Chinese Capital Account Liberalisation: process, structure and consequences

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What happens in China matters to the world economy. China is the largest merchandise trader, second largest economy and third largest net creditor nation globally. It also has the largest banking system, second largest stock market and third largest bond market on earth.

For decades China has absorbed private capital from the rest of the world while serving as a big official lender in the world but this is now changing. The gradual liberalisation of capital flows has led to a major shift in offshore investment from China. Reinforced by a switch from entities parking funds in renminbi (RMB) to take advantage of ongoing appreciations of the currency, to moving money out of RMB as depreciation seems more likely, this has led to Chinese official reserves falling from mid-2014 onward.

We expect ongoing liberalisation of the capital account. The process will be gradual and punctuated as has been the norm with the government’s managing of liberalisations in other areas. As a one party state, China cannot afford to make major economic mistakes. The current tightening of regulations, processes and oversight of offshore investment should be seen as a pause, not more.

The Chinese offshore investment position is currently dominated by official holdings of reserves. Private outflows have been small, and dominated by inflows even though those too have been controlled and restricted in many sectors.

As the opening progresses, outflows are likely to dominate inflows. The best available estimates suggest this is likely to be of the order of a net 10 per cent of GDP, with outflows of over 25 per cent and inflows of around 15 per cent.

The implications for Australia are relatively clear.

We can expect a lot more foreign direct investment (FDI) from China into Australia, a lot more portfolio investment, and probably a lot more private investment including into property. This may cause political issues but is part of the normal diversification of portfolios we see as countries open their capital accounts.
We can also expect China to open its markets to increased foreign investment so that the opportunities to invest into China will also be substantial. This is likely to progressively shift away from FDI towards portfolio holdings (because FDI has been relatively less closed in the past).

The risks of a contagion from an economic or financial disruption in China increase to the extent that our economies become more closely integrated. However, given the deep engagement of our resources and trade sectors with China, the major challenges to Australia from any shock are likely to dominate through the trade channel rather than the financial channel.

That said, opening the capital account will inevitably make macroeconomic management in China more difficult. Fuller internationalisation of the RMB will put strains on the local financial institutions and financial markets. Currency markets will need to deepen significantly and hedging markets expand so that people can trade into and out of RMB positions at speed and at scale. Few countries have managed the transition without some sort of financial shock.

Australia has a huge stake in a successful and relatively smooth financial integration of China into the global market. To add to the risk to this historical transition, the country currently faces the challenges of rising leverage and slowing economic growth as it attempts to transition from a development model based around public investment and export-led growth.

This paper was produced under the Financial Integration in the Asia-Pacific project, which aims to provide Australian and Asian industry practitioners, policymakers and other stakeholders with the data and research necessary to enhance long-term strategic planning and decision-making. Other research produced under the project can be accessed here