1. Course and current state of China’s financial opening

Reform and opening was instituted from 1978 until the end of the century and, although China’s foreign trade appeared poised to continue to expand, the financial authorities remained essentially mired in a closed mode. This situation gradually began to change in 2001 after China’s accession to the World Trade Organization. From the gradual easing of restrictions on investment inflows and outflows and by introducing such capital market opening initiatives as the Qualified Foreign Institutional Investor (QFII)/Renminbi Qualified Foreign Institutional Investor (QFII), Qualified Domestic Institutional Investor (QDII), the ‘Shenzhen-Hong Kong Connect,’ the ‘Shanghai-Hong Kong Connect,’ the ‘Bond Connect,’ and the ‘Wealth Management Connect,’ approvals for bond issuances abroad changed to a filing and registration system, then eliminated the equity ratio for foreign investors buying into banks and other financial institutions, and thus the extent of China’s financial opening rose overall.

It must be noted, however, that, even after 20 years’ effort, the level of opening among China’s government departments is still very low. As data from the Organisation for Economic Co-operation and Development (OECD) shows, if the combined total of a country’s external assets and liabilities, divided by GDP, serves as an indicator measuring the degree of its financial opening, then, as of the end of 2022, China’s financial opening was a mere 88.44 percent, whereas the average of OECD countries is 543 percent. In other words, based on this indicator, China’s degree of financial opening is just 16.29 percent¹ of the average of OECD nations. Let us look at some other indicators. Former People’s Bank of China Deputy Governor Ms Hu Xiaolian noted in a speech that, as of September 2023, foreign banks operating in China’s total asset amount had reached RMB3.79 trillion, making up about 1 percent of national banking institutions total assets (this metric is about 2 percent lower than the level at the time of China’s WTO accession); foreign finance insurance institutions’ total assets were some RMB2.33 trillion, accounting for 8 percent of the national total of insurance institutions; funds managed by foreign institutions in China’s bond market made up 2.4 percent of the total of managed funds in China’s bond market, while the proportion of foreign-held A share circulating capital in the Chinese market was about 4.35 percent² of the total value of capital circulating in the market. Therefore, it is not difficult to discern from this that China's degree of financial opening is not only lower than that of developed countries, but also lower than that of no few emerging market economies, and far from the requirements of high-level financial opening.

Noteworthy is that, following the introduction of various successive measures to expand opening in recent years, and in particular since the cancellation of various investment restrictions since 2018, the results do not appear satisfactory. The reasons for this may relate to such aspects as the business and investment environment - especially market access - the legal environment, and intellectual property protection in relevant areas, which still need improvement. After the expansion of institutional opening, if one desires foreign investors to actively flood in, one needs to ensure better transparency and consistency of policy. To adduce an analogy, when the door opens, whether one enters or not largely depends on whether the room within is bright and tidy.

2. Significance and import of high-level financial opening

The Report of the 20th National Congress of the Communist Party of China proposed to promote high-level opening to the outside world. It is among the fundamental content of high-level opening to the outside, and high-level financial opening is undoubtedly a key item on its agenda. The Finance Work Meeting convened at the end of last year proposed the objective of building up a financially strong nation, and set forth six core elements for this, i.e.:  possessing a powerful currency, a powerful central bank, powerful financial institutions, a powerful international finance center, powerful financial oversight, and a powerful financial workforce. One may recognize that fostering and fortifying these six core elements is inseparable from continuing the steady pace of advance of financial opening.

The import of high-level financial opening may include four fundamental aspects. One is continuing to simplify or eliminate various unnecessary administrative regulatory measures to elevate the institutional level of opening, and coupling rules, regulations, and norms to international ones. Two is, with a more open institutional environment, improving the business and investment environment, which will cause China to become an important place for global financing and capital allocation and, by elevating the overall extent of opening, the main indicators of openness may reach or even exceed the average levels of mid- and high-income emerging market economies. Three is for Chinese residents to have more opportunities for their own wealth to participate in global capital allocations. Four is to enhance foreign-related financial oversight and ensure financial risks can be controlled after the process of elevating the level of openness.

