Dic LO, Guicai Li, Yingquan Jiang, and Tao Qin

International Conference on “Regulating Finance for Economic Development” December 2011，Suzhou Consideration on China’s Capital Controls Dic LO, Guicai Li, Yingquan Jiang, and Tao Qin Dic Lo (SOAS and RUC), Gucai Li (JUEF and RUC), Yingquan Jiang (SOAS), Tao Qin (RUC and HKBU) For correspondence: Dic Lo, diclo@soas.ac.uk

China liberalized capital flows under the current account in 1996, and FDI inflows much earlier, with the objective of fully liberalizing the capital account by the year 2000. • The reality is that, today, this objective still remains one for the long-term future (by 2015 the earliest). Portfolio inflows and outflows are still under severe restrictions, despite some degree of limited liberalization. • Initially, shelving the achievement of the objective was just a response to the 1997-98 East Asian crisis. This became an established policy when the government seemed to reach the judgement that the East Asian crisis was at least partly ascribable to premature opening of the capital account. • After the outbreak of the financial crisis in the advanced countries, the policy has become long-term – in practice, if not yet in strategy. POLICY ISSUES

Liberalization of the capital account has been a core doctrine of the Washington Consensus since the mid-1990s. The financial crisis emanating from the advanced countries might have pushed the IMF to become a little bit more flexible with this stance. Yet, as far as China is concerned, the pressure seems to remain. • The argument for China to liberalize its capital account, sooner rather than later, is framed in two different ways. • First, it is argued that China’s continuous capital controls are to the detriment of correcting global imbalances. • The accumulation of official foreign exchange reserves is claimed to be a symptom of exchange rate manipulation. • Behind the demand for the appreciation of the yuan is the demand for opening up the Chinese market for portfolio capital flows.

Second, it is argued that the controls are very costly for the Chinese economy itself. • Again, the accumulation of official foreign exchange reserves is found to be problematic: it leads to inflationary pressure. • More important, capital controls have become increasingly ineffective – which has resulted in decreasing monetary policy autonomy. • The fact that China has avoided East Asian-type currency and financial crisis has been widely cited in support for capital controls. In addition to deterring speculative capital inflows, the prevention of capital flights in China has formed another core argument for capital controls. • Both of these are in contrast to mainstream arguments: free capital flows promote allocative efficiency and utilizing foreign savings, avoid rent-seeking…

The purpose of this presentation is to analyse the main trends of evolution of China’s cross-border capital flows, and, on that basis, to assess the effectiveness and efficiency of its capital controls. • The objective is not only to assess the efficacy of the alternative policy doctrines (and theoretical positions), but also to come out with some policy conclusions for Chinese economic transformation in this particular area.

Opening to cross-border capital flows has become increasingly important in shaping Chinese economic transformation since the turn of the century. • Both the current account and the capital account have registered sizeable surpluses, with capital flows under the category “errors and omissions” – which can be seen as an approximate indication of speculative inflows and/or capital flights – exhibiting serious fluctuations (Figure 1). • A closer look at the flows under the capital account reveals that net FDI has accounted for the main part of the capital account surpluses (Figure 2). This is to be expected, an intentional policy outcome. • Yet, the scales and fluctuations of portfolio and other investment surplus have also been very significant – albeit these have been partly accounted for by the implementation of QFII since 2002 and QDII since 2006. MAIN TRENDS OF EVOLUTION

Figure 1. China’s Balance of Payment (US dollar 100 million) Sources: China Statistical Yearbook and China Financial Yearbook, various issues.

Figure 2. Capital Account Balances (US dollar 100 million) Sources: China Statistical Yearbook and China Financial Yearbook, various issues.

Expressed as ratios to GDP, Figure 3 indicates the scales and fluctuations of the “unaccounted for” capital flows (Figure 3). The measure used is defined as the following: change in official reserves - current account balance - net FDI Whether or not capital flows so measured include those under QFII and QDII, the point is that these flows have been very volatile. The flows could reach -6.5% of GDP in 1998 and +4.4% of GDP in 2004 • In this connection, and for the consideration of long-term development, note the rising importance of short-term capital flows vis-à-vis long-term flows since the late 1990s (Table 1). • All these give rise to questioning the effectiveness of China’s capital controls – and also the opposite question as to whether the volatility would have been even more serious if there were no capital controls.

Figure 3. “Unaccounted for” Capital Flows Sources: China Statistical Yearbook and China Financial Yearbook, various issues. Note: A = errors and omissions; B = change in official reserves – current account balance – net FDI.

Table1. Short-term and Long-term Capital Inflows (US dollar billion) Sources: China Statistical Yearbook and China Financial Yearbook, various issues.

