified domestic banking and financial sector is necessary for the full liberalization of China’s capital account.

The policy direction is clear: to move from a quantity-based system to a more price-based system (at the moment, there is a mixture of both). Price-based instruments use prices—notably, interest rates—to change the amount of money available in the financial system. Quantity-based instruments, on the other hand, focus on changing the amount of money available in the financial system. An example of these quantity-based measures is the reserve requirement—the amount of cash that banks must hold in their reserves. By increasing or reducing this requirement, the monetary authorities can control liquidity in ways that have expansionary or contractionary effects on the domestic economy. For instance, in April 2015, the PBoC cut the reserve requirement ratio by 100 basis points in order to create more liquidity and offset the impact of the exchange rate on exports—and therefore on growth.

Quantity-based instruments like this blur the transmission of monetary policy. In market economies, monetary policy works through the banking and financial system: changes in the interest rate are reflected in changes in the refinancing cost for commercial banks, which, in turn, transmit these changes to individuals and enterprises. Monetary policy decisions thus have an impact through the whole money chain, from the wholesale interbank market to retail deposits. But in China’s mixed system of quantitative-based and price-based measures (and the need to give commercial banks access to funds at rates below the deposit rates to ensure that they are profitable) the transmission of monetary policy has been less fluid, making the interbank rate (such as, for example, the overnight or the seven-day repo rate)²¹ less effective in guiding market interest rates and channeling wholesale funding to retail funding.

This distortion ultimately affects borrowing costs in the economy. The dominance of banks in China’s financial system amplifies the problem and further constrains the transmission of interest rate changes to the wider economy—with negative effects on the disposable income of individuals and families.²² The liberalization of rates on bank deposits would improve returns on savings, resulting in an increase in disposable income and thus in support for consumer demand. According to estimates, such liberalization could increase the income share of gross domestic product by 4–5 percent.²³

The situation is currently up in the air—reforms are under way, but many elements of the old, quantity-based system still exist. For instance, the PBoC has removed all restrictions on money market and bond market rates in order to underpin interbank lending. There has also been movement in the reform of interest rates for bank loans and bank deposits, starting with the removal of all upper-end limits on lending rates (i.e., banks are allowed to set higher lending rates for high-risk borrowers) and the removal of all lower-end limits on deposit rates in 2004. However, the reform of lending rates took precedence over that of deposit rates and proceeded at a faster pace. The reasoning here is that a sudden change in the allocation of capital could dramatically disrupt the banking sector; the authorities therefore decided to protect banks’ profit margins and gradually, rather than suddenly, expose them to more competition. In doing so, they were responding to and addressing the increasing concerns of, and resistance from, the banks. (A study published by the Swiss investment bank UBS at the beginning of this process found that a reduction in the deposit-loan spread of as little as 100 basis points would have wiped out all the profits of state-owned banks.²⁴) As Jiang Jianqing, chairman of the Industrial and Commercial Bank of China, pointed out, “slower economic growth and interest-rate liberalization are among the factors that are curbing our profit growth.”²⁵

The most significant measures concerning the rates on bank deposits were announced in October 2015, when the PBoC said that it was going to scrap the ceiling on deposit rates. This followed several series of measures that began in June 2012, when the monetary authorities allowed banks to pay as much as 10 percent over the benchmark rate on deposits of various maturities. For example, if the benchmark rate on a one-year deposit was 3 percent, then banks could offer a maximum of 3.3 percent. A year later, in July 2013, the authorities pushed the reform of interest rates for bank loans further by allowing banks to set rates for loans below the PBoC benchmark rates. In May 2015, the State Council gave the banks more flexibility to offer better rates and raised the deposit rate ceiling to 1.5 times the benchmark level. In addition, it launched a new deposit insurance scheme covering deposits from businesses and individuals of up to 500,000 renminbi per bank. A fund run by the central bank backs this scheme so that increased competition among banks to offer higher rates does not put savers’ money at risk—even if this creates a potential problem with “moral hazard.” The deposit insurance is a step toward the final liberalization of the interest rates on bank deposits.

These are all important steps. The reform of China’s interest rates is central to the upgrade of the country’s financial sector and key to its opening to external competition. More importantly, this reform is critical in the transformation of interest rates into an effective instrument of monetary policy. For example, after rates are fully liberalized, the central bank can influence deposit and lending rates by guiding money market rates such as the SHIBOR. In order to fully control its monetary policy, as the central banks of the United States and the euro area do, the PBoC needs to release control of either the exchange rate or capital flows (chapter 4). But, as I discuss in the following sections, releasing control of one of the two—ideally, the exchange rate—is proving very hard for the Chinese monetary authorities.

