The renminbi (RMB), China’s currency, also often referred to by its unit of account, the yuan, is rapidly gaining international attention. For years, there have been calls for full RMB convertibility. I would argue that full convertibility for the currency is a bad idea, and politically dangerous in the medium-term.
Not surprisingly, Chinese authorities, including Zhou Xiachuan, the head of the People’s Bank of China (PBOC), China’s central bank, have been clear that full convertibility would follow a slow and deliberate process. It has even been argued that Mr. Zhou was recently reappointed as head of the PBOC, despite passing the normal required retirement age for Chinese officials, because of his expertise regarding convertibility.
We need to understand what we mean when we say convertibility. For instance, the US dollar, the Japanese yen, the euro, etc. are fully convertible. That means cross border exchanges of dollars, yen or euros are allowed without restriction (except for political sanctions, criminal activities, etc.). If you remember my recent blog on the dollar, I pointed out that local currencies only exist in the issuing country. That implies that full convertibility allows a holder of a dollar to exchange that dollar asset with any other entity in the US or abroad in exchange for a good, service or other financial asset.
China already has a number of areas where it allows convertibility, in particular regarding the trade in goods and services. This is not risky for the Chinese government.
Capital Account Convertibility
From my perspective the risk rises when convertibility is extended to the capital accounts. China’s massive international reserves allow it to adopt any type of foreign exchange regime it wishes, even if it had full capital account convertibility. Concerns usually arise when emerging market countries adopt full convertibility and also adopt a fixed exchange rate regime. However, China does not face such risks because not only does the country regularly run large current account surpluses, possesses massive international reserves, but it already has a modified floating exchange rate regime. Given these factors, on the surface it would seem that full convertibility is not risky. However, when explored further, risks become apparent.
There are some economic risks to take into account. For instance, with full capital account convertibility, the country would likely face, in the near-term at least, large capital inflows. Unless the government allows the exchange rate to rise substantially against other currencies, the government would wind up registering a sharp increase in its international reserves. Since it is not in the best interest of the authorities to allow the RMB to appreciate rapidly because it would disrupt the vital export sector, it would more likely accumulate more reserves.
When a foreigner buys an RMB security, someone in China holding an RMB financial asset must be willing to accept a foreign currency in exchange. For the sake of simplicity, let’s just discuss this using the RMB and the dollar. If the government allows a free float of the currency, then if there are large numbers of foreigners trying to buy RMB financial assets, the most likely outcome would be for the price of dollar assets to fall relative to the RMB, which means an appreciation of the RMB.
If the government prevents a free float through intervention, then the Chinese government must be willing to accept more dollar assets. To do this, it will have to provide an ever-larger supply of RMB. The affect of this is potentially inflationary. The government would likely try tosterilize the increase in RMB deposits, by withdrawing RMBs from the financial system. In general, such sterilization measures do not work perfectly. The government already faces this issue because of its massive current account surpluses. If demand increases for more RMB because of capital account developments, then the sterilization problem rises significantly.
In the Chinese case, this would mean that already existing inflationary pressures might become even worse. Domestic inflation is politically hazardous for any Chinese regime.
On the other hand, if the government didn’t intervene, then a sharp appreciation of the RMB would reduce Chinese domestic growth through the negative effect on its vital export sector. Such a slowdown in the world’s second largest economy would not be desirable. Such a slowdown would likely impact commodity prices around the world. Lower commodity prices would hurt many emerging market economies.
Despite these obvious economic risks, from my perspective, the real risk for the government is political. If full capital account convertibility is permitted, then at some point in the future, if domestic political or economic events occur which call into question the overall direction of the country, capital account mobility will be an indirect way for both Chinese and foreigners to vote on what’s happening in China.
For now, we can assume foreigners want to hold more RMB assets. However, let’s think back to the Tiananmen Square protests of 1989. If something like that were to occur in the future, there would likely be a desire to reduce RMB holdings. The government would then face two choices: 1) Allow the RMB exchange rate to plunge; or 2) Provide enough foreign exchange to maintain the exchange rate. Either way it will be clear to the Chinese people that the government is facing a difficulty which be gaged by either the rate of depreciation or the loss of reserves.
Whenever these types of developments have taken place in other emerging market countries, political upheaval has frequently followed. Mexico, post-Tequila Crisis, was forced to adopt major political reforms. Following the East Asian crisis, Indonesians ousted the 30+ year Suharto regime and democratized. South Africa’s debt rescheduling of the 1980s, and international sanctions laid the groundwork for the eventual end of its apartheid regime.
You might quickly add that these developments were good. Yes, they were good. However, China is so big, and its history so complex, with centrifugal political pressures ever present, any sudden regime change or even too rapid a regime reform might destabilize not just the Chinese economy, but also the world economy in a way no other emerging market country would. To risk such a development simply to allow free capital movements seems to me to be poor public policy.
As usual, Clear and Candid.