China’s Financial Liberalization: A Delicate Balancing Act

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NANJING — Internal and external pressures have built for China to liberalize its financial system since its admittance to the World Trade Organization in 2001. By announcing and starting the implementation process for the Shanghai Free Trade Zone, the Chinese government has demonstrated that it now accepts that its ability to effectively manage an increasingly complex economy has diminished. In order to accomplish the goal of becoming an international financial hub, China must liberalize its capital controls, interest rate controls, and the Renminbi while remaining sensitive to the needs of its primary industries: manufacturing and exports.

According to Han Shen Lin, SAIS alumnus and current Senior Vice President of Wells Fargo’s Shanghai Branch, capital controls scare foreign direct investment away in many cases because investors desire certainty that they will be able to get their money out of China. Current regulation is not conducive to normal business operations of large international corporations because such entities need to move large sums of money freely. Regardless, the Chinese Communist Party hesitates to relinquish their controls because of their conservative approach to monitoring foreign money.

Interest rate controls also present a huge problem for the Chinese government. Currently, regulatory institutions set the interest rates for financial products offered by Chinese banks. In addition, the government subsidizes losses taken by these banks due to defaults on loans. This system has not efficiently allocated capital because banks have no incentive to analyze risk properly, which incurs huge costs for the Chinese government. When interest rates are allowed to fluctuate according to normal market forces, banks will begin to operate as profit-seeking entities and offer a wider variety of services to diversify income sources.

Renminbi internationalization, the most high profile aspect of China’s liberalization plan, also presents the biggest conundrum to China’s leaders. China has faced extreme pressure regarding allowing RMB exchange rate flotation for several years. They hesitate to relax their control because of the volatility that will inevitably result from doing so. Manufacturing and exports still drive Chinese GDP, and the country cannot transition to a service-based economy like that of the United States. RMB exchange rate volatility will cause the value of the RMB to rise compared to the USD, and Chinese labor and goods will become relatively more expensive globally. Companies would then move their operations to other developing countries such as Vietnam. Chinese exports and GDP would both crash down to Earth.

Special thanks to Mr. Lin for his contributions to this article.

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