Concrete manifestations of promoting the import of high-level financial opening inhere in the various aspects that follow. First is boosting the prosperity and development of China’s high-level market economic system. Since the adoption of reform and opening in 1978 and particularly following its accession to the World Trade Organization in 2001, China’s economy has widely integrated with the global economy. Introducing various types of foreign investment has caused the competitive market economy to constantly strengthen, and thus economic vitality has been markedly enhanced. Encouraging competition is one essential feature of the socialist market economy, and an important source of China’s rapid 30-year growth. Expanding financial opening may encourage Chinese financial enterprises to participate more in domestic and international competition, induce them to provide better quality services, and elevate their innovation and development ability.

Second is expanding the openness of financial services by entering into such high-standard open cooperative frameworks as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which will aid in hastening their coupling with international trade and financial rules and in elevating China’s domestic financial institutions and internationalizing their business spaces and expansion ability, thereby providing various improved ‘going overseas’ financial services for current and future domestic enterprises. Impacted by geopolitical factors, China’s private enterprises have hugely increased their investments in Southeast Asia, Mexico, and Canada in the last two years in a bid to circumvent some countries’ imposition of exorbitant tariffs and other trade obstacles. These enterprises have a great demand for cross-border financial services. Expanding the financial services industry’s bi-directional opening can thus better satisfy their development needs.

Third is steadily elevating the degree of opening of capital accounts by being able to effectively enhance China’s macroeconomic administrative ability to a certain extent, thus avoiding mistakes in formulating economic policies. Much relevant experience demonstrates that the more a country opens financially, worries induce capital flight or ‘voting with one’s feet,’ and often the more self-restrained a country’s fiscal and monetary policies are, so the fewer mistakes will be made as a result. An open capital account can indeed contribute to errors in macroeconomic policies, e.g., excessive reliance on external debt may delay needed adjustments in balance of payments and macroeconomic policies. There are however grounds to believe that increasing capital account convertibility and attainment of a high degree of financial openness are clearly more apt to make the economic policies of a responsible, people-oriented government sound and rational, rather than the converse.

Fourth is promoting the external economy’s long-term, balanced development. China was originally a country with a high rate of savings, but this situation may be undergoing change. The national 50 percent savings rate of 2010 had already fallen to a pre-pandemic 45 percent. Although this has rebounded in the past two years, when viewed from the mid- to long-term and accompanied by the advent of the era of aging, the Chinese savings rate is very likely to drop even further, and this may trigger a current account deficit. Furthermore, in the wake of the financial crisis and pandemic, China’s overall debt ratio has continued to rise, and currently already exceeds 270 percent (if hidden [or implied/Implicit] local debt is included, this indicator may already exceed 310 percent). Viewed from the perspective of intertemporal equilibrium, the future gradual repayment of these debts will render a decline in savings and a current account deficit inevitable. China thus needs to encourage more foreign capital to enter by expanding opening, so as to offset the current account deficit and promote long-term equilibrium in the country’s external economy.

Fifth is to promote the Internationalization of renminbi (RMB). As a key component part of China’s strategy of opening to the outside world, RMB internationalization got off to a start from scratch in 2009, with achievements that are now conspicuous 10-plus years on. However, low capital account opening has become a major hindrance to its continuing growth. In the most recent two years, China has concluded agreements with some other developing countries to use their local currencies for bilateral trade settlement. This serves a certain function in furthering RMB internationalization. Yet it must be recognized that using RMB in international trade is often subject to the bilateral balance of trade. Once China has a trade deficit, such a settlement deal will not long survive without China’s provision of RMB-denominated financial assets to the other country (the payment agreement China signed with the former Soviet Union is a prime example here). In fact, only when other countries are willing to use RMB in settlement when conducting trade among themselves will RMB be able to become a third-party currency widely used in their mutual trade, and only then can RMB internationalization truly rise to a new height. But whether or not it can become a third-party currency (often called a ‘vehicle currency’) will be determined by whether China can provide a developed and open RMB asset market in which foreign investors have abundant opportunities to conveniently hold Chinese bonds and other RMB-denominated financial assets. In sum, RMB internationalization will be unable to further progress without financial opening or RMB convertibility under capital account.

Sixth is to aid in the choices of enterprises and individuals engaged in investments in the international sphere to diversify and disperse [them] so as to better manage investment risks. From a mid- to long-term perspective, expanding the opening of capital accounts not only means further easing capital inflow restrictions, but also gradually relaxing capital outflow controls. Enterprises’ internationalized business and individuals’ global wealth allocations can reduce the instability of and risks to their business income and thereby exert a positive impact on economic growth and financial stability.

