Liberalizing China's Capital Account

Should emerging economies maintain an "appropriate" level of capital controls to cope with increasing volatility of international capital movements? This has become a hot topic among academics and a focus of discussion in domestic policy circles as well. In recent years,academic research has concluded that emerging markets should impose controls on capital flows under certain circumstances. Moreover,the International Monetary Fund has dropped opposition to capital control. Since 2012,domestic academics have argued over whether capital account liberalization should be accelerated,but no consensus has been reached. In the initial stages of capital account reform,the Chinese government followed a gradual and prudent approach,but after the 2008 global financial crisis,capital account liberalization was accelerated significantly in China. The speeding up in the pace of liberalization reflected a change in the Chinese government's thinking. However,the potential risks may have been underestimated. In view of the complicated international and domestic situation that the Chinese economy now encounters,the government should adhere to a more prudent,orderly and controllable approach to liberalizing the capital account. Otherwise we could be faced with a systemic financial crisis at some point in time. The government should follow a proper sequencing order in its effort to open up the capital account and speed up the construction of its macro-prudential regulatory framework. It should also vigorously promote domestic structural reforms and establish a reliable early warning system to signal potential crises and it needs adequate  management and response mechanisms.

The Paths to Capital Account Liberalization

Drawing important lessons from the experience of the Asian financial crisis of the late 1990s,the government has chosen to open the capital account in an orderly and controllable way. For instance,China has tried to open capital inflows first,followed by capital outflows. It seeks to deregulate long-term capital flows before addressing short-term capital movements. Generally,it has adopted a pilot project approach,allowing liberalized capital movements under quota systems. Once authorities have time to examine the results of their reforms,controls can be relaxed further or even eliminated.  

Before the 2008 financial crisis,China's capital account had already achieved partial liberalization. For cross-border direct investments,there had been substantial liberalization in regard to inbound foreign direct investments and outbound direct investments. These capital movements were permitted as long as they complied with relevant industry regulations,had gone through a verification process and had received required approvals.   Authorities had also implemented two-way quota management for cross-border investments in securities. Foreign portfolio investment in China was limited by quota restrictions under the Qualified Foreign Institutional Investor (QFII) program,while outbound portfolio investment was managed under the Qualified Domestic Institutional Investor (QDII) program. Through this quota management system,the Chinese government maintained a controlled liberalization of its regime for managing cross-border securities investments. Lastly,the government adopted a classified management method on other cross-border investments (fund flows related to bonds and borrowings).

For cross-border trade financing,as long as transactions cleared a verification audit,funds could be moved freely for the most part. Foreign-invested enterprises were able to apply for loans from their parent company overseas but within a limit that was determined by the difference between their registered capital and actual capital levels. Additionally,strict controls remained in place on short-term offshore borrowings and bond issues.

From 1999 to 2011,China had a "twin surplus" in its balance of payments from the current account and the capital account. As a direct result of this prolonged surplus,China's foreign exchange reserves soared to around $4 trillion at the peak,giving the country the world's largest holdings of foreign exchange,preserving and increasing the value of these foreign assets has been a key issue.

The 2008 US subprime mortgage crisis and the 2010 European sovereign debt crisis led to a profound change in the relative strength of the world's major economies. Asset prices in major developed economies declined and  economic growth slowed. In contrast,the impact of the crises on key emerging economies was less severe. What's more,developed countries chose to implement quantitative easing policies after the crisis,sending surplus liquidity around the world. This helped stimulate development of emerging economies. Their currencies appreciated,domestic asset prices rose,and the economy underwent rapid growth. During that period,China surpassed Japan to become the world's second largest economy,while it also became the world's biggest trading nation and top holder of foreign exchange.

After the 2008 financial crisis,the Chinese government launched two new major initiatives on capital account liberalization. It vigorously promoted a "go out" policy that encouraged Chinese companies to invest more overseas. After the crisis,asset prices in developed countries were relatively low and many of their companies were badly in need of capital injections. Chinese enterprises were encouraged to seize this opportunity to make direct investments in foreign markets. The theory was that Chinese enterprises could enhance their international competitiveness while the nation would make better use of its foreign exchange reserves and potentially increase the value of those assets.

At the same time,China made a push to internationalize the renminbi to reduce the nation's dependence on the US dollar in foreign trade and investment. This policy was aimed at slowing the accumulation of foreign exchange reserves,reducing foreign exchange risks and conversion costs for Chinese enterprises,and promoting domestic financial market reforms.

In promoting the internationalization of the renminbi,the government has adopted a three-pronged approach. It has expanded the pricing and settlement of renminbi in cross-border transactions and investments and it has sought to develop offshore renminbi centers,such as Hong Kong,Taipei and London. The People's Bank of China has also signed bilateral currency swap arrangements with the central banks of other countries and regions to provide liquidity to the renminbi offshore markets. By the end of June 2015,renminbi internationalization had achieved significant progress; around one-quarter of China's total cross-border trade is settled in renminbi and the currency now ranks fourth or fifth in global settlements. Renminbi deposits in global offshore markets have exceeded two trillion yuan,with Hong Kong accounting for around half of that total. So far,the People's Bank of China has signed bilateral currency swaps with more than 20 central banks and the total of these swap arrangements has reached nearly three trillion yuan.

Renminbi internationalization and capital account liberalization are essentially two sides of the same coin. In fact,since the Chinese government started to promote cross-border trade settlements in renminbi in 2009,the People's Bank of China has basically made progress in capital account liberalization through the promotion of renminbi internationalization. This is because in order to promote greater global use of the nation's currency,China must export renminbi and ensure there is a way to repatriate the currency that is held offshore. Only in this way will China be able to satisfy the offshore demand for renminbi - which is partly used to invest in China's onshore market. In order to achieve a two-way movement of the nation's currency between the onshore and offshore markets,further capital account. Liberalization is necessary.