The standard method for verifying the effectiveness of capital controls is to apply the criterion of uncovered interest rate differentials (CID). In other words, this is to analyse the differences between the onshore and offshore interest rates for the same financial instruments. • Define NDF = S(1 + i)/(1 + r*) where NDF = non-deliverable forward, S = spot rate, i = the NDF-implied yield on the home currency offshore, and r* the dollar interest rate. From the criterion indicated above CID = r - i = r – [NDF(1 + r*)/S-1] where r is the interest rate on the home currency onshore. It is postulated that CID > 0 implies appreciation pressures on the home currency in the present of capital controls, and vice versa. EFFECTIVENESS

Figure 4 applies the CID criterion by using the base rate of RMB one-year deposit for r for the period 19th January 1999 to 31st May 2011 (Figure 4), while Figure 5 uses the Shanghai Interbank Offered Rate (shibor) for r for the period from 8th October 2006 to 31st May 2011 (Figure 5). In both cases, we use the London Interbank Offered Rate (libor) for r*. • Both Figures 4 and 5 indicate a large and persistent onshore-offshore spread (r - i), which implies the presence of effective restrictions over cross-border capital flows. • Figure 4 also indicates that there were pressures to depreciate before 2003, but mostly pressure to appreciate after that. Moreover, both of the two figures indicate that the spread has not decreased even after China lifted the yuan-dollar peg in July 2005 – there were actually very serious fluctuations in 2007-09.

Figure 4. Onshore-Offshore Spread: One-Year Deposit Rate

Figure 5. Onshore-Offshore Spread: One-Year SHIBOR

The basically effective capital controls have been achieved at heavy cost, at least in the short term. This in the first takes the form of heavy inflationary pressure, arising from the accumulation of official reserves in foreign exchange • It is found that, for the quarterly data from 1999 fourth quarter to 2011 third quarter, ln BMt = 1.712 + 0.764*ln FCRt + 0.937AR(1) + ut (1) (1.153) （4.061）*** (15.682) *** Adj R-square = 0.992 DW = 1.907 where BM = base money, FCR = foreign exchange reserves, and numbers in parentheses are t statistics. Unit-root tests confirm this result. It can thus be inferred that the money supply is influenced by the change in official foreign exchange reserves, i.e., a constraint on the autonomy of monetary policy. EFFICIENCY

To act against this influence, the People’s Bank of China (PBC) has had to resort to either increasing the issuance of central bank debts or raising the reserve requirement ratios on commercial banks. Both measures involve costs for the PBC. • Figure 6 indicates the massive increases in central bank debts in recent years, a leap of more than 26 times between 2002 and 2008 (Figure 6). Table 2 provides the data of the reserve requirement ratios on commercial banks after successive adjustments, from November 1999 until December 2011(Table 2). There is a clear trend of progressive increases. • Taking into account of the interest rates on the debts and required reserves of commercial banks, and given the low yield rates of the foreign exchange reserves, it is estimated (by CASS-IWPE) that the resulting, actual rate of returns to official reserves was 3.5% in 2002-05, -1.64% in 2006-09 and 1.49% in 2010.

Figure 6. Central Bank Debts (RMB billion) Sources: PBC official web.

Table 2. Adjustments in Reserve Requirement Ratios (post-adjustment ratios) Sources: PBC official web.

Are these costs – for the Chinese economy as a whole – worthwhile? From the perspective of long-term economic development, we seek to analyse the impact of capital controls by applying the following: (1) (2) (3) (4) (5) (6) (7) (8)

where y = annual growth rate per capita real GDP; c = ratio of outflows plus inflows to GDP; tr = ratio of export plus import to GDP; fd = ratio of total outstanding loans plus total market capitalisation of shares and bonds plus broad money supply to GDP; and k = annual growth rate of capital per person. • Table 3 gives the results of the regression analyses. It can be seen that: (1) Openness of capital account is found to be insignificant or only weakly significant in its correlation with per capita GDP growth. (2) Openness of foreign trade is persistently found to be significant in terms of its positive correlation with per capita GDP growth. (3) Financial development is mostly found to be significant in terms of its negative correlation with per capita GDP growth. (4) The substantial increases in the value of the adjusted R-square when k is included as an explanatory variable suggests that domestic accumulation has remained the main driving force of output growth.

Table 3. Finance and Economic Growth, 1985-2010

To further analyse the impact of short-term capital flows – as opposed to long-term capital flows on economic development, a simply causality test can be applied. • Define lci = the ratio of long-term capital net inflows to GDP, and sci = the ratio of short-term capital net inflows to GDP. From Table 4, • (a) y Granger causes lci, but not vice versa; and • (b) sci Granger causes y, but not vice versa. • These results suggest that long-term economic development has been mainly a cause, rather than a consequence, of long-term capital inflows. This is consistent with finding (1) as indicated earlier, as well as our previous work on FDI and Chinese economic growth. Meanwhile, the above results also suggest that short-term capital inflows have the effect of causing fluctuations in economic growth.

Table 4. Granger Causality Tests: Per Capital GDP Growth, Long-term and Short-term Capital Flows

Since the series of y, lci and sci are all I (0), we can construct the following VAR model for analysis. (9) (10) • Set the maximum lag period as 1 in accordance with the criteria of minimising AIC and SC. Table 5 gives the results of the analysis. It is confirmed that • (a) y has a significant effect on lci, but not vice versa; and • (b) the effect of y on sci, or vice versa, are not significant.

Table 5. VAR Analyses: Per Capital GDP Growth, Long-term and Short-term Capital Flows

The policy regime governing China’s cross-border capital flows has remained a mixed regime. Its attributes of effectiveness and efficiency thus can in no sense be simply inferred from economic theories. Economic theory, of course, has also been equivocal, or controversial, for this issue. CONCLUDING REMARKS

Dic LO, Guicai Li, Yingquan Jiang, and Tao Qin