Capital Mobility as Trojan Horse

In my Jacobin piece on finance, I observed in passing that financial commitments across borders — what’s sometimes called capital mobility — enforce the logic of markets on national governments. This disciplining role has been on vivid display in the euro area over the past few years. Here, courtesy of yesterday’s Financial Times, is a great example of the obverse: If a state does want to resist liberal “reforms”, it needs to limit financial flows across the border.

The headline in the online edition spells it right out:

Renminbi stalls on road to being a global currency. New capital controls lead to doubt, especially over hopes of forcing economic reform.

The print edition is wordier but even clearer:

Renminbi reaches its high water mark. Fresh capital controls cast doubt over the push to increase the global use of its global currency. But what does that mean for the Chinese policymakers who saw it as a ‘Trojan horse’ to force through economic reform?

The whole article is fascinating. On the substance it’s really quite good — anyone who teaches international finance or open-economy macroeconomics should bookmark it to share with students. Along with the political-economy question I’m interested in here, it touches on almost all the most important points you’d want to make about what determines exchange rates. [1]

The article’s starting point is that for most of the past decade, international use of the Chinese renminbi (Rmb) has been steadily increasing. Some people even saw a future rival to the dollar. For most of the period, the renminbi was appreciating against the dollar, and the Chinese government was loosening restrictions on cross-border financial transactions. But recently those trends have reversed:

The share of China’s foreign trade settled in its own currency has shrunk from 26 per cent to 16 per cent over the past year while renminbi deposits in Hong Kong — the currency’s largest offshore centre — are down 30 per cent from a 2014 peak of Rmb1tn. Foreign ownership of Chinese domestic financial assets peaked at Rmb4.6tn in May 2015; it now stands at just Rmb3.3tn. In terms of turnover on global foreign exchange markets, the renminbi is only the world’s eighth most-traded currency — squeezed between the Swiss franc and Swedish krona — barely changed from ninth position in 2013.

What appeared to be structural drivers supporting greater international use of the Chinese currency now appear more like opportunism and speculation.

Large financial outflows — including capital flight by Chinese wealthholders and currency speculators reversing their bets — have led the renminbi to lose 10 percent of its value against the dollar over the past year or so. The Chinese central bank (the People’s Bank of China, or PBoC) has had to use a substantial part of its dollar reserves to keep the renminbi from depreciating even further.

… the PBoC remains active in the foreign exchange market as buyer and seller. Over the past 18 months, this has mostly meant selling dollars from foreign exchange reserves to counteract the depreciation pressure weighing on the renminbi.

This strategy has been expensive, contributing to a decline in reserves from $4tn in June 2014 to $3.1tn at the end of November. Defenders of the PBoC believe such aggressive action to curb depreciation has been worth the price because it prevented panic selling by global investors. Critics counter that costly forex intervention has merely delayed an inevitable exchange-rate adjustment.

For years, the IMF, US Treasury and other outside experts have urged China to embrace a floating exchange rate. In theory, such a step should eliminate the need to tighten capital controls or to spend precious foreign reserves on propping up the exchange rate. Instead, the currency would weaken until inflows and outflows balance.

In the age of Trump, it’s worth stressing this point: The Chinese central bank has been intervening to make the renminbi stronger, not weaker — to keep Chinese goods relatively expensive, not cheap. This has been true for a while, actually, although you can still find prominent liberals complaining about China boosting its exports through “currency manipulation”.  Also, as the article notes, the Washington Consensus line has been that China should end foreign-exchange interventions and abolish capital controls, allowing the renminbi to depreciate even further.

For most countries, continuing to spend down reserves would be the only alternative to uncontrolled depreciation. But China, unlike most countries, has maintained effective controls over cross-border financial flows, so it has another option: limiting the ability of households and businesses to trade renminbi claims for dollar ones.

The State Administration of Foreign Exchange, the regulator, last week said it would continue to encourage outbound investment deals that support the country’s efforts to transform its economy… But the agency said it would apply tighter scrutiny to acquisitions of real estate, hotels, Hollywood studios and sport teams.