3. Rational risk management in the course of high-level financial opening

In late 2023, the Central Financial Work Committee proposed to expend efforts to promote high-level financial opening to ensure the security of the nation’s finances and the economy. From simply highlighting the expansion of financial opening to underscoring the simultaneous promotion of guarantees of the security of the nation’s finances and economy, this [shift] thus reflects the certain changes underway in the policy thinking of relevant departments confronted by the complex and severe domestic and international situations.

In the present and in future periods, continuing financial opening may primarily face two major risks. How these should be rationally assessed and responded to will require careful analysis.

One, in expanding financial opening, especially after further opening of capital markets to the outside, China’s economy may easily suffer various external shocks. Beset by the impact of fluctuations in international growth, changes in major developed economies’ monetary policies, and some sudden international events, large inflows and outflows of international capital (particularly security portfolio capital) will be difficult to entirely avert, and these may lead to fluctuations in asset prices and exchange rates. If the fundamental domestic macroeconomic aspect is unsound, the likelihood of these shocks occurring is quite high. Yet if we are able to preserve a favorable macroeconomic aspect, above all by preventing the occurrence of major economic policy mistakes, then the probability of these shocks occurring will be greatly reduced - in layman’s terms, the axiomatic ‘flies don’t bite uncracked eggs.’ At times, even in the absence of macroeconomic problems, purely external shocks may indeed arise. At such times, sound economic policy (proper, timely adjustment) is also a natural barrier to avert such shocks.

Risks exist objectively. Proactive and effective responses embody a subjective initiative function and determine to a large extent whether risks transform into actual shocks. If decision-making departments can ultimately maintain a positive macroeconomic policy, particularly sound monetary and exchange rate policies, and strengthen prudent macroeconomic oversight when necessary, then one need not be overly concerned about shocks to cross-border capital flows. Actually, in this regard, China has already amassed no few successful experiences. For example, in the last two years, confronting the shocks of aggressive interest hikes by the United States Federal Reserve, and based on the mindset of ‘Looking out for Number One,’ the People’s Bank of China has successfully responded on the one hand by tolerating RMB depreciation to an appropriate degree, and on the other by imposing a heightened long-term reserve ratio for foreign exchange sales, downwardly adjusting the foreign currency reserve ratio of financial institutions, and upwardly adjusting the macroeconomic parameters of regulation of cross-border financing. It may be said that these are classic successful use cases countering the Mundellian Trilemma [also ‘impossible trinity’].

Two, geopolitical conflicts and big-power gamesmanship tend to exert their influence. Will expanding financial opening expose it to the risk of greater financial sanctions? It may indeed. After the outbreak of the Russia-Ukraine conflict two years ago, the US and Europe froze up to USD300 billion in Russia’s foreign currency reserves - also some of importance for the ‘SWIFT’ system itself - which aroused concerns among international society over the weaponization of the dollar and sanctions. In a situation wherein big-power games tend to induce jitters, China may not exclude encounters with the miscellaneous risks of financial sanctions. Thus, because of the trend in recent years in which China has appeared to hasten and enhance trade links with such countries as Russia and Iran, the possibility of secondary sanctions in the trade and financial spheres cannot be disregarded.

Nonetheless, from the perspective of these nations currently suffering under US-European sanctions, the extent of financial openness of neither is high. One may therefore deem no direct nexus to necessarily exist between the risk of sanctions and financial openness. Aside from the occurrence of exigent circumstances, the results of expanding financial openness may well cause the opposite situation to eventuate. Because two countries’ financial links become ever deeper, so the costs of one country imposing economic sanctions on the other rise ever higher, and this thus lowers the likelihood of such sanctions. Furthermore, if residents are allowed to independently increase their overseas investments, national foreign currency reserves are likely to shrink, thus considerably reducing the risk of these foreign currency reserves being frozen.

