Why China Is a Financial Midget

Beijing's economic model will prevent the yuan from replacing the dollar as the world's reserve currency.

By JONATHAN ANDERSON

Source: The Wall Street Journal

The title says it all: "Eclipse: Living in the Shadow of China's Economic Dominance." Arvind Subramanian's new book is a good example of a more aggressive line of argument regarding China—that it's a matter of whether, not when, China will take over economic leadership of the world. But China's road to real financial influence promises to be far longer and rockier than the GDP numbers would suggest.

The argument for dominance has two prongs. The first is that China's economy will very soon be larger than either the U.S. or the EU. And second, as this happens the yuan will also naturally replace the dollar as the global reserve currency, with profound consequences for international markets.

On the first issue, there is little debate. China already has a $7 trillion economy, roughly half the size of the U.S. or the EU. If it can continue to grow even at 6% to 7% a year, not even at 10% or 11% as it did through much of the 2000s, then in five years the Chinese economy could easily pass the $15 trillion mark, where the U.S. is today. By the end of this decade, China should already be larger than the U.S. and equal to Europe.

The future of China's financial role is murkier. Within 10 years the yuan will probably play only a marginally more important global role than it does today. It won't replace the U.S. dollar as the world's reserve currency, and it may not even challenge the Japanese yen or the pound sterling.

Why? It's one thing to hold the yuan for trade invoicing, but if you're going to hold it as a liquid "safe haven" portfolio investment choice, you need free and unfettered access to deep domestic fixed-income markets. This is what the dollar and euro offer, and essentially so do the yen and other G-10 major currencies.

But not China, which maintains one of the most closed capital account regimes in the world. That is true in comparison to developed markets and to lower-income neighbors in Asia and other emerging regions.

Chinese President Hu Jintao (left) wonders if his country can dominate the U.S.

The bigger problem is that China can't open its capital regime, at least not fast enough to matter. For more than two decades, China's philosophy of monetary management and financial development has been based on a closed-economy system: maintaining low and stable interest rates without having to worry about external arbitrage, breezily adopting economic stimulus when needed without concern about the banking system's asset quality, propping up banks with historically high nonperforming loan ratios and fixed-cost pricing, and keeping iron-clad control over the exchange rate. All of these only work when foreign portfolio funds cannot influence asset prices, and when locals have nowhere else to go.

While China's GDP may be 10 times larger than it was in 1995, its external capital controls are still similar to what they were back then. China has opened a few windows at the margin, but it has never seriously opened the doors. If anything, the financial crises of 1997-98 and 2008-09 have taught the authorities to be as slow as possible in making adjustments.

Even if China were to remove external controls, this still leaves the lack of deep domestic markets. Put simply, there's nothing to invest in. You need a local bond market, and China doesn't have one. Relative to its size, China has a much less mature fixed-income market than most of its major emerging-market peers.

As with capital controls, this is part of the financial model. China's unique prevalence of undisciplined state-owned borrowers and reliance on quantitative macro-credit measures makes it imperative to keep financial flows concentrated in the banking system.

This explains why the bond market failed to outgrow GDP for much of the 2000s. And it explains why, after the unbridled explosion of corporate paper in the past two years, the authorities are now back-pedaling to bring down exposures, precisely to preserve bank asset quality and leverage ratios.

One common rejoinder is that China has no option but to open up its capital markets and make reforms to pave the way for yuan convertibility, since the alternative is to continue to accumulate hundreds of billions of dollars per year in questionable foreign assets—a trend that is increasingly unpalatable to China's leadership.

This argument makes no economic sense. As long as China's domestic saving rate is above its domestic investment rate—as long as it is running external current account surpluses—it will continue to accumulate foreign assets.

If the yuan were the world's reserve currency, China might be able to stop accumulating claims denominated in dollars and euros and generate claims in its own currency instead (as the U.S. is able to borrow in dollars abroad today). But we're still talking about an ever-increasing pile of claims on questionable sovereign borrowers in the West, regardless of the currency those debts are kept in.

In short, making the yuan into a true global reserve currency doesn't solve any of China's current problems and could create very painful new ones along the way. Which is why it's not going to happen any time soon. China may be an economic giant on the world stage, but in this sense it will remain a financial midget.

Mr. Anderson is a global emerging-market economist at UBS.