That will probably mean fewer food-additive tycoons buying second-tier UK football clubs. It also suggests a crackdown on fake trade invoices, Hong Kong insurance purchases and gambling losses in Macau — all channels used to spirit money out of China. …

“They are trying to squeeze out all the low quality or suspicious or fraudulent outbound investment. But they have also made it clear they support genuine high-quality investment,” says Mr Qu.

These moves come on top of other limits on financial outflows. This passage highlights a couple additional points. First, effective controls on financial flows require controls on cross-border transactions in general. Second, there’s no sharp line between macro policy aimed at the exchange rate or other monetary aggregates, and micro-interventions aimed at channeling credit in particular directions.

Now to the political economy point:

China’s recent moves to tighten approvals for foreign acquisitions by Chinese companies, as well as other transactions that require selling renminbi for foreign currency, cast further doubt on China’s commitment to currency internationalisation.

“There is a fundamental conflict between preserving stability and allowing the freedom and flexibility required of a global currency,” says Brad Setser, senior fellow at the Council on Foreign Relations and a former US Treasury official. “Now that the cost is becoming clear, Chinese policymakers may be realising they are not willing to do what it takes to maintain a global currency. Capital controls certainly set back the cause of renminbi internationalisation but they may well be the appropriate step given the outflow pressures.”

As a topic for banking conferences and think-tank seminars, renminbi internationalisation could not be beaten. It offered a way to express dissatisfaction with the US dollar-dominated monetary system, as laid bare by the 2008 financial crisis, while signalling an eagerness to do business with China’s large, fast-growing economy.

For China’s reform-minded central bank, however, renminbi internationalisation … offered something else: a Trojan horse that could be used to persuade Communist party leaders in Beijing and financial elites to accept reforms that were, in reality, more important for China’s domestic financial system than for the renminbi’s international status. Since 2010, when the internationalisation drive began, many of those reforms have been adopted…

This is the dynamic we’ve seen over and over. Real or imagined pressure from the outside — from international creditors , institutions like the IMF, “the markets” in general — is needed to push through a liberal agenda that would not be accepted on its own merits. This is true in China, with its multiple competing power centers and effective if disorganized popular protests, just as it is for countries with more formally democratic political systems. What’s unusual about China’s case is that the “reform” side may no longer be winning.

What’s  unusual about this article is that it’s spelled out so clearly. “Trojan horse”: Their words, not mine.

The article continues:

The totem of currency internationalisation also served as justification for China’s moves over the past half-decade to open up its domestic financial markets to foreign investment, a process known as capital account liberalisation, that has been crucial to the global push of the renminbi. If foreign investors are to hold large quantities of China’s currency, they must have access to a deep and diverse pool of renminbi assets — and the peace of mind of knowing that they are free to sell those assets and convert proceeds back into their home currency as needed.

Again, thinking of classroom use, this is a nice illustration of liquidity preference.

Until last week, regulators had also steadily loosened approval requirements for foreign direct investment, in to and out of the country.  But those reforms occurred at a time when capital inflows and outflows were roughly balanced, which meant that liberalisation did not create strong pressure on the exchange rate. Now, the situation is very different. Beijing faces a stark choice. Either row back on freeing up capital flows — as it has already begun to do this year — or relinquish control of the exchange rate and accept a hefty devaluation.

We used to talk about a trilemma: A country cannot simultaneously peg its currency, set interest rates at the level required by the domestic economy, and allow free financial flows across its borders. At most you can manage two of the three. But it’s becoming clear that for most countries it’s  more of a dilemma: If you allow free capital mobility, you can’t control either the exchange rate or domestic credit conditions. International financial shifts are so large, and so unpredictable, that for most central banks they’ll overwhelm anything that can be done with conventional tools.

And when you accept free capital mobility, with its dubious rewards, it’s not just control over interest rates and exchange rates you’re giving up. In the absence of  controls over international financial flows, the whole range of economic policy — of public decisions in general — is potentially subject to the veto of finance. If you need foreign wealth-owners to voluntarily hold your assets, the only way to keep them happy — so goes the approved catechism — is to adopt the full range of market-friendly reforms. The FT again:

Economists argue that the fate of renminbi internationalisation ultimately depends on far-reaching economic reforms rather than short-term responses to rising capital outflows.

