Here is my regular follow up to my work for BloombergView on why capital controls are not a good idea for China. I write these follow up pieces for my blog only because due to space considerations I may not be able to get deep enough into ideas as I would like. Very thankful to Bloomberg for giving me the platform and my editor Nisid Hajari makes me sound better than I really am, so always start there before coming here.
Before I launch more specifically into why I do not think capital controls are a good idea, I want to note two further background points. First, I am a business school professor so I will admit to having strong leanings towards free markets. However, I think I am also pragmatic and realistic enough to be able to examine situations on their merits. I am also willing to change my mind if superior arguments are presented or if situations change. I know markets are not perfect or can sometimes be irrational, for instance, you do not need to convince me. I just want to confess my bias but note that as you will see, I think my arguments here are distinctly more pragmatic and empirical than ideological.
Second, this piece was driven by a number of articles I saw in the past week calling for or strongly suggesting capital controls for China. The Economist, Financial Times, and Bank of Japan have all suggested that China should impose capital controls to prevent a further slide in the RMB. This is primarily a response to those pieces. Now, let us begin.
In my personal opinion, the arguments I are codswollop which is British for non-sense (I’m currently in London and trying to learn the language). Let me detail why in no specific order of importance.
- Many people have assumed that since the IMF admitted that capital controls had some place in global financial flows, they could and should be used much more widely. However, this betrays a very poor understanding on many levels of what the IMF actually said. The technical parts of what the IMF actually said are vitally important. The IMF said that capital controls could be during periods of crisis on a temporary basis focused on slowing or restricting outflows of international money from previous periods of large inflows. There are many important things there. The could means that it is not required or necessary but may depending on circumstances be useful. The IMF does not suggest making capital controls a knee jerk reaction. It also said capital controls should be limited to periods of crisis. I am pessimistic and concerned about the Chinese economy and finances for empirical reasons but I have to ask: what crisis? An economy not growing at 7% is not a crisis. A country with downward pressure on its currency is not a crisis. I could write this list all day long but the point is, if you are arguing that China right now should impose capital controls, there is virtually no country on the planet you wouldn’t be able to make the same argument for. It is an awful precedent to recommend countries impose capital controls because their economy isn’t growing quite as strong or because their currency declines. (I am going to focus on the other parts of the IMF recommendations later). The important point is that it betrays a very poor understanding of what the IMF actually said and how to apply that to the real world even if you are recommending capital controls.
- I have two fundamental objections to the arguments for capital controls that I have heard so far. First, I don’t believe capital controls will address the problems that need to be solved or even the problems raised by those arguing for capital controls. I will get into the specific arguments shortly, but I mean simply if you need to fix your knee you don’t operate on the shoulder. The arguments all seem to fall back on capital controls with no clear link to whatever problems they see as needing to be solved. Second, I do not believe that capital controls have any realistic chance of success. Even if we assume a tenuous link between capital controls being able to solve a specific economic/financial problem, it is important to ask, what are my expected chances of success by using a specific policy? In virtually every case, for multiple reasons, one would have to believe, the chances of capital controls resulting in a successful outcome is exceedingly low.
- Now let me turn to some of the specific arguments. Bank of Japan governor Haruhiko Kuroda called on China at Davos to implement stricter capital controls. I only have access to the FT article on what he said so if there is more nuance or detail not captured, I apologize in advance. The FT writes the following about his comments:
“Mr Kuroda suggested capital controls would allow Beijing not to waste its foreign exchange reserves defending the currency while allowing its domestic monetary policy to stimulate consumption at home. ‘Capital controls could be useful to manage [China’s] exchange rate as well as domestic monetary policy in a constructive way,’ he said.”
Noting the use of FX reserves, capital controls, and monetary policy is implicitly the widely known trillema. He is essentially saying to manage that contradiction, China should use more monetary easing and impose tighter capital controls. By using more monetary easing, Kuroda, and this is the important part if we are asking what will be accomplished by a policy, says this will stimulate “consumption at home”. Just on the face of it, I believe it is highly unlikely that monetary easing in China will stimulate demand to any significant degree. Just as a point of economic theory, it is tenuous at best to say that imposing capital controls would boost domestic consumption. If people are scared by the future due to capital controls and economic concern, they are not going to engage in a consumption spree. The link between those two things is very weak. If we break this up into consumer and business consumption and introduce empirics, we can see what we mean. Business demand is very low and being propped up primarily government driven stimulus projects. Loan demand is low and continuing to fall even as the PBOC has lowered interest rates. This is due primarily to surplus capacity. Very hard to see how capital controls will impact this. Looking at consumer behavior, it might shift existing consumption to domestic producers, however, given the low single digit growth in consumer product output and sales, there is little reason to believe that imposing capital controls and lower interest rates would prompt a consumer rebound. A weak labor market which continues to deteriorate, simply won’t give people reason to go spend money. I see very little link between imposing capital controls and boosting consumption and even less chance of success.
