Variable choices on reform map

Domestic factors should be the main drivers of monetary reforms in China

There have been rumors recently that China would speed up the relaxation of capital controls, a topic closely related to making the renminbi a truly convertible and international currency.

Undoubtedly, the international payment and clearing of the renminbi has been a major item in the Chinese financial reform agenda for some time now. It is particularly important because the internationalization of the renminbi has bearings on two other major aspects of Chinese financial reform, namely toward market-determined interest rates domestically, and market-determined currency rates for the renminbi internationally.

Whereas there is little controversy about the importance of all three aspects of the reform, there has always been debate about how reform should take place, and whether one should first heed to domestic or international reform.

One major motivation behind the push to make the renminbi an international currency may be very specific to transforming economies. Many factor prices, including the interest rate that is essentially the price for capital may be distorted within transforming economies. Thus, opening up the capital flow and making the home currency an international one may help even the domestic and overseas interest rate, thereby speeding up reforms in other areas of the domestic economy.

There may be similar logic in China's endeavor to make the renminbi a truly international currency. Small and medium-sized enterprises' difficulty in obtaining bank credit, the flourishing yet under-regulated off-balance-sheet financing by banks and financial institutions, and the recent credit crunch that rendered sharp drops in the Chinese A-shares market, all suggest that further reform in the Chinese domestic financial system is much needed.

Making the renminbi a truly international currency is widely expected to trigger further reform within China.

However, one has to be realistic about how high to set the expectation. It was not until some 70 years after the US economy surpassed that of Britain, that the US dollar became the dominant international currency. Based on the current trajectory, China's economy may overtake the US' to become the world's largest in a decade, but it may take much longer before the renminbi can become a dominant international currency.

If China's goal in the short term focuses on making the renminbi more widely accepted by foreign trade partners and investors, then it would have to relax its constraints on capital account flows to compensate for the lack of renminbi investment products in offshore markets.

At the same time, opening up the capital account may bring a string of unexpected outcomes. If historical incidents with other countries serve as lessons, one would worry whether the abrupt relaxation in flows under the capital account would result in sudden flight of capital from China. Such sudden outflows may cause disruption in the economy and dent investor confidence, which may lead to stock market panic and bank-run problems, as experienced during the 1998 Southeast Asia financial crisis.

As indicated by the recent credit crunch, a bigger threat lies in that a sudden drop in liquidity in the economy may drain capital from many capital-intensive investment projects that have been used for the fast credit expansion of the past few years. Real estate development projects, local infrastructure projects, urbanization plans and local government financing vehicles may all feel the chill or even fall apart if there are considerable negative shocks to the available capital. As a result, the attempt to open up the capital account has to take place gradually, consistently and in an orderly fashion.

Even if China manages to succeed in its plan to internationalize the renminbi, it has to be prepared for the true cost of having a truly international currency. China would have to take up the related burdens. It would have to set aside everything else and ensure that the confidence and stability of the renminbi currency rate is maintained.

China's central bank will lose a lot of its flexibility when it sets domestic monetary policies. But in full equilibrium, or in an open economy, the central bank will find itself stuck in a quandary in which it cannot fulfill all of its policy objectives, as manifested by the Triffin dilemma.

Finally, even though opening up the capital account and speeding up the internationalization of the renminbi may have profound and favorable implications on the reform taking place within China, it may be meaningful to ask the question why such changes cannot take place without influence from the outside. Especially given the uncertainties in opening up the flow under capital account, there should be stronger incentives for the domestic financial system to transform itself more aggressively, in the interest of a better, faster and smoother reform in the entire economy. As attractive as an ideal road map may sound, pushing through market-oriented reforms whenever possible may be a more pragmatic and effective path itself.

The author is faculty fellow at the International Center for Finance, Yale University, and deputy director of the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University.