Liberalize capital account controls only when required

By Cecily Liu (China Daily) Updated: 2015-03-02 07:00

The goal of helping renminbi become a global reserve currency has experienced some milestones, as several foreign central banks have decided to hold a small proportion of their foreign reserves in the Chinese currency.

However, the gain from carry trade from holding the renminbi is one key motivation for such measures. This means China is paying out a large amount of interest to foreign central banks for holding its currency over the years.

"China has gained a lot from its currency's internationalization, but such progress is also made with significant costs," Yu says.

He says China should not completely open its capital account controls, as currency stability is an essential part of having a stable economy.

One major issue for China is its high M2 to GDP ratio, meaning much of the country's money is in the hands of a few, and opening up capital account controls too quickly could lead to capital flight, Yu says.

"Although there are no actual figures, there is a lot of anecdotal evidence that many corrupt officials are putting their money offshore, in jurisdictions like the Virgin Islands or Cayman Islands. This could generate a very large capital outflow if adequate controls are not put in place."

Although China's central bank has set a target to make the renminbi partly convertible by this year and fully convertible by 2020, Yu believes the mindset of having such a target is not right.

Instead, the correct method is to segment different market players' needs, encourage foreign direct investment flows into and out of China when there is a real economic need for such flows, but restrict speculative flows.

In the long term, Yu says the renminbi needs to be fully convertible for it to be a global reserve currency, because a reserve currency is one that can be freely traded by those who hold it, so it requires high liquidity.

And in the short term, it is still important for the Chinese central bank to use exchange rate controls to stabilize economic growth in reaction to monetary policies practiced by other major economies, and the quantitative easing about to be implemented in Europe could be an example of this.

According to an European Central Bank announcements last month, at least 1.1 trillion euros will be injected into the ailing eurozone economy, and the program is expected to start next month.

"The QE in Europe could have very negative consequences for the Chinese economy, and it is our priority to guard China's economic growth against such big shocks.

"We are already in a currency war. So either we have international coordination to have no intervention by governments in our financial markets, or alternatively we will need to intervene to reduce adverse effects on our economy brought by other countries' monetary policies," Yu says.