The major measures in liberalizing the capital account under the renminbi internationalization program include having the People's Bank of China relax regulations on the renminbi-settled cross-border trade and investment. Currently,the policies on foreign currency-denominated cross-border trade and investments are still managed by branches of the State Administration of Foreign Exchange in each region,while the policies on renminbi-denominated cross-border trade and settlements are now managed by each local office (cross-border office) of the monetary policy department of the People's Bank of China -- a newly established unit set by the central bank to promote renminbi internationalization. Generally speaking,the cross-border office's management of cross-border movements of renminbi is more relaxed than SAFE's management of cross-border foreign currency flows. In order to facilitate the repatriation of offshore renminbi funds,the government has opened the domestic bond market to foreign central banks and offshore renminbi clearing banks. At the same time,the government has launched the Renminbi Qualified Foreign Institutional Investors (R-QFII) system,allowing overseas institutional investors to invest,within quota limitations,in China's domestic financial market using renminbi funds they obtained abroad. Also,as to the offering of cross-border financial products,the government encourages various types of domestic and foreign institutions to issue renminbi-denominated bonds on offshore markets (dim sum bonds,for exmple),and gradually relax controls on the issuance of renminbi-denominated bonds by foreign institutions on the onshore renminbi markets (panda bonds). What's more,the Shanghai-Hong Kong Stock Connect program,which links the stock exchanges in Shanghai and Hong Kong,has been put in place and other mechanisms to connect domestic and offshore markets - such as the Shenzhen-Hong Kong Stock Connect - are moving forward. In addition to the QDII program for institutions,the government will soon roll out QDII2 which will allow domestic individuals to directly invest in offshore financial markets. In the Qianhai pilot zone in Shenzhen,for example,the government has implemented the Qualified Domestic Limited Partner (QDLP) system which places no restrictions on the type of offshore foreign investment.

However,when the People's Bank of China began promoting renminbi internationalization and capital account liberalization,the mechanisms for determining the renminbi exchange rate and domestic interest rates were not entirely market-based. As a result of wide gaps between onshore and offshore exchange rates and interest rates,there has been a great deal of cross-border arbitrage activity. In the onshore renminbi market,the People's Bank of China has maintained a certain degree of control over interest rates and the exchange rate,while offshore market relies on supply and demand.  This has resulted in a wide gap in renminbi pricing (for interest rates and the exchange rate) between the onshore and offshore markets,giving ample room for arbitrage activity. From 2009 to 2013,there were significant expectations of appreciation for the renminbi,and the currency's trading level on the offshore market was much higher than on the onshore market. Many companies pretended to import renminbi for settlement,but actually were merely transferring renminbi from the onshore market to the offshore market to take advantage of the exchange rate spreads. Since 2009,the renminbi interest rate levels on the onshore market have been much higher than those of the offshore market,and many companies used disguised cross-border renminbi settlements,borrowing renminbi funds from offshore banks using onshore guarantees of offshore loans. They then transferred the funds for domestic use to take advantage of the higher interest rates. Over the past few years,there has a great deal of cross-border arbitrage activity focused on interest rates and the exchange rate. Such activity has not only undermined the effectiveness of the government's macro-controls,but also damaged the national interest and inflated the official data on renminbi internationalization.

The Transformation of China's Capital Account Liberalization

We can see that before the 2008 financial crisis,the liberalization of China's capital account held to its orderly pace,but became significantly faster afterwards.

However,since the 2008 crisis,the liberalization of China's capital account has gathered pace,and the regulatory logic has also undergone significant changes.

With the expansion of China's economy as well as the rise of the economy's  global ranking,the government sought a more important role on the global stage. It turned to the promotion of renminbi as an international currency and this required support from capital account liberalization. Since the financial crisis,the economic growth of Europe,the US,Japan and other developed countries has seen a marked slowing,while China has maintained a fairly rapid pace of development. The government sought to address what it saw as a mismatch in the status of its economy and currency relative to their global importance by pushing for greater renminbi internationalization. In order to speed up use of the renminbi outside of China,the government had to accelerate capital account liberalization. This on one hand required the government to allow more of the currency to move offshore through trade,investment and financial channels. It also required the government to permit the repatriation of renminbi parked offshore by opening up the domestic stock,bond and other financial markets.

Meanwhile,China's industrial restructuring and upgrading requires the promotion of outward direct investments by the nation's corporations. The export-oriented development model is no longer sustainable due to China's prolonged economic expansion,the rise in domestic factor prices,and the continuous appreciation of the renminbi. China's companies need to shift from traditional low value-added labor-intensive production to higher value-added capital and technology-intensive industries. And they need to gain advanced technology and management experience from abroad through overseas mergers and acquisitions. In the past,China's capital account was open to inbound foreign direct investment but less open when it came to  outbound direct investment. This relaxation of restrictions on outbound investment was needed so that domestic companies could assume this bigger global role.

Moreover,with the steep rise in foreign exchange reserves and the need to preserve the value of the nation's reserves,the People's Bank of China faced a considerable challenge. China's foreign exchange reserves are still mainly invested in the government debt of developed countries,such as US treasury debt. However,since the 2008 financial crisis,the central banks of the United States,the Eurozone,the United Kingdom and Japan have all cut their domestic interest rates to near zero. Furthermore,they have rolled out unconventional monetary policies,such as quantitative easing,and this has resulted in even lower returns on China's foreign exchange reserves. It has also exposed China to heightened exchange rate risks from weaker currencies of the developed countries. Former premier Wen Jiabao publicly expressed his concerns over the security of China's foreign exchange reserves invested in US treasury debt. In order to improve the return on the nation's foreign exchange reserves,the Chinese government moved to