David Dollar is a Senior Fellow in the John L. Thornton China Center at the Brookings Institution. From 2009 to 2013 Dollar was the U.S. Treasury’s Economic and Financial Emissary to China, based in Beijing, facilitating the macroeconomic and financial policy dialogue between the U.S. and China. Prior to joining Treasury Dollar worked 20 years for the World Bank, serving as Country Director for China and Mongolia, based in Beijing (2004-2009). His other World Bank assignments focused on Asian economies, including South Korea, Vietnam, Cambodia, Thailand, Bangladesh, and India. Dollar also worked in the World Bank’s research department. His publications focus on economic reform in China, globalization, and economic growth. He also taught economics at UCLA, during which time he spent a semester in Beijing at the Graduate School of the Chinese Academy of Social Sciences (1986). He has a PhD in economics from New York University and a B.A. in Chinese history and language from Dartmouth College. On February 1, 2017, he spoke with Yujia Yao CMC '19.
Bio and photograph courtesy of David Dollar
In response to a weaker Yuan and falling foreign exchange reserves in 2016, the Chinese government has recently sought to limit the ability of businesses and individuals to send money out of China. How would you characterize the tangible effects of increased capital controls in China? Have restrictions on capital movements been effective?
China has tightened its existing capital controls rather than introduced new ones. Government approval of foreign transactions have always been required. On the corporate level, capital used for mergers and acquisitions between Chinese firms and foreign ones needs to be reported to and approved by the government. On the household level, each Chinese citizen can convert the equivalent of $50,000 per year from Chinese yuan to U.S. dollar. These household transactions are mainly current account transactions for international traveling and studying. The Chinese government has been relatively lax in terms of approving all foreign transactions. Now it has imposed tighter restrictions on the approval of such transactions to enforce the regulation. For example, officials would ask more specifically about the purpose of the transaction and would verify the detailed travel plans and educational documents.
It is effective so far because the decline in foreign reserves of China slowed down after Chinese government introduced tighter capital control. The government has been very successful in managing the net capital outflows. Prior to December, 2016, it had been spending foreign reserves to stabilize its currency. In December, only a small amount of reserves was spent, which indicates that capital control has been effective in helping stabilize the situation.
You recently wrote that it is important for China to tighten its capital controls to keep the Yuan stable under the “new normal.” Could you briefly explain why you expect current pressure on the Yuan to persist?
The pressure will persist because for several years China has been over-investing and has created severe overcapacity in the economy. Government spending contributed a lot to the excess capacity. It is most evident in the heavy industry sector such as steel and cement. It is also true in the real estate market and even in infrastructure. For example, there are a lot of empty houses in some cities and recent infrastructure projects are simply not useful. Given the overcapacity, the return to further investment in China has declined. Investment in the private sector is declining as well. Private investment is growing at as low as three percent per year, which used to be much faster. However, there is still a large amount of savings in China. The combination of large savings and few good investment opportunities in China makes it natural for capital to flow abroad.
Under current circumstances, it is beneficial for China and the world to have moderate capital flows from China. My worry is that if too much cash flows out in too short a time, it will destabilize the global economy. It will push the Chinese currency to depreciate by a large amount, and China is one of the biggest trading nations in the world. The outcome will be very disruptive. Given China’s sheer immensity, there might be hundreds of billions of cash flowing to foreign markets with little good investment.
Overall, the process of capital starting to move out of China is good, but I respect the government’s effort to try to manage and maintain the outflow at a moderate level so that it doesn’t become excessive.
Follow-up: Given China’s huge savings and moderate consumption, could there still be any good investment opportunities?
The crucial problem here is the overcapacity that we have been discussing. Since China has built up large excess capacity, it’s hard to believe that real estate or heavy industry could be good investments. Chinese stock market has been volatile. The best alternative for profitable investment is the underdeveloped service sector, which has long been dominated by state-owned enterprises that tend to be inefficient. If China liberalizes and opens these service sectors such as telecom, media, and different types of financial services, it will perhaps see more technological innovation. There is plenty of room for innovative development in China, but it will need further economic reform.
If the U.S. Federal Reserve intends to raise interest rates, what would you anticipate for the cash outflow in China? How do you expect the Chinese government to respond?