The list of course starts with privatization of state-owned companies and continues with deregulating finance.

“When you reimpose capital controls after having rolled them back, it can sometimes have a perverse effect,” says Mr Prasad… “What they need to do is something much harder — actually to get started on the broader reform agenda and show that they are serious about it. Right now the sense is that there is very little happening on other reforms.”

This is what it comes down to: If China is going to reach the grail of international-currency status, it is going to have to focus on the “reform” agenda dictated by financial markets — it’s going to have to earn their trust and prove it is “serious.” What exactly are the benefits of that status for China? It’s far from clear. (Of course it’s an attractive prospect for Chinese individuals who own lots of renminbi-denominated assets.) But it doesn’t matter as long as it serves as a seemingly objective basis for continued liberalization, which otherwise might face serious resistance.

“The question is which is to be the master — that’s all.”



[1] It doesn’t, of course, mention uncovered interest parity, the idea that interest rate differences between currencies exactly offset expected exchange rate changes. This doctrine dominates textbook discussion of exchange rate movements but plays no role in any real-life discussion of them.

10 thoughts on “Capital Mobility as Trojan Horse”

  1. “In the age of Trump, it’s worth stressing this point: The Chinese central bank has been intervening to make the renminbi stronger, not weaker — to keep Chinese goods relatively expensive, not cheap. This has been true for a while, actually, although you can still find prominent liberals complaining about China boosting its exports through “currency manipulation”. Also, as the article notes, the Washington Consensus line has been that China should end foreign-exchange interventions and abolish capital controls, allowing the renminbi to depreciate even further.”

    There has been a fierce debate on the left – and in the mainstream – as to what extent trade and “globalization” has been bad for workers.

    Imagine if Clinton hadn’t pushed through NAFTA or the WTO or Obama pushed the TPP. Trump wouldn’t have been able to use trade in his populist campaign. This doens’t change just b/c the Chinese have been intervening to strengthen their currency in recent years.

    I agree that the best politics would be for international solidarity which would help improve conditions for foreign workers while improving their living standards.

    To me that means faster growth which can be shared within an environmentally sustainable context if we’re going to be utopian and wishful.

    1. I agree with your larger point. But I think — as I know you think also — that there are other possibilities besides the smug, complacent pro-globalization position of Clinton, Obama, etc., and anti-China jingoism.

  2. But in that paragraph you seem to be taking a poke at liberals who have been complaining about Chinese “currency manipulation” which is done with tacit agreement of US corporations and the US government, i.e. US elites. They like it, even if they’d rather have a floating currency.

    Maybe I misunderstood you. The liberals I read are aware that lately China has been intervening to strengthen their currency. Your link says:

    “. Over the past two decades, currency manipulation by about 20 countries, led by China, has inflated U.S. trade deficits, which (in combination with the lingering effects of the Great Recession) is largely responsible for the loss of more than five million U.S. manufacturing jobs. ”

    Trump didn’t pull his economic message out of nowhere. It’s gotten traction from populists (of the more xenophobic variet) about jobs being offshored. It’s from their personal experience no matter how much smug economists like Krugamn tell them that their experience is wrong and besides we get cheaper goods.

    1. “. Over the past two decades, currency manipulation by about 20 countries, led by China, has inflated U.S. trade deficits, which (in combination with the lingering effects of the Great Recession) is largely responsible for the loss of more than five million U.S. manufacturing jobs. ”

      I have a doubt:
      If we assume that the international market tends to a trade balance, when a country like China sells cheap goods to the USA, the unemployment in the USA rises until the wages fall so much that the trade balance is restored.
      But, this is not what happened in the last 20-30 years, instead the trade is still unbalanced, and the USA government budget more or less covers the difference.
      So, with no trade umbalance and the same deficit, we get less unemployment, or with no trade umbalance and no government deficit we get the same unemployment, or half and half, but we can’t count the trade umbalance twice, once for the unemployment and once for the deficit.
      I say this because in “the age of Trump” it seems that all the problems come from trade umbalances, but I think that both the USA and China would still have big employment problems without trade (or with 0 umbalances), it just happens that the USA government has to go into debt for both.

