IMF warns China over limited progress on reform

Fund notes the challenges posed by the “impossible trinity” are becoming apparent and need to be addressed

Cause for concern: “Gaps in supervision, regulation and in the macroprudential framework, as well as high corporate debt… raise potential systemic risk concerns" – IMF

The failure of the People’s Bank of China to implement measures to strengthen the country’s resilience to capital flow volatility has increased risks to its financial stability, forcing the central bank to rely heavily on FX interventions to smooth monetary policy, the International Monetary Fund warned on August 15.

In its annual health check of China, the Fund stressed the “progress in implementing necessary supporting reforms has been slower than desirable”, and cautioned that even modest interest rate increases have the potential to create stress for smaller and overleveraged financial institutions.

“Faster progress on increasing exchange rate flexibility and further developing the monetary policy framework would have strengthened the ability of the economy to manage better capital flows following their liberalisation,” the IMF said.

“Gaps in supervision, regulation and in the macroprudential framework, as well as high corporate debt and insufficient progress in reforming state-owned enterprises… raise potential systemic risk concerns. Quasi-fiscal pressures from local governments have also contributed to increasing debt and vulnerabilities,” it added.

The IMF noted that given the limited progress on reform, China had to rely heavily on tighter enforcement of existing restrictions during recent bouts of capital outflows. In order to absorb shocks and deal with capital flow volatility, a significant burden had been placed on capital flow management measures (CFMs) and FX intervention.

Net capital outflows reached a record of about $648 billion in 2015 (5.8% of GDP) and amounted to almost $640 billion (5.7% of GDP) in 2016. These outflows resulted in significant depreciation of the renminbi, which dropped 6.6% against the US dollar last year, and was only partially cushioned by repeated FX intervention.

Since mid-2016, Chinese authorities have put in place rigorous capital controls and implemented several other CFMs, including a set of measures limiting the amount of FX purchases by individuals and restrictions on foreign acquisitions.

As necessary supporting reforms have not kept pace with the liberalisation of capital flows, a tightening in CFMs is a possible policy response to capital outflows
International Monetary Fund

While these measures have successfully contributed to curbing outflow pressure since late 2016, the IMF expressed a series of concerns in its report.

“As necessary supporting reforms have not kept pace with the liberalisation of capital flows, a tightening in CFMs is a possible policy response to capital outflows. Nonetheless, macroeconomic policies should play a more central role in managing outflows and structural reforms should be accelerated. In addition, tightening of CFMs will likely lose effectiveness over time, adversely affect the business climate and could reduce incentives for reforms,” the paper stated.

In its report, the Fund noted pressure on the exchange rate could resume in the event of a faster than expected normalisation of US interest rates, a weaker growth rate in China or other confidence shocks.

In this scenario, “the pressure could lead to renewed large reserve loss and eventually a potential disruptive exchange rate depreciation”. However, the IMF added, this risk was likely to be small in the short term due to the stronger enforcement of CFMs, the prominence of state-owned banks in the foreign exchange market and ample FX reserves.

After a long period of reserve accumulation, FX reserves declined in 2015 and 2016 by $513 billion and $320 billion, respectively, of which intervention accounted for about $342 billion and $448 billion.

China’s stockpile of reserves currently stands at $3.081 trillion – the highest level since October 2016. Figures published on August 7 signal the longest run of increases since June 2014, when the total reached a record high of $3.99 trillion.

Towards a floating exchange rate

In light of the latest numbers, the IMF said China’s reserves are more than adequate to allow a gradual move to a floating exchange rate. The Fund spelled out two key considerations when applying its composite metric for assessing reserve adequacy to China.

“First, given that China has neither a fully open nor fully closed capital account and an exchange rate which is closer to, but not fully, fixed, it is not obvious which weights to apply. The $1 trillion threshold implied by the composite metric for a floating exchange rate with capital controls is too low, and the $2.9 trillion threshold for a fixed but open regime is too high. On balance, the appropriate precautionary level lies in between,” the report read.

“Second, the composite metric is designed to guide the appropriate level of reserves to acquire in a normal period so they can serve as a buffer if a capital account crisis materialises. It is not meant to be a minimum to maintain at all stages of capital outflow pressure,” it added.

To help support a more flexible exchange rate, the IMF suggested Beijing should consider eliminating or gradually reducing the reserve requirement for onshore FX hedging. It also said that moving towards an independent monetary policy would be desirable, given the size of the Chinese economy. To do so, China would have to abandon a macroeconomic policy dilemma called the “impossible trinity”, which states a country cannot have free movement of capital, independent monetary policy and a fixed FX rate all at the same time.

“This implies the authorities must choose between the extent of capital account openness and exchange rate flexibility. Exchange rate flexibility will help absorb the impact of shocks, including those resulting from capital flows surges, while relaxing the necessity to impose or maintain a wide range of CFMs. Thus, deep reforms, including those which allow for greater macroeconomic policy adjustment, should be expedited to allow the country to benefit from greater financial openness while mitigating the associated risks,” the IMF said.

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