研究组

China’s Capital Account Liberalization:

A ruby jubilee & beyond

Yanliang Miao & Tuo Deng

August 2018

Outline of Chapter

Three debates that shaped China’s capital account liberalization

Lessons learned: the good, the bad, and the “ugly”

China’s capital account policy, through the lens of the three debates

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Three Debates

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1. How open is China’s capital account? What remains to be done?

De jure openness: mixed

Chinn-Ito: unchanged since 1993!

Quinn: improving, but trails average EME

De facto openness: substantially improved, but not complete

IIP: fast growing

Capital account: increasingly volatile

Long-term bond yields: co-moving

Incompleteness: portfolio flows remain scheme-based

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Chinn-Ito Quinn (RHS)

De jure openness: Chinn-Ito vs. Quinn

Source: Chinn & Ito, IMF AREAER.

De facto openness: China’s IIP (Tln. $)

Source: IMF.

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Assets Liabilities Net Position

China’s IIP

China's International Investment Position (Bil. $)

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Net Position 1494 1491 1688 1688 1867 1996 1603 1673 1950 1814

Assets 2957 3437 4119 4735 5213 5986 6438 6156 6507 6926

FDI 186 246 317 425 532 660 883 1096 1357 1473

Portfolio 253 243 257 204 241 259 263 261 367 497

Equity 21 55 63 86 130 153 161 162 215 308

Debt 231 188 194 118 111 105 101 99 152 190

Other

Investment552 495 630 850 1053 1187 1394 1389 1680 1714

Reserve Assets 1966 2453 2914 3256 3388 3880 3899 3406 3098 3236

FX Reserves 1946 2399 2847 3181 3312 3821 3843 3330 3011 3140

Liabilities 1463 1946 2431 3046 3347 3990 4836 4483 4557 5112

FDI 916 1315 1570 1907 2068 2331 2599 2696 2755 2901

Portfolio 168 190 224 249 336 387 796 817 811 1044

Equity 151 175 206 211 262 298 651 597 580 717

Debt 17 15 18 37 74 89 145 220 232 327

Other

Investment380 442 637 891 943 1272 1440 964 984 1163

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De facto openness cont’d

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Composition of net capital flows (Bil. $)

Source: SAFE.

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China US

Source: Chinabond, Federal Reserve Board.

10-year bond yields: China vs. US

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FDI Portfolio Others KA (incl. E&O)

What remains to be done?

IMF’s AREAER

Glass-half-empty: 80% types of capital transactions are subject to some control (Schipke 2017)

Least restricted transactions: FDI, ODI

Glass-half-full: 90% types are at least partially convertible (PBOC 2017)

3 types of unconvertible transactions: foreigners’ equity & money market issuance in domestic markets, derivative transactions

Portfolio investment: low foreign penetration

Foreigners hold 0.4% of China’s credit bonds, and 2% of A-shares

Individual investors: limited ways of investing abroad

Available: QDII funds and Stock Connects

QDII2: under study since 2013, almost launched in 2015

Overseas insurance and home purchases still restricted

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2012 2016

Unconvertible 6 3

Partially convertible 19 20

Mostly convertible 8 9

Convertible 7 8

Source: Jingshan Report (2017), Chapter 5.

China’s capital account convertibility

according to IMF’s AREAER classifications

2. How committed is China to opening its capital account?

Official: vocal commitments

Skepticisms:

Deliberate slowdown, to resist inflows and keep RMB undervalued (Jeanne, Subramanian & Williamson 2011)

Tightening of controls in 2015-2016 reflects lack of commitment (Wharton 2016)

Fear of a massive capital flight and its stress on financial system (Yu 2017)

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3. Is China ready to liberalize its capital account further, and how?

Cautions:

Many preconditions have not been met (Lardy & Douglass 2011, Yu 2015)

External environment is not friendly (Zhang 2015)

Possible side effects (Zhang 2015)

Optimism:

China’s financial system is becoming more robust (Sheng, Xu, Yan & Zhu 2012)

Subtle changes in policymakers’ view:

Early 2010s: optimistic

PBOC’s proposition of studying of QDII2 in 2013

3rd Plenary Meeting of the 18th CPC Central Committee: accelerating capital account convertibility

2015-2016: cautious, focusing on risk

Since 2017: cautiously optimistic

Pan (2017): “The pace of capital account liberalization should be consistent with a country’s economic development, financial market and financial stability, and external conditions.”

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Lessons Learned

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The good: pick the right sequence, and proceed gradually

Open up to FDI flows first

Long-term, stable, low financial risk

Brings in technological & managerial know-how

Gradualism

FDI: pilot programs in the 1980s before fully embracing it

Portfolio: gradually raise the quotas of Q schemes, then introduce C schemes (no individual quotas)

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FDI Portfolio Others

Source: SAFE.

Capital inflows by type, 1982-2000 (Bil. $)

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QFII (Bil.$) QDII (Bil.$)

RQFII (Bil.CNY, RHS)

Source: SAFE.

Approved quotas of “Q” schemes

The bad: unevenly paced capital flow management reform

Capital flow management reform has undergone a philosophical change since 2009

Ex ante review & approval ex post monitoring & analysis

Positive list negative list

Why skepticism remains?

