SPEAKING FREELY
What about the capital account?
By Huw McKay

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Editor's note: ATol would like to define the following economics terms used by Mr McKay (definitions from Wikipedia) as a courtesy to readers who may be unfamiliar with them.

Current account: records the net flow of money into a country resulting from trade in goods and services and transfer payments made from abroad. The current account itself comprises of 3 accounts: the trade account, income account and transfers account. A trade deficit (surplus) arises when there is a deficit (surplus) in the merchandise trade within the current account.

Capital account: records the net flow of money into a country from purchases and sales of assets such as stocks, bonds and land.

The July 21 announcement on China's altered foreign exchange regime has implications beyond rapprochement with the US in the matter of fiduciary suzerainty. The major side effect of the "compromise regime" that China has chosen is that it restricts the potential timing of a shift to full capital account convertibility. And that in turn will restrict the potential timing of any future alterations of China's foreign exchange policy in favor of flexibility.

This collection of statements may seem counterintuitive at first. But read on.

Under benign internal and external economic conditions, the normative path from a fixed to a floating exchange rate is well defined. The following catalogue of tasks will get the job done over a decade or so.

1. Establish convertibility on the current account, and unify onshore trading of the currency.
2. Work toward establishing an alternative anchor for monetary policy. Inflation targeting is the popular choice, the successful application of which requires central bank independence, the unification of monetary and foreign exchange policy, and the establishment of inflation-fighting "credibility" with the market.
3. Establish an offshore forward market to provide domestic institutions with the tools to hedge the risks associated with flexibility.
4. Widen the allowable trading band around the existing peg to give domestic institutions a chance to "train" themselves to deal with exchange rate volatility under protected conditions.
5. Work to alleviate any existing asymmetries in the capital account, and have a strategy for ensuring capital account convertibility in the future.
6. Progressively increase the allowable degree of volatility as competency improves.
7. When the allowable degree of volatility reaches a level where it is essentially redundant on most trading days, quietly move to a free-floating market-determined exchange rate.

China's chosen path is a curious one when viewed through this grid. Besides the first point above, China has now deviated substantially from this path. Indeed, given the nature of the deviation, China's ability to get back on the path later on, should it decide to do so, has been compromised. The reason for this is that the assumption "benign internal and external conditions" is already breached on at least two counts. The first is the weakness of China's domestic banking system. The second is the haunting specter of the highly mobile community of international financial speculators, who are armed and ready to place enormous bets on trending markets anywhere in the world.

China's brittle banking system clearly inhibits international financial reform. It is not foreign exchange rate flexibility per se that threatens these banks - it is reduced access to domestic savings. China's banks, particularly the big four state institutions, survive by accessing captive domestic savings at meager interest rates and consuming a fat margin on performing loans. Take away that prop via savings outflows, and the profitability of the banking system is seriously weakened. This situation points to a go-slow on capital account reforms.

The second breach is particularly damaging. China has moved from a soft peg to an intermediate regime. The difference between the two is that the second has the potential to be flexible, although we know nothing about the eventuality yet. This potential is the key. The market now has an open invitation to charge at the matador, an opportunity that did not exist under the prior arrangements.

That opportunity will heighten the intervention requirements to keep the exchange rate stable on busy days. There are no guarantees that reserves will accumulate at a slower pace over the coming months, and the weight of flows will be determined to some extent by the degree to which capital can swiftly ingress and egress Fortress China.

In this analysis it is the ease of egress that has our attention. The administration has made their incentives in the matter of capital account reform doubly strong. The banks won't like the reform of capital controls, and neither will the monetary authority, which is trying to keep a tenuous grip on the rate of growth in the money supply.

Why is capital account reform so important? It is crucial to remove the asymmetries present in the existing arrangements, to enable a clearer balance between supply and demand for domestic and foreign currencies. This balance is critical to the "training wheels" phase of international financial reform. This is the period in which firms learn to deal with heightened exchange rate flexibility and banks learn to deal with two-way cross-border capital flows. By adjusting the axis of the foreign exchange/capital account where the foreign pressure was most strongly brought to bear, China has impaired its near-term ability to reform the other arm.

Thus, China has chosen a reform chronology that is out of step with our assessment of the optimal theoretical conditions for this delicate process. It is a struggle to paint this move as anything but politically designed. The economic impact will not be significant, so it bears little risk from a growth perspective. As an open policy of diplomatic appeasement, it is short of the mark but certainly shows a willingness to engage and compromise. However, as an important initial step in a sharply defined strategy to reform the structure of China's economic institutions, it falls down rather badly.

Huw McKay is a senior international economist at Westpac Bank in Sydney, Australia. He is the bank's spokesperson on pan-Asian economic and market issues, and manages the bank's foreign exchange and global growth forecasting processes.
Mr McKay is a long-time proponent of gradualism regarding
the deregulation of China's international financial infrastructure.

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.