Peter Pang: Capital account liberalisation - international experience and
implications for China
Opening speech by Mr Peter Pang, Deputy Chief Executive of the Hong Kong Monetary
Authority, for the conference "Capital account liberalisation: international experience and
implications for China", Hong Kong, 17 November 2008.
* * *
Good morning, ladies and gentlemen.
It is my great pleasure to open this conference on "capital account liberalisation: international
experience and implications for China".
This conference is taking place at a crucial time, as one of the most tumultuous periods in
the financial history has put to test our ability of crisis management. Even as governments
across the world keep their focus on the immediate task of stabilising financial markets and
supporting economic growth, wide-ranging discussions are already under way as to what
lessons can be drawn from the crisis. These discussions are likely to affect many aspects of
policy thinking on how best to monitor and manage risks in the financial system in order to
achieve sustained economic growth and prosperity.
The topic of this conference - the costs and benefits as well as experiences of capital
account liberalisation - is likely to be one such area of intense interest, particularly from
emerging markets' point of view. As financially more closed economies have been less
affected so far by the global turmoil, the merit of financial liberalisation and greater opening
up to the rest of the world by the emerging economies has been questioned. Indeed, this
crisis has brought us to a juncture where a better understanding of capital account
liberalisation - through learning from in-depth analysis and open debates - is required in
order to formulate better policies in the area.
The potentially destabilising effects that capital flows could inflict on the domestic economy
are widely recognised. When it rains, it pours: as noted by an NBER research, capital flows
tend to be pro-cyclical.1 Large influxes of capital could push up the value of currencies, drive
up inflation and fuel asset bubbles, while affecting the competitiveness of the export sector,
posing challenges to the authorities of the host country in managing domestic monetary
conditions and maintaining financial stability. Capital flows can also quickly reverse, often
driven by changes in market sentiment or external environment. The "sudden stops" of
capital flows have, in recent decades, brought severe financial stress to emerging markets,
with substantial costs to the real economy. Such volatility is perhaps one main reason why
the cross-country studies on growth benefits of a more open capital account have remained
largely inconclusive. The current financial crisis brings home the message that integration
with the global financial market could expose a country to global financial turbulence even
when its own financial sector and real economy are fundamentally sound.
Despite the recent turbulence and the spillover effects of capital flows, we should not, in my
view, lose sight of the many benefits of an open capital account. Free flows of capital across
borders can make the domestic financial market deeper and wider, increase liquidity, and
facilitate price discovery, thus improving efficiency of resource allocation. At the same time,
diversification by investing overseas can help raise investment returns for households, which
would in turn help promote private consumption and support sustainable growth. For
emerging markets in particular, participation of foreign financial institutions can speed up the
learning process and facilitate the adoption of best international practices by the financial
sector. Therefore, while a more liberal regime for capital flows could at times bring about
negative impacts, the relevant response should not be to keep the capital account closed
forever, but to find ways of effectively managing the potential risks.
International experiences have provided some broad suggestions on how such risks could be
managed. Foremost is the importance of appropriate sequencing between liberalising the
capital account and other domestic reforms. Development of financial institutions and
markets, enhanced macroeconomic stability, and proper risk management by banks and
enterprises would help to increase the resilience of the domestic entities in dealing with
volatile capital flows. In addition, prudential regulation and supervisory framework need to be
established, in order to prevent excessive risk-taking by domestic financial institutions. Such
framework needs to be accompanied by adequate accounting, auditing and disclosure
standards, to improve market transparency and enhance supervisory effectiveness.
Turning to Mainland China's experience, the liberalisation of capital account has been
selective. Inflows of foreign direct investment have long been encouraged, which has
contributed significantly to China's robust economic growth. In more recent years, steps have
been taken by the authorities to allow greater portfolio flows. In particular, the Qualified
Foreign Institutional Investors (QFII) schemes have enabled foreign investors to access the
domestic financial market, while under the Qualified Domestic Institutional Investors (QDII)
schemes, financial institutions can, upon approval, invest overseas on behalf of domestic
investors.
Reflecting the limited channels of outward investment and market conditions, however,
capital flows have been overwhelmingly inward bound in recent years, and China has
experienced a rapid accumulation of foreign exchange reserves. This had fed into pressures
on the exchange rate and inflation which were only eased somewhat by the global economic
slowdown in more recent months. The People's Bank of China has employed sterilisation
through open market operations, reserve requirements and credit quota in order to offset the
impact of capital inflows on domestic monetary conditions. Such measures, however, have
incurred costs to the central bank and the banking sector. Thus it would be useful to consider
ways in which outflows of capital can be liberalised in an orderly and regulated manner to
alleviate the BOP pressures in the near term. From a longer term perspective, greater
financial integration with the rest of the world is probably inevitable, with China now
becoming the fourth largest economy and the third largest trading nation. Indeed, large
financial crises in the past such as the Mexican crisis of 1994 and Asian crisis in 1997-8 have
not prevented global financial integration.
