International | Apr 07 2006
As of February this year China held more than US$853 billion in foreign reserves, making it the world’s largest holder by surpassing Japan. The pace of this accumulation isn’t likely to slow significantly either, with DBS noting the country’s holdings could pass US$1 trillion by the end of the year.
As these reserves have increased and as China has enjoyed strong growth in GDP there has been an increase in the political pressure being applied on it to move more quickly to liberalise its capital account position.
Just as with its currency though the Chinese have been moving slower than some others in the world want, with DBS noting such an approach is appropriate in this case as there remains a large imbalance between the state of the capital account and the health of the domestic banking sector.
As DBS points out much work has been done in recent years to improve the banking sector and the quality of its assets through measures such as the recapitalisation of state banks and the adoption of new accounting standards.
The changes haven’t included one important area though, that of risk pricing. As DBS notes this remains strictly the preserve of the central bank, meaning the risk premiums being charged by regional banks are out of line with what market conditions would dictate.
As a result, a move by China to free up its capital account without making related changes to the current system of interest rate controls would present the risk of an asset price spiral, as both foreign and domestic capital could then enter asset markets more easily.
Historically DBS notes the time between adopting a more liberal current account approach and the achievement of capital account convertibility is around 20 years, so any increase in the pace of reforms will still have only a limited impact in its view.
It suggests of more importance in the short-term is improving the ability of the banking sector to drive domestic savings, which are equal to about 40% of GDP, into more productive investments. This is important in DBS’s view, as it would go a long way to addressing structural issues such as overcapacity in some areas of the economy, which is of greater short-term importance than addressing the capital account issue.
