As the Fed continues to unwind its stimulus, even amidst threats of global deflation, there are hopes that China will accelerate the liberalization of its capital account and take over the Fed's role as the global supplier of liquidity. The idea of the redback (renminbi) taking over leadership from the greenback (US dollar) is argued as beneficial to China, which has been facing excess capacity and ageing in recent years. A comparison is thus made to Japan during the mid-1980s when the US drove Japan to open up its capital account on the rationale that the internationalizing of the yen would help to rebalance the global economy, particularly the US' huge trade deficit against Japan. The push culminated in the Plaza Accord in October 1985 that led the yen to strengthen by more than three-fold in the ensuing decade.
While the parallel between today's China and Japan in the mid-1980s seems reasonable on the surface, there are important differences to show that the transformation of China into a global capital exporter might still be a good few years away. Indeed, China will stay on track to fully liberalize the CNY as the need to do so is clear – namely, to bring free market efficiency to its domestic markets, an agenda already openly endorsed by the Chinese leaders. Over the past year, regulators have expedited the processing of inbound investment licences, and shaken up the governance of shadow banking and local government finances. Policymakers have made the CNY exchange rate more flexible as well as made changes to the domestic money market to prepare for a market-based framework.
However, the timing simply isn't ripe now for China to readily assume the role Japan played three decades ago. Firstly, China is not Japan in the mid-1980s, especially regarding its excess capacity and ageing. As shown in Chart 1, China's output gap today is much less wide than Japan's gap during the 1980s.
Chart 1: Output Gaps as % of GDP
Chart 2 shows China's aging of population is starting from a much younger level than Japan did in the mid-1980s. A surge in births during the 80s and 90s means that many of these people have only recently entered the workforce, compared with more people already at mid-career in Japan during the 80s. In fact, China is currently facing disinflation, so if China fully opened its capital account soon, it might trigger an avalanche of capital outflows that could shake up its real estate, mining and commodities sectors, as well as its shadow banking and local government debt structures, so much that it could plunge the economy into deflation and recession.
Chart 2: Working age (15-64) as % of total population
Source: World Bank
Neither is the US economy facing the kind of economic dislocations like it did back in the mid-1980s when its current account deficit plunged to over 3% while Japan was running a surplus of similar magnitude. In the aftermath of the 2007-08 global financial crisis, the US current account deficit has narrowed sharply from -6% to -2% while China's current account surplus has reversed from 10% to 2% (see Chart 3).
Chart 3: Current Account Balances, as % of GDP
For China to assume global monetary leadership, it would require the world's largest economy with dominance in international finance (the US), to push for the creation of a Euro-yuan market. Clearly, the US has neither the need nor the interest to play this role at this juncture. In other words, the Plaza Accord worked because there was a push (from the US) and there was a pull (from Japan) which spawned the Euroyen or the samurai market. Unfortunately, this effort faltered because Japan experienced a market meltdown (see Chart 4). This is a lesson that Chinese policymakers are likely studying to avoid a similar fate in the future.
Chart 4: Market Share of USD and JPY Denomination of International Debt*
Source: World Bank
From China's perspective, therefore, the right timing for opening up its capital market will be after it has ironed out its host of problems and deepened its own domestic markets. From the perspective of the outside world, however, the ideal timing is "now" before the Fed embarks on the actual reduction of its balance sheet, which might only occur a year or so hence.
We should be prepared for a period, hopefully a brief one, when the world faces a liquidity withdrawal, but this is ultimately a small price to pay to be sure that China is ready. Meanwhile, the seed of a Euro-yuan has already been planted in the offshore "dim sum" market that has now expanded beyond the shores of Hong Kong. As the outstanding stock of JPY-denominated debt instruments continues to diminish since hitting a peak in the mid-1990s, CNY-denominated debt instruments have been on the rise, albeit remaining of minor international significance (see Chart 5).
Chart 5: Market share of JPY and CNY Denomination of International Debt*
Source: Bank of International Settlements
In sum, it is clear that China is not ready to be a leading provider of global liquidity in the short-term. Of course, there may be significant outflows due to its current account surplus and as local investors, both retail and institutional, implement portfolio diversification, but the effects of such on global markets should not be major this year. Global investors, therefore, will need to maintain their concentration on the G-3 central banks in order to analyze global liquidity conditions.