- The Economist in three separate pieces (here, here, and here) argue in favor of capital controls in China. What I find most puzzling is that they do not make a strong argument as to what problem capital controls would solve. Honestly, it feels like they are not even convinced capital controls would accomplish much and that they are arguing for capital controls out of laziness rather than conviction. In one piece they argue that depreciation would “puncture the PBOC’s air of invulnerability.” First off, what’s wrong with the RMB falling? (more on that later though). Second, the PBOC air of invulnerability is lying in tatters by the side of the road having been run over multiple times. Probably only the CSRC and NBS have worse reputations in Beijing policy making. The problem here is simple and will not be easily fixed. The PBOC has very little credibility and has let the RMB fix out of the bottle. If they behave like the CSRC in the past 8 months, trying to make small commitments to deal with the problem, the RMB problem will linger on, consume lots of capital to its defense, and most likely still lose in the end. Not a winning strategy. The Economist elsewhere argues that capital controls would give China “freedom to clean up the country’s bad debts and push through structural reform”. There are numerous problems with this argument. First, this is not remotely close to “temporary”. Banks have recently gone public with bad debts from the lending binge more than a decade ago. Second, there is absolutely no evidence that Beijing and banks are taking concrete steps to address the bad loan problem. Credit continues to expand at approximately twice the rate of GDP, companies continue to get bailed out despite a small rise in the number of defaults, and even Chinese bankers admit NPLs are radically understated. To their credit Beijing has now said they want to “deleverage”, there is however, no concrete evidence of steps to address this. Policy needs to be made on evidence and facts, leave hope and faith to theology. Third, unless there is concern that capital outflows will create a liquidity crisis in banks, something that cannot be ruled but it is not currently happening or the most likely, it is unclear how imposing capital controls would prompt this change. The causative link between imposing capital controls and prompting better bank management is weak at best. In fact, lots evidence points to the idea that more financial repression would inhibit restructuring and reform. The problems Beijing is facing were created by Beijing through financial repression, not international investors or market forces bubbling, but by Beijing financial repression. Seems unlikely even more Beijing financial repression will solve this problem. Finally, they argue that imposing capital controls would help Beijing “prepare financial institutions for currency volatility”. This is a specious argument for third very empirical reasons. First, Chinese firms already deal with currency volatility they just do it in essentially an n-1 world. By that I mean, they already deal with currency volatility in the trade weighted currency basket for all currencies except the USD. The Euro, the Yen, the GBP, etc etc are all managed for currency volatility. The USD is the biggest but it is blindness to think Chinese firms do not deal with currency volatility. Second, Chinese firms owe relatively little in absolute terms of foreign denominated debt and it is shrinking everyday and international firms hold in absolute and relative firms, little in the way of liquid Chinese assets (this excludes FDI assets like plants). In other words, foreign investors even if they really wanted to, won’t be impacted by capital controls. Third, if as Beijing is proud to announce and push, international transactions with China are in RMB, this essentially pushes the currency risk to the foreign party rather than the Chinese firm. The Chinese firm is has both its expenses in RMB and sells in RMB. This lowers, does not eliminate but lowers the risk to Chinese firms. In short, the arguments presented by The Economist are weak at best.
- Even the Financial Times has decided to toy with the idea of capital controls writing. To be fair, they just toy with the idea and do not seem convinced by the arguments.
- There is one last piece that just got sent to me written by former PBOC Monetary Policy Committee member Yu Yongding where he advocates “reinforce(ing) the Chinese governments market oriented reform plans and allow the RMB to float.” To briefly sum up a good piece, the path has been set and since we know the destination, all other options just delay the inevitable with large costs. It would be best to move there deliberately, carefully, but quickly.
- There are a number of economic points that are vital, to reincorporate the earlier points from the IMF and one that was also noted by the FT piece. It is important to understand the nature of the outflow. The IMF is worried about outflows from large destabilizing inflows. The current capital outflows leaving China are not due to previous rapid/destabilizing capital inflows nor are they due to international investors. This is a vital and absolutely fundamental difference to understand. There was no large international investor capital inflow into China and the money leaving has very little to do with international investors. Most international investment in China, overwhelmingly so actually, is in the form of FDI. We do not see that this FDI is being sold off or used up and transferred out. International investor portfolio asset holdings are tiny in relative terms and have not changed nearly enough to make any appreciable impact. The capital outflows are driven almost entirely by Chinese citizens and firms voting with their RMB.
