from Follow the Money

Capital freedom, not exchange rate freedom …

January 29, 2007

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That, more or less, is the conclusion of today’s Wall Street Journal oped on China.    

I loved the title – talking of the People’s Investment Company is far more catchy than talking of a sovereign wealth fund or a government investment fund.    But I didn’t love the content, as my regular readers know (this oped ran on Friday in the Asian edition of the Journal).    It would be nice, for example, if the Journal recognized that foreign exchange reserves are an asset – not a liability – on a central bank’s balance sheet.    The FT consistently gets these kinds of things right in its leaders.

But the bigger issue is would “capital freedom” – lifting China’s capital controls – reduce the pressures facing China’s central bank in the absence of “exchange rate freedom” – letting the RMB  appreciate a bit. 

My answer is an unequivocal no. There just isn’t much evidence private Chinese savers want dollars.  At least not at current interest rates and exchange rates.  The dollar share of domestic deposits is falling.    Chinese savers aren’t shying away from the cleaned up domestic banking system (nor, for that matter, are foreign investors).  There hasn’t been much interest in the Qualified Domestic Investor Initiative, as the Journal notes.   And given how well Chinese stocks have done recently, it isn’t obvious that letting Chinese domestic investors buy equities would dramatically change the dynamics. Controls on outflows are being tightened, controls on inflows are loosened.   The money that is flowing out of China seems to be coming from state institutions – whether state banks, state insurance companies or state pension funds.  

If anyone has good evidence to the contrary – do tell.  I would be most interested. 

The basic problem China faces – highlighted by Dr. Jen among others – is that at current exchange rates both Chinese goods and Chinese financial assets are cheap.  At least for foreigners.   Conversely, both foreign goods and foreign financial assets are expensive for Chinese investors.   At least for those who cannot borrow the PBoC’s dollars at a fixed rate in the swaps market …  

As a result, my guess is that if China truly lifted all controls on capital at the current exchange rate, far more money would flow into China than would flow out of China.   Rather than reducing pressure on China’s balance of payments, capital account liberalization would add to it.    That is why I am fairly sure Chinese policy makers won’t be embracing “capital freedom” any time soon.

Update: I would happily take 3% on 3 year Chinese sterilization bonds plus any RMB appreciation over the next few years over 5% on Treasuries or 4% (ballpark) on safe euro denomianted bonds.    3% + 5% (appreciation) = 8%.  3%+3% = 6%.   And my worst case scenario is that the RMB is basically stable ... and I lose 2% a year.   I rather suspect that I am not the only one itching to do this trade if China dropped its capital controls.

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