Unrestricted fund outflows have potential to hurt the economy on a broad scale

Fund outflows could undermine the economy if China liberalizes its capital account too rapidly, a senior economist has warned.

Yu Yongding, a researcher at the leading government think tank, the Chinese Academy of Social Sciences, said that the trend of moving capital overseas by the country's wealthy could be a potential risk for China.

He said that the government should think twice before making the yuan fully convertible, given the economic slowdown.

"China has a high savings rate, but sentiment can be easily influenced. If the economic outlook changes, the rich will soon channel their wealth out of the country, which will likely have a huge negative impact on the economy," Yu said in an interview with China Business News.

China has pledged to achieve full convertibility of the yuan under the capital account by this year. People's Bank of China Governor Zhou Xiaochuan reiterated that intention during a recent economic forum in Beijing.

But Yu, a former central bank adviser, argued that it is unnecessary to accelerate the process, because China's problems such as financial stability, corporate debt and labor shortages cannot be resolved simply by capital liberalization.

"The opening of the capital account should be carried out in a progressive manner, (a strategy) that has proved to be successful in the past," he said.

Yu said that the government could ease controls on the yearly ceiling for overseas remittances of foreign exchange, which is now $50,000 per person. The ceiling could go up to $60,000 or $70,000, but it should not be removed, he said.

Other economists have suggested that China liberalize its capital account through pilot programs. They said that the regulator could always reimpose capital controls if the experiment does not work to the country's advantage.

Yu said that such a strategy could hurt the government's credibility, and regulators must remain prudent when opening the capital account. Recent capital outflows that appear to be illegal have alarmed regulators.

Analysts believe that one common channel for companies to evade capital controls is through a practice known as round-tripping foreign direct investment. By registering an entity in an overseas tax haven such as the Virgin Islands, Chinese companies can disguise capital flows as FDI, which can mean lost tax revenue and cause "distortions", Yu said.

False trade invoicing is another way for Chinese companies to make illegal capital transfers, Yu said.

The government seems to have toned down the rhetoric on the full convertibility of the yuan under the capital account, which demonstrates a prudent attitude toward capital liberalization, Yu said.

But this does not mean that capital account reform has stopped. The central bank is accelerating the establishment of cross-border interbank payment systems, for instance.

The system will help boost the international use of the yuan and reduce transaction costs. More importantly, such mechanisms allow regulators to better monitor and target illegal cross-border capital flows, analysts have said.

The China (Shanghai) Pilot Free Trade Zone is a testing ground for capital liberalization. Regulators plan to grant qualified individual investors within the free trade area larger quotas to engage in overseas investment.

Lu Lei, head of the research bureau at the PBOC, told the audience at a recent economic forum in Beijing that a fully convertible yuan under the capital account requires a "robust and prudent market" and institutional mechanisms within the financial system.

"It is not simply an announcement made by the monetary authorities," he said.

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