The U.S. interest rates naturally have some effects on this process (of cash outflow from China). If U.S. interest rate rises, it is one more attraction for Chinese capital to flow abroad. However, I wouldn’t exaggerate the importance of this. Each movement (of the U.S. interest rate) is 25 basis points, which is rather minor. Many other events may prove to be more important. For example, if there really is a trade conflict between U.S. and China, that is going to create a bad environment and lots of uncertainty. It will lead to more capital flow to the U.S. In that case, the political relation between U.S. and China, whether the two countries still enjoy smooth trade relation, is more important than two or three interest hikes by the Fed.
You wrote that it would be a good idea for the Chinese Central Bank to raise interest rates and for the Chinese government to further expand its fiscal expenditures. Could you explain your perspective, in particular given that China’s savings rate and debt are already quite high?
During recent periods when excess capacity was building up, a lot of the investment was backed by borrowing. I emphasize that China has been building up the excess capacity. Looking at the problem from the financial side, there has been a big run-up in debt relative to GDP, so debt has been growing faster than the economy and it is now at an alarming level. When we look at earlier cases of financial crisis such as those in Spain and Thailand, a common characteristic is a big run up in debt relative to GDP. So right now the situation in China is worrisome. The only way to get it under control is to slow down the growth of credit, and that is inherently a tightening of monetary conditions. It could be achieved through lending controls, and I think China will also benefit by raising the interest rate, which is the price of borrowing. It’s true that raising the interest rate is going to create problems for some of these companies that have over-invested. Eventually there is going to be a shake-out: some of these companies, especially some of the state-owned enterprises, are going to close. Keeping those companies alive with cheap credit is prolonging the problem. If China takes some courage to raise interest rates, it will be better-off in the medium to long rum.
How should the Chinese government address the problem of accumulating debt after the fiscal stimulus plan in 2008?
The good news is that China still grows relatively rapidly, when facing the problem of too much debt relative to GDP, it doesn’t necessarily have to reduce the debt. For a growing economy, it is only necessary to slow down the growth of debt and let the growth of the economy catch up. What China really needs to do is to slow down the growth of credit and let GDP catch up after several years. The best way to achieve that is through further economic reform that opens more space for the private sector and active participation in international trade.
Given that Chinese overseas investments are becoming more substantial and influential, how does China’s greater reliance on capital controls affect the global market? By extension, how does it affect the U.S. economy, a popular target for Chinese investors?
China is trying to manage the capital outflow so that the net outflow roughly balances with the trade surplus. Trade surplus is above three hundred billion dollars per year. China can be a net exporter of three hundred billion dollars a year of capital while maintaining a balance of payments and stable exchange rate. The purpose of the capital control is to keep outflow at the three hundred billion (dollars) level, and that is a lot of resources to provide to the rest of the world. More than that (three hundred billion dollars) would be destabilizing. If U.S. maintains a normal trade relation with China and helps it stabilize, it won’t be affected very much.
If the capital control is not permanently effective, which will result in a surge of capital outflow from China, the outcome would be more disturbing. There was one year that almost a trillion dollars flowed out from China. If China can’t manage that trillion dollars’ outflow, there will be a big depreciation of Chinese currency which won’t last forever, it will eventually swing the other way. It will be very disruptive for Chinese producers and consumers. China is now offering capital to the rest of the world, and it should be in a stable and sustainable way.
Contrary to recent statements by President Xi, China seems to be growing more and more closed. Do you agree with this characterization? How would you assess the effectiveness of economic reform under Xi’s administration?
I agree. I think Xi Jinping administration talks a good line about continuing to open up and reform, but they haven’t actually done very much. In term of opening up more sectors of the economy to foreign trade and foreign investment, they haven’t done anything. There was a recent announcement from the state council about opening-up more sectors, but there were no details nor actions. I do think Xi’s administration has good plans as demonstrated by the Third Plenum resolution and President Xi at Davos talking about free trade, but they haven’t followed through with their own policies in terms of reform and opening-up.
That is going to be a problem if the government doesn’t pursuit economic reform. It will be hard for China to grow well while dealing with the vulnerability that is building up. There are some commentators who hope that after the 19th party congress there will be more actions. I think we will have to wait and see. It is striking that after the announcement of the general plans, things haven’t started to change. It suggests the existence of deep-rooted political opposition to economic reforms such as bureaucracy in the state-owned enterprises.