The most important story in global economics nobody is paying attention to

The most important economic story that people aren’t paying attention to this week is coming out of China.

The nation’s powerful State Council said it will move to open its borders to the freer flow of capital. At present, there are strict limits on the ability of, say, a U.S. company to convert dollars to the Chinese currency in order to build a factory, or of a Chinese citizen to convert yuan to euros to invest in the German stock market. The State Council says plans for changing that will be unveiled this year.


Will Shanhai one day be a financial center on the caliber of New York or London? (ZHOU JUNXIANG - IMAGINECHINA)

The new endorsement of liberalizing capital controls accompanies a related move, underway since June 2010, to allow the Chinese currency to rise in value relative to the dollar, something long-sought by the U.S. government and a sign that China has been shifting toward policies that put the value of its currency more in line with market fundamentals.

Put it together, and the new Chinese government that took power at the end of last year is sending signals on all fronts that it is proceeding—in its measured, careful way—with liberalizing China’s financial system. That is no small thing.  It helps answer one of the great questions for the future of the world. Namely, what sort of economic power will China be? Will it remain an inwardly focused nation concerned only with attaining rising incomes for its own population? Or will it become a major force in international finance, with Shanghai one day emerging as a financial center on par with New York or London?


The value of the dollar relative to the yuan has been falling since June 2010, as the Chinese government has allowed its currency to more closely match fundamentals.

The answer has all kinds of consequences: From a U.S. perspective, that includes the question of whether the dollar will remain the bedrock of the world financial center in the decades ahead, or if the renminbi will become a rival for global trade, particularly within Asia. For China, the stakes are even higher.

China is essentially weighing a trade-off.  A transition to a freer, more market-based financial system could pack many advantages, including a more efficient system of funneling savings into productive investment, more reliable savings vehicles available for its citizens, and advantages for Chinese companies as they do business across Asia and beyond.

But getting those advantages will come at a price. It means pivoting away from an export-led growth strategy that has been wildly successful over the last generation and has benefited from an artificially low yuan. It leaves China with greater risk of volatile capital flows that have created booms and busts, and bursts of inflation, in many other emerging economies over the years.  And most importantly, from the vantage point of the ruling Communist party, it will mean ceding some of the power now held by top party officials to the hard-to-corral whims of markets.

The decision over how much financial liberalization, how fast, has been (by all appearances) an ongoing internal battle within the Chinese government. The evidence lately is that the reformers, not least People’s Bank of China governor Zhou Xiaochuan, are winning in behind-the-scenes battles with entrenched export interests and politicians who would just as soon keep control of capital allocation in the world’s second largest economy for themselves.

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Dylan Matthews | May 8, 2013