The reform of the exchange rate is another pillar of China’s broader financial reform agenda. It has been a work in progress for years, moving cautiously through “a self-initiated, gradual and controllable process.”²⁶ In chapter 4, I looked at the reforms that started in the early 1980s, when the old regime—a grossly overvalued exchange rate and rigid exchange controls that dated to the economic planning system initially adopted in the 1950s—was dismantled. Through a series of gradual steps between 1980 and 1995,²⁷ the exchange rate was substantially lowered and was pegged first to the dollar and later to a basket of currencies (among which the dollar dominates). Although this system of a capped and managed exchange rate served China’s development well, it also cemented the status of the renminbi as a dwarf currency.

For the renminbi to become a full-fledged international currency, the exchange rate system needs to change. This is starting to happen, with the gradually increasing trading band that allows the renminbi’s exchange rate to move above or below the PBoC’s predetermined rate by a set percentage. This band has widened from 0.5 percent in 2010, to 1 percent in 2012, to 2 percent in 2014. The idea has been to overcome the ingrained market expectation of continuous currency appreciation—or, more recently, of continuous depreciation—and to create an expectation of two-way movement in the currency. By widening the trading band and intervening in the market, the PBoC aims to fend off pressures and let economic fundamentals, such as growth, inflation, and the country’s external balance, influence the currency.²⁸ A further reform was introduced in August 2015, when the PBoC allowed thirty-five large banks to set the opening daily fix in the onshore foreign exchange market. In doing this, the PBoC gave up some control of the exchange rate and allowed it to be more market led while retaining the power to intervene as necessary.

By making the exchange rate more flexible and allowing the currency to depreciate as well as to appreciate, China’s monetary authorities have also expanded the array of measures they can use to manage the exchange rate, to control liquidity and volatility, and to better respond to cyclical conditions in the economy. In theory, this wider band means that the central bank no longer needs to engineer significant market interventions in order to manage expectations—market players understand that the renminbi is no longer a one-way bet. In practice, however, China is now in the middle of the road with regard to exchange rate management—so why does this system remain problematic?

Part of the problem comes from conflicting objectives vis-à-vis a related set of policy measures—the liberalization of the capital account and the creation of offshore markets. It is difficult for the central bank to manage the exchange rate and keep it within the predetermined band when capital can easily flow in and out. Especially at times of rising market pressure, with more money flowing in or out, managing the exchange rate is a daunting task—and even more so if markets decide to test the determination (and the resources) of the monetary authorities to keep the exchange rate stable. China experienced these pressures in August 2015 and then again in January 2016, when the PBoC had to intervene and buy renminbi—and sell dollars—to keep the exchange rate aligned with the daily fix. And the existence of two exchange rates—one for renminbi in the onshore market (CNY) and one for renminbi in the offshore market (CNH)—creates the opportunity for exchange rate arbitrage and carry trades. If expectations are not aligned and one rate is stronger than the other, speculative activities generate considerable risks for financial stability. In January 2016, the spread between the CNY and the CNH was the widest since September 2011, due to market intervention in the onshore market; the CNY was trading at around 6.52 per dollar in the onshore market because of the PBoC intervention, whereas the CNH was trading at 6.65 per dollar in the offshore market.²⁹

There are other problems that arise from opening the capital account without reforming the exchange rate. One is the increasing pressure to allow domestic interest rates to align with international levels, regardless of the conditions of the domestic economy, in order to avoid excessive inflows and outflows. Because the monetary absorption capacity of China’s domestic capital market is lower than those of countries with more diversified capital markets, there is a significant risk of fast-rising inflationary pressure and asset price bubbles (such as, for example, in the real estate market).

Finally, the policy of managing the exchange rate is costly. As I discussed in chapter 5, it tends to result in a large accumulation of dollars in the foreign exchange reserves, with significant associated costs and risks, or in a depletion of dollars when interventions are necessary to prop up the exchange rate. Switching to a fully floating exchange rate would remove—or reduce—the need to intervene in exchange markets in order to keep the exchange rate aligned with the government’s policy goals.

Given all these reasons why the policy of managing the exchange rate is suboptimal, why is there so much resistance to abandoning the managed float and switching to a fully floating exchange rate? First, the authorities are concerned about currency stability. A key international currency, as the renminbi aspires to be, is expected to be stable so that foreigners consider it a store of value and want to hold it. Second, they are worried that a fully floating exchange rate might make the renminbi too strong and thus decrease the competitiveness of Chinese exports. As a result, there is political pressure to contain the renminbi’s potential for appreciation, especially as economic growth slows and the demand for Chinese exports softens.

These defensive arguments fail to account for the fact that the renminbi exchange rate seems to be close to its equilibrium level. As the International Monetary Fund (IMF) said in the 2015 Article IV Consultation on China that was published before the market turmoil of the second half of 2015, the renminbi is only “moderately undervalued.”³⁰ This means that, if the renminbi became a fully floating currency, it would quickly reach its equilibrium level and would achieve two-way flexibility around this central parity, without the need for further intervention and foreign reserve accumulation. This is a necessary and sufficient condition in order to mitigate risks to financial stability.