If superpower tensions persist in China-US relations, the risk of increasing capital flows abroad will predictably increase. As past experience shows, as regards such outward flows, timely imposition of strict controls can only with great difficulty put a complete stop to them, because multiple channels may be used to divert capital. Moreover, with respect to relevant direct supply-chain investment outflows, although we would not wish to witness their occurrence, yet these acts conducted in the ordinary course of business cannot be artificially stopped, either. Actually, the key to controlling these kinds of risks does not inhere in economic events themselves, but in whether one can control big-power games, and especially China-US bilateral relations. Last year, Morgan Stanley’s Director of Asia-Pacific, and economist and Yale Prof Steven Roach propounded his vision of establishing a China-US secretariat, [an idea] which warrants our serious study. Strengthening communication and exchanges and expanding the number of treaties to the extent possible in every area is key to preventing further China-US technological and trade decoupling, and is also key to preventing the risks of capital outflows. China’s economic growth potential remains enormous, so if we can constantly accelerate development of new value production capability, continue to optimize the business and investment environment, and do well in such areas as building up the legal regime and intellectual property protection, then the result of expanding bi-directional financial opening will certainly be increased capital flows, rather than the converse.

4. Master planning for high-level financial opening, financial security

Five years ago, to commemorate the 40th anniversary of reform and opening, this author wrote a short essay that summarized four items³ in China’s successful capital account convertibility. Firstly, was correctly choosing the opportuneness and sequence of issuance of reform measures. China’s capital account opening was gradually promoted following liberalization of trade, domestic finance, and the reform of the modern enterprise system in accordance with the general rules Prof Ronald McKinley laid down for the sequence of transitional economic policy, and thus essentially avoiding financial turbulence in the course of the transition to a market economy. Secondly, was the persistent adoption of ‘pilot and [then] expand,’ this reform model so clearly imbued with a Chinese character, such as the timing for relaxing direct investment restrictions, from industry selection to gradually expanding monetary amounts, undergoing pilot testing and expansion; when reducing restrictions on securities investments (QFII, QDII, RQFII), selecting institutions and varieties, to amounts, all these were also chosen for gradual expansion. This reform model lowered ‘trial and error costs’ and averted large-scale financial risks induced by expansive financial opening. Once more， confronting adjustments in US Federal Reserve monetary policy, using major reforms such as the 8.11 exchange rate system, relevant oversight departments strengthened temporary capital controls in a timely manner in the face of sudden domestic and external shocks and thus averted even larger-scale exchange rate fluctuations. These response measures have also elicited recognition from the International Monetary Fund in the last 10 years⁴. Lastly, strengthening the sustainability and steadiness of advancing prudent macro regulation and necessary micro financial supervision of reform of capital account convertibility has been of key significance. In this area, as previously noted, China has already amassed no few successful means of providing important assurances of effectively preventing financial risks.

The successful experience mentioned above will still hold important guiding significance in China’s current and future overall planning for high-level financial opening and financial security. Presently, the China-US economic cycles are out of step, dollar interest rates remain high, and the China-US interest disparity is relatively apparent. In such an environment, strengthened harmonization between exchange rate policy, monetary policy, and capital flow management policy is the one key to master planning of financial opening and financial security. To ensure the aims of economic growth, we must continue to adopt ‘Looking out for Number One’ as our policy fundament, ensure a relatively loose monetary policy, and tolerate RMB depreciation to an appropriate degree, while ensuring the utmost the convenience and relative freedom of cross-border capital flows. If panic RMB depreciation and capital outflows do occur and intensify into a vicious cycle, then restrictions on cross-border capital flows must indeed be appropriately enhanced. Furthermore, when confronted by the risks of financial sanctions by European and American countries while continuing to steadfastly advance financial opening, RMB internationalization must be actively promoted, particularly by accelerating the building of a system of direct RMB cross-border settlement payments.

References：

1. This indicator of financial openness is also referred to as a ‘fact-based’ (de facto) openness indicator. Original data derives from Milesi-Ferretti G. M., ‘The External Wealth of Nations Database,’ the Brookings Institution, 2023

2. ‘High-level financial opening space is huge, still needs more effort,’ https://www.chinatradenews.com.cn/epaper/content/2023-12/26/content_87525.htm

3. Zhang Liqing, ‘The Process of Capital Account Convertibility in China: Experience and Outlook,’ published in the seventh issue of China Foreign Exchange on April 1, 2019

4. Zhang Liqing et al.,‘The IMF’s Shifting Views on Cross-Border Capital Flows,’ published in the 11th issue of China Foreign Exchange on June 1, 2022

This article was first published by China Forex.

Author: Prof Zhang Liqing, Member of the IFF Academic Committee