Peking University, April 12, 2021: China is working on its new dual circulation development plan in which domestic and overseas markets reinforce each other with the domestic market as the mainstay. “The domestic market as the mainstay” has been misunderstood to some extent. It has particularly aroused suspicion among some international investors that China’s policies will tend to favor the domestic side.

Visitors on the Bund in Shanghai

In my opinion, such misunderstanding can be avoided by taking a long historical view of “dual circulation.” China’s emphasis on domestic economic circulation does not signal its cutting-off from the outside world to exclusively attend to domestic affairs.

Let’s say that each country is like a boat, and all the boats are sailing forward at top speed. Some may be big, some small, some modern and others more rudimentary, but they are all moving forward; they are all progressing to achieve economic growth and bypass the middle income trap.

Over the last four to five decades of globalization, many boats have been lashed together to forge ahead. After the reform and opening-up, China has prioritized international circulation, which in my view it was like using a tow line to connect with the fast boats. The fast ships in the very front are adding speed. Countries lagging behind, at one point including China, can row with their own oars, but they can also take advantage of international circulation by borrowing the power of the fastest boats like Europe and the U.S., moving us forward together.

We can say that in the past 40 years, this focus on international circulation has been a successful practice for China. The problem now is that the fast ships are slowing down, and some boats keep cutting away at their tow lines. Under such circumstances, should we continue to be tied to them?

In my opinion, the ultimate goal of domestic circulation is shared development rather than decoupling from the fast ships and sailing alone. Beyond that, China should endeavor to stand at the center of the world stage. If it does well, China will be the big ship — or one of the big ships — pulling others forward.

From this perspective, the significance of the opening-up policies is twofold.

First, to do domestic affairs right, we must continue opening up. We cannot make it alone; at least, this is not the most efficient way.

Second, only by opening up can we integrate well into global economic circulation and possibly even become a major part of it, so that we can pull more boats forward with us. Although no one can be sure whether European countries and the U.S. will work with China as before, China will at least move forward together with the economies along the Belt and Road Initiative.

The open-economy policy is of the utmost importance. Thus the initiative to take “domestic circulation as the mainstay” does not, and should not, mean we turn inward or neglect the international economy.

Goals for China’s financial opening-up

The same logic also applies to financial opening-up.

China’s next step is to steadily promote financial opening-up while maintaining a balance between openness and stability. This has indeed been a problem for many countries. Over the past 40 years, numerous emerging markets have suffered from the liberalization-induced financial crisis.

Despite the threat of financial crisis, however, we must continue financial opening-up, learning how to achieve a balance between openness and stability.

Taking a long view, one day China will become a “megaship” in the world economy, at which point it must have high requirements for finance. The past 40 years of financial reform in China are characterized by the large scale of reform, excessive government intervention and relatively weak supervision. These issues will need to be resolved before China can become a world-class megaship economy.

The 14th Five-Year Plan contains specific objectives for finance; these are systematically expounded upon in official documents, but here I will summarize them into two goals:

First, to strengthen financial support for the real economy and make finance a key engine of economic development.

Second, to “ensure the stability of the ship” — namely, to hold the bottom line of preventing systemic financial crisis in the process of development.

I think that these two objectives are extremely important and that financial opening-up is an important channel to achieve both. Although the content of financial opening-up is plentiful and diverse, it can be simply divided into two aspects:

First, the opening-up of the financial services industry.

In the past few years, domestic banks, insurance and securities companies and other financial service institutions have continually applied measures of opening-up. China has created a favorable environment for the financial services industry by issuing business licenses and certificates, lifting restrictions on domestic operating equity and adopting other relevant methods.

Looking ahead, the industry will remain open as it begins to carry out an important transformation — from practicing a positive list system to a negative list system. In the past, China formulated a “positive list” to clarify which players, scopes and fields were approved by the government for market entry. However, in the future it will operate by a “negative list.” The basic principle of the negative list is “items not found on the list will be deemed as permissible” — in other words, only listed items are prohibited. This model of financial opening-up meets a high standard and world-class level.

The second aspect is capital account convertibility. One of China’s major tasks in 2021, which marks the opening year of the 14th Five-Year Plan, is to increase capital account convertibility. This is also a priority for China’s next step in financial opening-up. However, the liberalization of capital accounts may prove to be a double-edged sword. When it comes to balancing openness and stability, there are a slew of specific tasks ahead.

Balancing efficiency and stability

In the process of liberalizing capital accounts, cross-border capital flows will progressively become more flexible and less restricted in the future. But in the meantime, financial stability needs to be guarded. To this end, I will quickly introduce three items of advice.

First of all, we should follow and respect the sequence of reforms. As the saying goes, “More haste, less speed.” Take the exchange rate of the renminbi, for example: Without flexible exchange rates, liberalizing capital accounts is a waste of time. We learned this lesson back in 2015.

Second, we should introduce some macroprudential policies. Opening-up is naturally beneficial; however, excessive openness — for example, in the frequent instances and large volume of short-term cross-border capital inflows and outflows — is a detriment to financial stability. Can we therefore put some measures in place early on to prevent risks from escaping our control? Macroprudential policies can do the job. In the next step, they will be an important part of the overall financial stability system and opening-up policy.

Third and finally, reasonable and acceptable capital account management policies should be put in place.

One major controversy in this regard is whether the government should impose some controls on cross-border flows of capital. Under most circumstances, economists would not make such a suggestion, as the presence of controls always entails a loss in efficiency.

But my own views have come to change recently: For most countries with a mature market system, cross-border capital flows do not beget disaster, so controls are unreasonable in such contexts. However, experience over the past 50 years tells us that many countries were eventually embroiled in severe financial crises after opening-up. Considering this situation, the choice is no longer between seeking maximum efficiency and tolerating a loss in efficiency, but between tolerating a loss in efficiency and having to cope with a massive financial crisis. After weighing the possibilities, I would prefer to retain some controls on cross-border capital flows to try to avoid a financial crisis, even though this may entail some loss of efficiency.

After all, making economic policy decisions — including financial policy decisions — is ultimately a trade-off between different options. If you look at the textbooks, there are abundant optimal choices. However, when it comes to real cases, one has to weigh the pros and cons and conduct a practical cost-benefit analysis.

The author is Huang Yiping, Sinar Mas chair professor of finance and economics and deputy dean of the National School of Development at Peking University and director of the University’s Institute of Digital Finance.

Source: Caixin Global