      In my view, what happened is that international competition forced governments to change the laws in a worker-unfriendly way to become more competitive, but this did lead to a race to the bottom of wage shares everywhere.
      Then as “capitalists” save more than workers someone has to make up the difference with an increase of debt (that corresponds to an increase of financial wealth for “capitalists”) to stave off an underconsumption crisis.
      Nations that are net importers are the ones that are forced to increase debt faster, so everyone tries to become more “competitive” to become a net exporter, wich creates a vicious circle.

      But at the point we are now, even net exporter nations like China are forced to pump up debt to keep the economy going on.

      1. In my view, what happened is that international competition forced governments to change the laws in a worker-unfriendly way to become more competitive, but this did lead to a race to the bottom of wage shares everywhere.

        Right. In my view — and this is sort of the point of the post — the real importance of international trade and financial flows is not (usually) their direct economic effects, but the way they constrain the policy space available for governments.

    2. I think the passage quoted is seriously misleading, even if it is not literally false. It’s been many years since China has actively intervened to weaken the renminbi, and even then it was a matter of managing its appreciation. You’d have to go back to 2005 to find a sustained period in which China was holding the renminbi at a rate that was arguably weaker than the market level. And even then, the exchange rate interventions were accompanied by — in support of — strict controls on outward foreign investment whose effect was to strengthen the renminbi. Of course we can’t test the counterfactual, but I think it’s likely that the entire period of large US deficits with China, the net effect of Chinese deviations from Washington-approved policy has been to strengthen the renbinmi, not weaken it.

      More fundamentally I think blaming China is a distraction from the actual problem, which is the capture of US corporations by financial interests which prioritize liquidity and quick payouts over productive investment, and which are more hostile to the claims of labor than employers of a generation ago. Let’s coopt the anti-Wall Street part of Trump’s populism, not the anti-China part.

      (Besides, and I know this won’t win US elections, let’s not forget that the growth of China over the past generation is one of the largest improvements in material living standards in human history.)

  3. “International financial shifts are so large, and so unpredictable, that for most central banks they’ll overwhelm anything that can be done with conventional tools.”

    Perhaps then it is the convention that is wrong. Structurally and intellectually wrong.

    For every currency pair there are two central banks, each of which has infinite capacity to holds its currency down to any value in terms of the other currency.

    Therefore in co-ordination they can hold any mutual value they wish, and in competition can maintain a stalemate.

    Any rise in a currency value is therefore a policy choice. The other actors in the market have limited funds and play each other to a draw. Which is why they always agitate to try and get the central bank to play patsy on the wrong side of the trade. Good policy would outlaw that.

    1. Yes. One of the main reasons the core gold standard countries were able to maintain convertibility between 1870 and 1914 was active cooperation between central banks. And today the unlimited swap lines between major central banks in principle mean that they can always counteract unwanted movements in their exchange rates — tho of course it remains to be seen how those commitments hold up in a crisis.

      But in the absence of a supernational monetary authority, what this means in practice is that financial openness is another way that stronger states can push around weaker ones. Seems to me the periphery is usually better off opting out.

  4. I don’t think that use of the swap lines would be very effective as a means of influencing currency movement and that’s certainly not their purpose. It doesn’t involve either central bank changing their open position in the other’s currency, which is what normally has to happen when they intervene in the currency market. It’s possible that, by enabling central banks to provide foreign currency liquidity to domestic banks, thereby preventing bank defaults, there is some knock-on effect on foreign exchange markets, but it would be very unpredictable.

    (Great post by the way.)

    1. You may be right. I’m far from confident in my views on this stuff. Altho it does seem to me that in many balance of payments crises the foreign-currency liabilities of domestic banks are the central issue — both in transmitting the external crisis to domestic activity, and in driving the uncontrolled depreciation (since foreign obligations create completely price-ineleastic demand for foreign exchange). So your last sentence seems important. And, thanks.

Comments are closed.