In these pages earlier this year, Shyam Saran, in his column titled "The Chinese (yuan) are coming" (January 14, 2014), noted the many steps that the Chinese have taken over the past 18 months to expand the international role of their domestic currency (the Chinese yuan is also known as the renminbi). These steps have succeeded in expanding the offshore use of the renminbi as a currency of trade invoicing and settlement, even though China continues to maintain relatively tight capital controls to seal off its domestic financial system from these offshore developments.
In this column I take this discussion forward to examine the prospects for a more substantial opening of China's capital account and the implications for India. As the terminology in this area can be confusing even for specialists, let me clarify what I mean by an open capital account: two-way freedom for cross-border asset purchases and ownership between residents and non-residents, subject to the usual disclosure and taxation provisions. The assets in question can be real (factories, residences, and valuables such as gold and jewellery), in which case the investment is called foreign direct investment (FDI); or, more controversially, financial, such as bank accounts, bonds and equities.
India's own cautious journey along this path indicates the infinite gradations that are possible: differential rules as between sectors (in the case of FDI), and as between the type of investor and the type of instrument where portfolio (that is, financial ) investment is concerned. Distinctions can also vary, both inbound and outbound. India's case also reveals an important distinction between liberalisation by administrative decision and liberalisation guaranteed by statute. The administrative permission granted to resident individuals to remit funds from India, for example, was reduced from $200,000 to $75,000 in the rupee wobble of last year.
It is also important not to confuse opening of the capital account with the choice of an exchange rate regime. As it happens, most advanced countries with largely open capital accounts now operate with freely floating exchange rates with relatively infrequent currency intervention, but the Swiss National Bank famously intervened to deal with hot money flows by capping the appreciation of the Swiss franc against the euro. Banking regulators have, in effect, imposed restrictions on the free flow of capital even within the euro zone during the current euro crisis in order to protect their taxpayers from the risk of loan default. So China has a wide array of choices available to it. The questions are what it will choose, why it will choose to move and when it might act.
Within a large recent literature on this subject, I have found two recent commentaries to be especially illuminating, largely because they take sharply opposing positions. The first was published in the Bank of England's Quarterly Bulletin at the end of last year. The second is a column by Martin Wolf in Financial Times last week. The Bank of England article notes that China's integration with global finance lags well behind its standing in world trade, particularly if one excludes its accumulation of official foreign exchange reserves.
Compared with a share in world nominal GDP (at market exchange rates) of 10 per cent at the end of 2011 and a share in global trade of nine per cent, external assets and liabilities of Chinese entities (also called China's gross investment position) accounted for less than two per cent of the world's gross external assets and liabilities. Put another way, China's gross investment position is estimated at five per cent of global GDP at the end of 2012. Under plausible assumptions, the Bank of England believes this figure could exceed 30 per cent of world nominal GDP by 2025, just over a decade from now, provided of course China chooses to liberalise its capital account.
The article acknowledges both that there is no official Chinese road map for liberalisation and that there is no reason to assume that China will choose to become as internationally open as the United Kingdom (or the United States). But, in a comment that is equally relevant for Indian planners, it observes: "Although the path of reform is uncertain, it nevertheless seems prudent to consider the issue now, as few events are likely to have more impact on the shape of the global financial system over the next decade." A particular reason for the Bank of England to take note is because any such development is likely to have a major impact for good or for ill on the status of London as a global financial centre.
If the Bank of England article is relatively upbeat about the prospects and impact of gradual opening of China's capital account, Mr Wolf takes an altogether more sceptical view. This is summed up in his characteristically blunt assessment: given the risks of capital account liberalisation, particularly in such a huge economy, the sensible view is that China is not yet ready. Mr Wolf is concerned not only with the risks to the Chinese economy itself, but with the global economy as a whole. He drily observes: "We have all had fun enough with financial crises to last a long time. Beijing must reform first and only then open up."
India has much at stake, no matter which trajectory China follows. In some respects, India has successfully negotiated several of the domestic reform challenges facing China, particularly the controlled liberalisation of bank interest rates as well as the transition from a fixed exchange rate to a managed float. Despite India's still robust saving rate, its investment needs are even greater and it has an abiding interest in stable long-term sources of finance particularly to support its infrastructure requirements.
The Percy Mistry report of 2007 suggested a series of steps to make Mumbai an international financial centre, on the grounds that India's own private sector needed a sophisticated and diverse set of financial instruments, and that India possessed many of the human skills (as well as a useful time zone) that might be needed. While much water has flowed under the bridge globally and locally since then, the needs have not gone away. As London is doing, we should also think of how we can best piggyback on China's financial opening, which is likely to be the next big thing in global finance.
The writer is group chief economist, Royal Dutch Shell.
These views are personal
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