China’s Next Big Round of Economic Reform

There is every sign that the new Chinese leadership is contemplating a major round of economic reform comparable to that when Zhu Rongji took China into the WTOmore than a decade ago.

China’s accession to the WTO had a profound effect on the global trading and economic system.

As China’s markets were opened up, Chinese and international traders became confident in exchange of commodities with China. It had an even more profound effect in the way China’s economy and markets and institutions operated. Before China’s accession to the WTO, the market system was being opened up but was still under-developed. Prices in Chinese commodity markets — for agricultural and manufactured goods — were set in a variety of ways but independently of their prices in the international market place. There was a big wedge between Chinese and international goods prices, the size of which reflected the protection of Chinese industry and state intervention in Chinese markets. On the 15-year march towards accession to the WTO and after accession there was steady convergence of the prices of Chinese goods towards international prices, as the Chinese leadership committed to liberalisation and abiding by the rules and norms of the international trading system. There remain, of course, some exceptions but they are trivial in considering what this reform meant for the way in which the Chinese economy is organised and how it is now deeply integrated into the international economy.

This big round of Chinese economic reforms and China’s commitment to the rules of the liberal international trading system was a major triumph. It supported a remarkable acceleration of economic growth and the transformation of Chinese and international welfare and prosperity.

Chinese reform, of course, still has a way to go.

The focus, especially since the global financial crisis, has been on structural imbalances in the Chinese and international economy. They are associated with incomplete reform in the major factor markets, particularly the financial and capital market. There are different ideas about what the priority should be in China’s reform agenda but it’s clear that financial and capital market reform are at the core of everything else that has to be done now.

Financial and capital market reform, like reform of commodity and goods markets earlier — through accession to the WTO — has a crucial international dimension. There will only be true reform of Chinese capital and financial markets when they are more fully integration with international financial and capital markets. That requires, at its core, liberalisation of China’s international capital account so that Chinese firms and individuals are free to buy international assets with minimal controls and foreign firms and individuals are similarly free to buy Chinese assets.

Liberalisation of China’s capital account is now at the front line of economic reform in China and the new leadership will be closely focused on how to achieve this and manage all its attendant impacts on the organisation of China’s economy and political system in the smoothest way possible.

Liberalisation of the Chinese capital account is deeply related to the Chinese economy’s status in the international financial system and whether the Chinese currency, the RMB, can become an international currency like the US dollar, the euro or the Japanese yen. The scale of the Chinese economy suggests that one day the RMB has the potential to match and vie with the US dollar in international currency arrangements. The Japanese economist, Takatoshi Ito, who has written most authoritatively on this subject, observes that this will become so only if a number of important conditions are met. These include the liberalisation of interest rates, benchmark financial products such as government bonds with standard maturities being issued and traded in large volume, entry of foreign financial institutions into the Chinese market and the easing of inward and outward capital flow restrictions.

This week’s lead essay by Liu Dongmin notes that president Xi Jinping’s first travel within China after becoming president led him to Shenzhen and in particular to Qianhai where the Chinese authorities are experimenting with an open financial zone between Qianhai and Hong Kong. This is typical of China’s approach to step-by-step reform, testing models and institutions for wider application across the economy. It is clear that ‘Qianhai is a pilot program for internationalising China’s currency and opening up the capital account’, Liu says, and that the Qianhai experiment in internationalising the RMB has a ‘significant purpose — to set up a ‘reverse transmission mechanism’; that is, to force internal financial reforms’.

This is a small beginning but the funds that are already beginning to trickle between Qianhai and Hong Kong would turn into a veritable torrent of financial flows into and out of the Chinese economy when there is serious commitment to liberalisation of the capital account over a longer period of time. This step would not only change the way in which Chinese capital markets work but also, of course, have a deep impact on the way in which businesses, banks and financial institutions relate to the international market and also — through the necessary changes in the way state owned banks operate — the domestic political process.

Liberalisation of the capital account was raised in the World Bank’s China 2030 report with which premier Li Keqiang was closely associated. There is likely to be an important signal of intent on pushing forward on liberalisation of the capital account when the Central Leading Group on Financial and Economic Affairs outlines its blueprint for reform later this year in October to the Third Plenum of the 18th Communist Party Congress. It will be an important more generally of the new Chinese leadership’s reform credentials.

Peter Drysdale is Editor of the East Asia Forum.