Opening China’s Capital Account – An Irresistible Force Meets an Immovable Object

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Op-Ed Commentary: Chris Devonshire-Ellis

Nov. 7 – Over the past three weeks in the United States I have been meeting with many businesspeople, lawyers, VC firms and hedge funds, and when it comes to China, the first questions I’m asked almost always concern reform in China – specifically over the opening up of China’s capital account. Such a move, if it happened, would permit free flow of the RMB into and out of China and introduce a currency fully convertible on the world’s trading floors.

The reason this has become a hot topic recently has been to do with recent announcements concerning the Shanghai Free Trade Zone, and apparent moves by China to “liberalize the currency” and introduce “financial reforms.” Free trading of the RMB in the Shanghai FTZ was also announced. Yet behind the intention, little if any infrastructure has been put in place to see these announcements come to fruition, and no implementing rules have been introduced to explain how these reforms would actually work.

That has got everybody looking towards the Third Party Plenum, which is to be held later this month, for indications towards the direction of China’s future reforms. The Communist Party leadership typically announces strategic reforms at these meetings, and indeed China’s Development Research Center (DRC) has just recently listed numerous areas of reform that would be discussed at the Plenum. These range from the breaking up of specific state-owned monopolies, the abolishment of the hukou system, and financial reform.

On that latter-most subject, which has generated so much interest in New York, London and so on, the DRC had this to say: “(there would be) lower entry barriers to financial markets to form a diversified competitive financial system, to propel interest rate liberalization and RMB internationalization.”

The key phrase here is “RMB internationalization” which can frankly mean anything. It could point to an opening of the RMB to international free trade, or it could equally mean conducting more swap deals with other countries’ currencies, just as China has recently conducted with Indonesia for example.

Opening up the RMB to international trade would be a good thing for China in the longer term, as it would settle the currency down to established global market norms and do away with the government’s dependence upon having to constantly buy U.S. debt. It would also allow Chinese manufacturers far easier access to international markets, and the Chinese government has indicated it wishes to move in this direction. The DRC has also stated that “Macro-economic measures such as monetary and fiscal policies will be used to adjust the market instead of direct government intervention.” This means that China apparently recognizes the need to open up its capital account and will do so in time. It is an irresistible force.

However, much as I would like to see China open up its current account, I don’t think that it is going to happen anytime soon. To allow the RMB to freely exit the country would lead to massive capital flight, which in turn would completely destabilize the Chinese economy, burst the housing bubble in a spectacular crash, and lead to mass social unrest as property prices collapse and Chinese homeowners end up with negative equity and massive debts owed to China’s state-owned banks. The Chinese public would be outraged and the nation (and its banking institutions) would effectively be faced with a huge repeat of the U.S. sub-prime housing crisis.


This 5-bedroom detached property in Toronto close to Lake Ontario was recently sold at just 30% of the cost of a 3-bedroom apartment in Shanghai’s Pudong

To illustrate why, a simple online search explains the reality. A 3-bedroom luxury apartment in Shanghai’s Pudong District is currently selling for about RMB18 million – roughly equivalent to US$3 million. The 5-bedroom detached house pictured to the right is near the shores of Lake Ontario in Toronto, and recently sold for US$900,000, or about 30 percent of the total cost of the Shanghai apartment.

Opening up China’s capital account would lead to mass movement of capital out of China to buy properties such as the one above. The Toronto property and many others like it are simply far better value. That, in turn, will lead to a collapse in value for the likes of the Pudong apartment, currently on sale for over three times as much. To say there is no property bubble in China is nonsense, yet the repercussions of pricking this bubble are akin to them being an immovable political object. China simply dare not.

So what happens when an irresistible force meets an immovable object?

In China, one or the other will prevail over time. But while the economists and strategic planners wait for other influences to arrive to break this deadlock, nothing much will be done. The only constant is change of course, but quite how that change will come about, and what as yet unknown influences will come to break this impasse remains unknown. In short, China will not open its capital account anytime soon, until the problem over its property bubble can be fully addressed.

Chris Devonshire-Ellis is the Founding Partner of Dezan Shira & Associates – a specialist foreign direct investment practice providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.

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