The PBoC has struggled to control market pressures on the renminbi—the same forces that always end up battering emerging markets’ currencies—and has intervened several times to settle the markets. In the meantime, however, the appreciation trend has reversed, and more money now flows in the opposite direction. In 2014, China’s outbound foreign direct investment outstripped inbound investment for the first time. In December of the same year, foreign exchange purchases by domestic banks—a rough proxy for capital inflows—fell by 118 billion renminbi, the largest monthly decline on record, despite the biggest trade surplus on record. Since the beginning of 2015, capital outflows have been significant—in the whole 2015, approximately $676 billion left the country.³¹

In addition, like other emerging markets’ economies, China has felt the impact of the stronger dollar since the expected change in the U.S. monetary policy started to crystallize in late 2014 (with a 0.25 rise in interest rates announced in December 2015). This has been compounded by the indirect effects of the fall in the euro, yen, and emerging markets’ currencies over the same period. The global financial crisis had pushed international money toward emerging markets’ economies—in particular, Brazil, Turkey, and India—increasing the value of their currencies. But expectations about the shift in U.S. monetary policy and then the actual increase in U.S. interest rates—coupled with quantitative easing by European and Japanese central banks—contributed to turn the tide.

Capital controls have partially insulated China from these movements. The steep depreciation of the renminbi through 2015 and the difficulties the monetary authorities had to keep the exchange rate stable are evidence of the problems that the complete removal of controls could trigger. The outflows could be much larger and the impact on the exchange rate much greater. Sterilized intervention, as I have discussed, is a way not only to manage the exchange rate but also to rein in excessive liquidity and harness large capital inflows that cannot be absorbed by the market. Absorbing or releasing liquidity in order to keep the currency stable within its fluctuation band is therefore used as a policy instrument that complements the gradual opening of the capital account.

As the renminbi becomes a “normal” currency and acquires more flexibility, the PBoC should be under less and less pressure to intervene in the foreign exchange market. Ideally, China should embrace a fully floating exchange rate or adopt a target zone—as has been done, for example, by India and South Africa—with a wide floating band (say, 10 percent above or below parity).

In his 2015 speech to the IMF, Governor Zhou reiterated the importance of lifting controls on the medium- and long-term capital flows that support the real economy. According to the IMF, only five of forty items remain nonconvertible. In line with this assessment, the governor indicated four cases where China’s monetary authorities will continue to retain control.³² The first case, cross-border financial transactions that involve money laundering and terrorism, is broadly consistent with international practice. The second case involves managing the size of the external debt—again, a rather uncontroversial policy for emerging-market economies such as China that find it difficult to borrow in their own currency. In the third case, the authorities will manage short-term speculative capital flows when appropriate, and in the fourth, they will monitor balance-of-payments statistics in order to be able to adopt temporary capital control measures when there are abnormal fluctuations in the international markets—in line with the IMF’s recent policy shift toward a “comprehensive, flexible and balanced approach for the management of capital flows” (in other words, the management of capital movements when these pose substantial risks to financial stability).³³

Together, these measures amount to a policy of managed convertibility, which is sensible and reflects the change of approach toward capital movements after the global financial crisis. Even the IMF, which for years championed financial liberalization and stigmatized capital controls, now recognizes that unfettered capital movements are a source of instability and a trigger for financial crises.³⁴ For Chinese policy makers, this shift in thinking away from a push toward full liberalization fits well into China’s gradualism in policy making and creates more time and space for reforms. Managed convertibility reflects a more accurate assessment of the possibilities for financial reforms, given that China’s banks and the financial sector are not ready to let money move into and out of the country unrestrained. China’s monetary authorities are attuned to the risks that volatile capital flows pose to financial stability, especially for countries that, like their own, manage the exchange rate. There is plenty of international evidence that countries with a managed exchange rate regime and a liberalized capital account are more vulnerable to crises, so maintaining control of capital movements (or managing convertibility) seems to be a wise choice.³⁵ Likewise, reforming interest rates and dismantling the link between state banks and state-owned enterprises must be timed in accordance with these overall policy goals, not tackled separately.

What does this policy shift mean for the renminbi? The authorities will continue to rely on the measures and schemes that so far have underpinned China’s renminbi strategy (as discussed in chapter 6) in order to expand the currency’s international use for trade and finance, and they will expand these schemes as a way of testing new directions. Back to Han Zheng, the Communist Party secretary of Shanghai, he carried on, in the interview with the Financial Times, explaining the recently established Shanghai free trade zone, “One of our key objectives is allowing qualified individuals within the free trade zone to open capital accounts in a gradual and orderly manner, on condition of good risk control.”³⁶ Within the Shanghai free trade zone, for instance, investors—both Chinese and overseas—have much greater freedom to shift money into and out of the country and invest in financial assets such as stocks and bonds as well as physical assets such as real estate. The authorities use schemes like this to test ways to open China’s domestic financial sector within controlled conditions.