Keep an eye on China’s move to end exchange controls

28th January 2014 by James Mahon

For those of us who can remember the extraordinarily cathartic effect of the scrapping of UK exchange controls in 1979, China’s move towards reform is interesting to watch.

Exchange controls had been in place in the UK in various guises since 1947. It all feels Dickensian now: UK residents could not invest overseas unless they could purchase foreign currency from other UK residents who wished to sell, leading to a ‘dollar premium’ market at higher than ‘official’ rates of exchange. Foreign investments in the UK could not be realised and withdrawn freely (looking back it is hard to remember why anybody thought this was a good idea). Private individuals were also subject to endless niggling irritants such as strict limits on how much currency they could take on holiday. All, naturally, supported by extensive rules and regulations.

The controls and political tinkering did nothing to help an economy that was heading for the ignominy of bail-out by the IMF and inflation close to 30%. The scrapping of the whole panoply of rules in 1979 quickly led to a dramatic increase in the free flow of capital. I fear that this might point to a more general problem with regulation: banks have been regulated for years, I wonder if ever tighter regulation is really the answer or will this just result in problems elsewhere? Perhaps that is for another day.

America had a similar experience with the regulation of interest rates which had initially been introduced in the 1930s, in the wake of the Great Depression. By the 1960/70s it was all getting very complicated: there was a limit to the rates that banks could pay on deposits so savers were penalised (corporations and the wealthy could take advantage of offshore ‘eurodollar’ markets and money market funds). With the inflation prevalent at the time, interest rates needed to rise or banks would (sensibly) be reluctant to lend; the regulations were having the opposite effect to that desired. The controls were phased-out over five years from 1981 to 1986.

China, under its new President Xi Jinping, has announced an ambitious set of reforms which, if implemented, could transform the Chinese economy and provide a boost to the world economy. Their economy needs to move from one which is ‘investment led’ – huge numbers of agricultural workers move to the cities and provide cheap labour for shiny new factories – to one where the economy is opened-up and the new ‘middle class’ can enjoy the fruits of their labour (i.e. become consumers). Without the reforms, a debt crisis looms (they do not need more investment in more factories, financed by debt). It looks encouraging.

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