When the IMF [Hearts] Capital Controls: PRC Case

My, my, how things have changed. As late as September 1997--with the Asian financial crisis already underway--the IMF was still arguing for amending its Articles of Agreement to include regulatory powers over opening up members' capital accounts:

Last September [1997] in Hong Kong, the Interim Committee of the IMF’s Board of Governors agreed that it was "time to add a new chapter to the Bretton Woods agreement." Thus, it invited the IMF’s Executive Board to complete work on a proposed amendment of the Fund’s Articles of Agreement to make the liberalization of capital movements one of the purposes of the Fund and extend its jurisdiction over capital movements.

Understandably, though, the aforementioned financial crisis hardened attitudes of developing countries to the suggestion of wealthier countries' representatives on the IMF's Board of Governors to further liberalization. As "sour grapes" perhaps, the IMF then declared this goal infeasible because of poor economic governance on the part of developing countries:

Indeed, the problem in Asia was not that countries had opened their capital accounts. In fact, the economies in the region with the most open capital accounts—Hong Kong and Singapore—have been among the most successful in contending with the crisis. Nor was the problem so much one of the speed of reform: the countries most affected by the crisis— Korea, Indonesia, and Thailand—had taken quite distinct approaches to capital account liberalization, which in some cases had been rather gradual. Rather, their difficulties arose from the macroeconomic environment and institutional setting in which they opened their capital accounts and the way in which measures to open their capital accounts were sequenced with other reforms. 

This idea--that Asian financial crisis demonstrated that premature liberalization of capital controls would expose a country's underdeveloped financial system to outsized risks--remains the IMF conventional wisdom. Nevermind that the IMF's (Western) leadership was obviously gung-ho on forcing other countries to open their capital accounts by enshrining this objective in IMF strictures during the onset of crisis, but we are where we are.

The irony is that, for a number of years now, the IMF has been discouraging China from liberalizing its capital account due to its perceived lack of financial reform necessary to obtain the benefits of such liberalization. You know what these include: market-determined exchange and interest rates are near the top of the list. In their absence, China could suffer from catastrophic capital outflows. With the PRC vowing to make major moves towards capital account liberalization in the near future, the IMF is now sounding yet more alarm bells, the contrast to its nonchalance pre-Asian financial crisis is striking:

While Chinese leaders are putting final touches on a plan to allow capital to flow more freely into and out of China, the International Monetary Fund has warned that such changes could lead to a massive exodus of money from the country if not handled properly.

Foreign investors have long clamored for greater access to China's financial markets, in part to benefit from future yuan appreciation. The IMF says financial-sector liberalization, especially for interest rates and currency, is necessary to keep China growing at a healthy clip over the coming decades. But it is wary about whether China is ready for significant capital-account liberalization.

According to IMF calculations, a speedy liberalization of cross-border capital movements could produce over several years net outflows from China equal to as much as 15% of the country's GDP, roughly $1.35 trillion [my emphasis]. Of that sum, the Chinese would send as much as $2.25 trillion overseas, while foreigners would invest $900 billion in China.

"The estimates assume a fairly large 'Big Bang' style adjustment," says Markus Rodlauer, the IMF's China mission chief. "We wouldn't advise doing this in one step. We'd advise continuing with a gradual approach." There is no indication Beijing plans a big-bang approach to liberalization. Though it isn't yet clear how it will proceed.

Given the IMF's track record on Asia, I wouldn't bet against them making a Type I error here by saying there is something amiss when there really isn't with regard to China. Prior to the Asian financial crisis, it was the other way around (Type II error)--they did not warn something was amiss when there was. (I'll leave it to you if premature regional capital account liberalization was due to IMF instigation. I believe so.)

Nevertheless, knowing the IMF's fallibility on such matters, I guess there's only way to find out Hu's right and Hu's wrong. Thankfully, the IMF cannot meddle with Chinese policy in this respect when and if it decides to open the floodgates to a yet-unspecified extent.

UPDATE: We now receive news that China will allow its banks to set interest rates below PBoC guidance. I guess that's a step towards interest rate liberalization so desired by IMFers, no matter how minor.