An open capital account has been generally considered as an ultimate policy objective in the
Mainland, as its many benefits are well recognised. However, there have been lots of
debates mostly with regard to the pace of the reforms. Although the stable macroeconomic
conditions, the improvement of the financial institutions' balance sheets, and the enhanced
supervisory framework in recent years have increased the economy's resilience, there are
vulnerabilities. Most notably, financial market development and the price discovery
mechanisms are still at their early stage, and the risk management capacity of the financial
institutions and the corporate sector remains limited. It is therefore understandable that
Mainland policymakers would prefer a gradual, controllable process in capital account
liberalisation, in order to reduce the shock on the domestic financial system from capital
flows.
Hong Kong fits well into this prudent strategy. It is well positioned to help the Mainland to
manage the process of liberalisation, while ensuring important reforms move forward
steadily. This unique role derives from Hong Kong's proximity with the Mainland and shared
culture and language, the close cooperation of the financial authorities of the two sides, and
importantly, Hong Kong's status as a well-established international financial centre. I will
point out two particular areas for such cooperation.
First, Hong Kong can be used as a platform for pilot schemes for further expansion of
crossborder fund flows. The use of Hong Kong as a financing platform has played an important
role in Mainland's economic development and a continued and expanded use should be
made going forward. In addition to the well developed platform for Mainland enterprises to list
on the Hong Kong's stock exchange, consideration could be given to facilitate SMEs to raise
funds through bond issuance with credit enhancement in Hong Kong. At the same time,
Hong Kong can serve as a platform for more investment outflows from the Mainland, which
would improve investment choices for Mainland investors. For instance, financial instruments
issued in Hong Kong could be allowed to be listed on the Mainland, or Mainland investors
could be allowed to use their own foreign currency deposits to invest overseas through Hong
Kong.
Second, Hong Kong can be a testing ground for the international use of the renminbi, a
process closely related to Mainland's capital account liberalisation. The renminbi business
scheme in Hong Kong, which is supported by a clearing arrangement provided by the
People's Bank of China, has developed steadily since its launch in early 2004. It has now
extended from personal banking to bonds issuance by Mainland financial institutions.
Renminbi deposits in the Hong Kong banking system have also risen significantly over the
last few years. Further expansion of renminbi business into trade settlement and related
financial services would bring convenience for traders and enterprises on both sides. More
importantly, it will help to lay the ground work for the use of renminbi for trade related
activities through a formal and supervised channel.
The demand for a wider use of renminbi outside the Mainland is likely to increase further as
the Mainland economy grows. In addition, the recent global financial turmoil has highlighted
the need for a more diversified international monetary system, including more currency
choices for international transactions. In time renminbi could be one of the obvious choices
for many countries. In this process, using the well-established institutional framework of
renminbi business in Hong Kong for pilot schemes will enable better monitoring and
assessment of the flows, and mitigate the potential risks particularly on the domestic
monetary policy management.
One important pre-requisite for designing appropriate policies to facilitate the Mainland's
capital account opening is a good understanding of the economy and financial system. Here
at the HKMA, we have closely monitored, as well as undertaken in-depth analytical work on
the Mainland economic, monetary and financial developments. Our Half-Yearly Financial
Stability Report has a section devoted to the Mainland economy, and research reports on the
Mainland are published as working papers available on our website. We also started in 2006
a China Economic Issues series dedicated to detailed analysis of economic and financial
market issues in the Mainland. This conference series is also a good way to organise
informed discussions on the Mainland's financial sector issues.
The first part of the conference examines the experiences of Chile, India, Korea and Thailand
in their capital account liberalisation, with the view of drawing useful lessons for Mainland
China. The second part focuses on the Mainland, assessing the effectiveness of current
policies in dampening the impact of capital inflows on the domestic economy, their costs, as
well as policy options of outward investment. A final paper will gauge the current level of
financial integration between the Mainland and Hong Kong, and discuss the policy
implications. I am pleased that this conference has brought together a group of experienced
researchers and policymakers from a wide range of central banks, international organisations
and research institutes. As earlier noted, the recent global financial turmoil will probably turn
out to be the most critical time in recent economic history which will shape future economic
and policy thinking. I hope this conference can provide a useful platform for fruitful
discussions on capital account liberalisation to enhance our understanding on the issue.
I wish the conference great success.