China is a major force in international trade but not in finance. The author outlines a number of weaknesses in China’s financial markets as well as suggestions for reform. He argues that the political leadership’s fear of instability will make it unlikely that the capital account will be liberalized quickly.
The author discusses China’s standing in the world economy and highlights the dichotomy between developments in trade and in the financial markets. Outlining current weaknesses in China’s financial architecture as well as needed improvements, the author argues that a gradual approach toward capital account liberalization is most likely and predicts a slow but steady increase in the importance of the yuan in international trade.
How Is This Article Useful to Practitioners?
Although China is a major force in international trade, its role in finance is still limited. Foreigners can build factories, but they cannot buy bonds. The Chinese can buy the goods of globally active companies, but they cannot buy the companies’ shares. China is a major buyer of oil, but the corresponding derivatives are traded elsewhere.
The author argues that such contradictions cannot continue indefinitely and that a bigger role in finance would benefit China in various ways. A floating yuan would provide several advantages, such as the easier adjustment of trade imbalances and a heightened status as a global reserve currency.
China has already taken important steps to implement the necessary financial infrastructure and institutions. Examples include the extensive swap lines with foreign counterparts established by China’s central bank and the formation of the Asian Infrastructure Investment Bank. China holds 26% of the votes, which provides veto power over important decisions, but more reforms are needed. These reforms include improving stock market regulations, strengthening the independence of the central bank, and privatizing state-run enterprises.
The liberalization of the financial markets is ultimately a political issue, and China’s leadership appears unwilling at the moment to take the bold steps necessary out of fear of instability in global financial markets. In the opinion of the author, a gradual approach is more likely. A logical next step is the strengthening of the yuan’s role in trade flows, especially in the settlement of oil and other commodity purchases.
As recent financial history has shown, China’s government may be well advised to move cautiously in its efforts to open up the capital account. This advice is good news for the US dollar because its leading role in the global financial architecture is unlikely to be challenged in the near term.