- This seemingly simple and straightforward conclusion however has a number significant implications. First, do not compare China to Asia 1997. Stop now. Do not say Malaysia, South Korea, Indonesia, Thailand. The details of the financial flows are radically different. There are some similarities due to the rapid expansion of credit/investment, but the prescriptions need to be crafted individually for China. Second, the capital outflows are most likely not short term outflows but rather a structural shift in capital flow directionality. The IMF argument about capital controls can be understood if “short term” capital inflows have suddenly reversed causing “short term” capital outflows leading to a disruption. However, we know that there were essentially no short term inflows that have reversed. The outflows being driven by Chinese citizens and firms are going to buy real estate and outward foreign direct investment (as simple examples). Neither of those are remotely close to being considered short term outflows. Capital leaving China is likely leaving essentially permanently. Furthermore, this trend is most likely unlikely to see a reversal anytime soon. In other words, the capital outflows are not going to reverse and turn into capital inflows anytime soon. This is another reason why the “temporary” moniker seems to make little sense. If the outflows were temporary or purchasing temporary external assets, there is some justification, however, neither holds here. It is worth noting that China is now the largest exporter of immigrants to the United States and most likely other countries also. This is not a temporary phenomenon. Third, if the East Asian crisis could potentially be thought of (in very crude, overly simplistic terms) as countries that liberalized their capital accounts too quickly and then gorged on available capital, China is almost the opposite. The imbalances are caused by a closed capital account gorging on capital because the money supply and credit, due to current account sterilization, grew so rapidly to such enormous volumes. If restricting capital account openness was the recipe for countries that had opened their capital accounts too much or too rapidly, it would seem to push openness for China that hasn’t opened its capital account. Fourth, the somewhat amusing cliche coined by Tracey Alloway of Bloomberg that has been coined is the “giant ball of money” that rolls between asset classes pumping up prices until it moves on. This is due to the closed capital account where capital simply cannot be used effectively. It pumps up prices until that goes out of style and moves on to other classes. Loan demand is down because there simply are no good projects because China is so overbuilt. In the past decade China has expanded money supply at enormous rate even after accounting for official real GDP growth. We see this in elevated asset prices across China that money supply has rapidly outpaced the real demand. This furthers this idea that the outflows are very unlikely to be temporary.
- There is one final point that is very important and that is how much would a fall in the RMB matter? I am only going to focus on China here as this is an issue you could many very long papers or books about and I am already quite far into this. I am honestly much more sanguine about the possibility of a lower RMB. Let me give you a number of reasons. First, most economies against the USD have fallen in the past 12-24 month pretty substantially and surprisingly, the world continues to spin on its axis, commodity dependent EMs are battered but that is due to falling commodity prices from surplus capacity and weak demand, with the significant problems less related to USD than other problems. DMs like Japan and Eurozone have fallen against the USD with almost no discernible impact on economic outcomes directly attributable to exchange rates. Taking Japan as one example, the Yen has fallen significantly against the USD in the past two years and there has been virtually not discernible change in trend economic data. You would be hard pressed to say any changes are anything other than statistical noise. Second, if we look empirically at China’s trade, any RMB fall would have a relatively muted impact on imports. Speaking simplistically, let’s classify Chinese trade as processing for re-export, commodity, and other assuming it is all for consumption (it’s not but work with me). The re-export and commodity imports will largely be unaffected by any change in the RMB, for different reasons though. This would likely leave at most let’s say 50% of exports up for grabs in our analysis. Since China already produces most the mass market products its consumes, whether it is cars to shoes, there is little reason to believe this consumption will be impacted and if anything will cause consumers to shift to domestic producers as imports become more expensive though likely a very small effect. People or firms on the upper end of the scale will still buy luxury products or specialty goods at a higher prices point as they tend to be less elastic in their purchasing decisions. In other words, while a fall in the RMB will undoubtedly bring additional pressures and stresses, it seems poorly informed to believe this would create a crisis or anything resembling such dislocations. Third, as I have already covered for BloombergViews, I believe it is very unlikely that a fall in the RMB would result in any sustained boost to trade or growth in China. Fourth, if China wants to become a major international currency, which I am still unsure if they understand what that entails, they absolutely must allow capital outflows. This doesn’t entail profound economic insight to understand: how can the RMB become a major international currency if there is no RMB in the rest of world and no one outside of China can use it? Fifth, currencies rise and currencies fall. That’s what they do, are supposed to do and should not be forgotten. Many people even international economists with regards to China, and really most similar situations, develop a degree of analytic Stockholm syndrome adapting the arguments of their kidnappers regardless of how non-sensical. As capital has left China and the RMB has declined, with no true crisis in sight, smart people are running around like chicken little calling for capital controls. It would definitely mark a change if the RMB floated, but that’s it. Most major currencies have fallen against the USD because of underlying economic issues and the streets of Tokyo remain oddly untouched by pillaging, fire, and villagers storming the castles. To have this degree of fear you would have to believe that China is an enormously fragile economic state which implies you don’t believe the finances or economic data. Very real possibilities, but avoid adopting the Chinese mantra of stability above all else. Sixth, the Chinese are moving capital out of China because they see long term economic problems.
I apologize for the length of this but I wanted to address some of these issues in a more detailed and technical manner. Once I got going, I was like Skynyrd on Free Bird. Balding out.