Reform focuses on micro-level management

Macroprudential framework has been slow to develop and implement

Result: continued reliance on administrative tools and discretion

2015-2016: tightening of de facto outflow controls (without changing the rules)

Market impression: still discriminative, time-inconsistent, and opaque

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The “ugly”: distorted financial system & inflexible exchange rate

2008-2013: sharp carry trade inflows

Financial misallocation at home: high marginal rate for private borrowers, hence large home-abroad interest gap (Song, Storesletten & Zilibotti 2011)

Overseas borrowing relaxed: sharp carry trade inflows

Amplification by inflexible exchange rate

2014-2016: carry trade unwinding

RMB became overvalued

Forced deleveraging of overseas debt by domestic enterprises

Sharp other investment and E&O outflows

13Source: SAFE.

Capital account balance by type (Bil. $)

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FDI Portfolio Others KA (incl. E&O)

The great capital reversal

The Great Capital Reversal (Bil. $)

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

1. Current Account 421 243 238 136 215 148 236 304 202 165

(in % GDP) 9.1% 4.8% 3.9% 1.8% 2.5% 1.5% 2.3% 2.8% 1.8% 1.3%

2. Capital Account 40 198 287 265 -32 346 -51 -434 -416 149

(in % GDP) 0.9% 3.9% 4.7% 3.5% -0.4% 3.6% -0.5% -4.0% -3.7% 1.2%

3. Net Errors and

Omission 19 -41 -53 -14 -87 -63 -67 -213 -229 -222

Δ Reserve Assets

(1+2+3) 480 400 472 388 97 431 118 -343 -444 92

FX Reserves 1946 2399 2847 3181 3312 3821 3843 3330 3011 3140

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Overseas borrowing by Chinese corporates

As the interest differential widened from 2008-2014, overseas borrowing by Chinese corporates totaled $1.1 trillion

Since 2015, interest differential narrowed, causing the sharp external deleveraging

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Bonded debt Loans 3m Shibor-Libor (%, RHS)

Capital account balance by type (Bil. $)

Source: Miao & Rao (2016).

The August 11, 2015 exchange rate reform

It was in fact long overdue

Greater exchange rate flexibility: could have dampened carry trade inflows ex ante, or reduce the loss of FX reserves by letting RMB fall

In practice, China relied on FX reserves to counterbalance outflows

A dangerous vicious cycle kicked in, costing $1 trillion in 18 months

Asymmetry: FX reserves can go up without limit, but are bounded from below at 0, at which the central bank is powerless in maintaining exchange rate

Market view FX reserves as the barometer of China’s financial strength (Miao 2018)

FX reserves fall market worry more FX reserves fall even further …

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FX Reserves (Bil.$) USDCNY exchange rate (RHS)

Source: SAFE.

China’s FX reserves and USDCNY exchange rate

China’s Capital Account Policy: Recent Developments

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Opening up further: direct & collateral benefits

Direct benefit: capital account liberalization as an end in itself

Open capital account offers better benefit-risk tradeoff for DMs than for EMs

“Threshold” effect: opening-up may be increasingly favorable for China over time (Kose, Prasad & Taylor 2009, Wei 2018)

“Collateral” benefits: to other key reforms (Kose, Prasad, Rogoff & Wei 2009)

“Ratchet effect”: commitment device for domestic financial reforms (Zhou 2017)

Accommodate RMB’s internationalization

RMB’s inclusion in the SDR basket in 2015: China’s capital account opening-up has passed the point of no return (Zhou 2017)

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Upgrading capital flow management: the dual pillars (Pan 2018)

Microprudential regulation: even-handed & time-consistent

Focus: authenticity & legality of individual transactions

Equal & time-consistent treatments, regardless of type, direction, and timing

Macroprudential regulation: targeted & countercyclical

Focus: overall financial stability

Targeting flows with the most threat: short-term, lending-related flows

Pre-emptive enforcement during inflow booms

Macroprudential regulation complements FX reserves in capital account stabilization

Before exchange rate becomes sufficiently flexible, macroprudential regulation is even more important

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Coordinating the reforms: a troika approach (Zhou 2017, Yi 2018)

In theory: many views

The preconditions view

The sequencing view

The stability view

In practice, the “troika” approach

Idea: pushing the backmarker forward to catch up others, so that all reforms gradually march ahead

Coordinating

Domestic financial reform: interest rate liberalization and beyond

Capital account liberalization

Exchange rate flexibility

Political economy

Helps to resolve bureaucratic deadlocks

Avoids rollbacks

The built-in gradualism and opportunism

No preset schedules

Proceed faster under more favorable conditions

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Adding up: China’s path on the Impossible Trinity

China’s path: B(1994) X(2005) Y(2015) O(2018)

From O A: many possible paths

More aggressive: (c)

More conservative: (b) or (a)

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China’s path on the Impossible Trinity

Source: Miao & Tan (2018).

Alternative paths towards A

Source: Miao & Tan (2018).

Conclusion

Substantial capital account liberalization in the past four decades

Incomplete efforts: portfolio flows still somewhat restricted

Good, bad & ugly lessons

Going forward: committed to financial opening-up, with three principles (Yi 2018)

Pre-establishment national treatment + negative lists for foreign institutions

Coordinating capital account opening-up with financial and exchange rate reforms

Matching the degree of opening-up with regulatory capabilities

The goal: a near-fully convertible capital account + flexible exchange rate + monetary autonomy

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Thank you!

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