A Microfounded Model of Chinese Capital Account Liberalisation

1. A Microfounded Model of Chinese Capital Account Liberalisation Dong He Hong Kong Monetary Authority and Hong Kong Institute for Monetary Research Paul Luk Hong Kong Institute for Monetary Research

2. Introduction • China has been growing rapidly for the last 30 years, but it’s involvement in the international financial market is small due to limited capital account convertibility. • The Chinese government plans to speed up the liberalisation of the capital account. • Capital account liberalisation is closely related to the process of the interanationalisation of the renminbi. • China’s international balance sheet has a ‘long debt, short equity’ asymmetry (Ma and Zhou, 2009). In contrast, the US’s balance sheet is China’s mirror image. • Gourinchas and Rey (2007) describe the US as the ‘world venture capitalist’.

3. Introduction

4. Three key questions • What is the relationship between the limited capital account convertibility in China and its international balance sheet? • How will the asset portfolio composition in China change after capital account liberalisation? • What are the consequences of the liberalisation to China’s gross international investment position? • What are the implications to renminbi internationalisation? • To what extent will the economic growth and the ongoing economic reform in China affect China’s international balance sheet? • We answer these questions with a general equilibrium model with endogenous portfolio choice.

5. Key findings • After capital account liberalisation in China, Chinese households will invest a substantial amount in the US firms. US will likewise invest more in Chinese firms. • China’s desired US bond holding will move from a long position to a short position. • US will hold a negative position in Chinese bonds. • As China grows and rebalances its economy with a higher share of labour income, Chinese holding of US equity will rise.

6. Related literature • International portfolio choice in gen. eq. models: • Devereux and Sutherland (2008), Engel and Matsumoto (2009), Coeurdacier and Gourinchas (2010), Coeurdacier, Kollmann and Martin (2010) etc. • Devereux and Sutherland (2009): asymmetric economies with different asset market configurations. • Models with imperfect substitutability of assets: • Blanchard Giavazzi and Sa (2005) etc. • Empirical literature on Chinese capital account liberalisation: • Ma and Zhou (2009) and He et al. (2012).

7. The model • A standard two country set-up similar to Coeurdacier, Kollmann and Martin (2010). • Households and firms in each country. • Endogenous capital accumulation. • Equity and bond in each country, so 4 assets in total. • Two asset market configurations: before/ after Chinese capital account liberalisation.

8. Consumption and investment • Each country {A,B} produces one good, which is used for consumption and investment in both countries, with home bias, a. • Demand for each country’s good is • And • Similarly for investment IAt, IBt, also with home bias a.

9. Household budget constraint • Country i households have the following budget constraint: • There are 4 assets in the economy, namely equity (S) and bond (b) of each of the two countries. Sijtdenotes country i’s holding of country j’s equity. Similar for bonds. • pSit denotes country i’s equity price, and so on. • Country i’s equity pays dividend dit. • Country i’s bond pays one unit of country i’s goods pit.

10. Asset market configuration • Asset market configuration: • Before Chinese capital account liberalisation, assume US equity and Chinese bond are not tradable internationally. Think of US as country A and China as country B. Then . • Only Chinese equity and US bond are tradable. • After Chinese capital account liberalisation, all four assets are tradable.

11. Household optimisation • Households have the following utility: • The optimality conditions are: Before liberalisation After liberalisation

12. Firms • Firms produce with the following production function • They accumulate capital as follows: • qitand cit are the TFP shock and investment efficiency shock (Justiniano et al. 2007) respectively, where • Hence, the financial market is incomplete before capital account liberalisation, and complete after liberalisation.

13. Firm profit maximisation • Firms maximise the discounted expected stream of dividends: • where Qit,t+sis country i’s stochastic discount factor, • The first order conditions are:

14. Market clearing conditions • Goods market clearing conditions are • Asset market clearing conditions are and

15. Calibration

16. Model solution • We are interested in the optimal portfolio allocations in the non-stochastic steady state under both asset market configuration. To compute these, we use a two-step procedure due to Devereux and Sutherland (2011). • First step: We approximate the non-portfolio system up to the first order around the non-stochastic steady state, temporary treating the excess portfolio return as an exogenous i.i.d process. • Second step: We make use of the second-order approximated optimal portfolio conditions to compute the portfolio allocations.

17. Financial assets as risk-sharing tools • In our model, assets are distinguishable only by their different risk characteristics. • In non-stochastic steady-state, assets have identical returns. • Since assets have different risk characteristics around the steady state, households buy and sell assets to share risk. • According to the portfolio choice equations, households buy (sell) assets whose returns are negatively (positively) correlated with their consumption. • This can insure against fluctuations in consumption.

18. Steady-state portfolio before capital account liberalisation

19. Steady-state portfolio before capital account liberalisation • Only US bond and Chinese equity are tradable. • Suppose US productivity (eqAt) receives a positive shock • Relative consumption in US rises. • US real exchange rate depreciates. • Due to the real exchange rate effect Chinese equity pays a higher return than US bonds. • Suppose instead Chinese productivity (eqBt) rises • Relative consumption in China rises. • Chinese firms increases investment and reduce relative dividend payout. • Chinese real exchange rate depreciates • Relative return of US bond rises.

20. Steady-state portfolio before capital account liberalisation (cont’d) • Suppose US investment efficiency (ecAt) receives a positive shock. • US reduces relative consumption to fund its investment. • Since investment exhibits home bias, a rise in demand for US goods appreciates its exchange rate. • On the other hand, Chinese firms reduce investment and pay out more dividend, increasing relative return of Chinese equity. • Finally, if Chinese investment efficiency (ecBt) rises • China’s relative consumption falls to fund investment. • Chinese firms reduce dividend payout. Relative return of Chinese equity falls. • Hence, the optimal portfolio depends on the relative volatilities of the two shocks. • When the investment efficiency shock is more volatile, households increase their holding of other country’s asset.

21. Numerical results

22. Steady-state portfolio after capital account liberalisation

23. Steady-state portfolio after capital account liberalisation • Analysis follows closely from Coeurdacier, Kollmmann and martin (2010) and Coeurdacier and Rey (2011). • In a complete market, perfect risk-sharing can be achieved. • Real exchange rate risks can be completely hedged by trading bonds. Relative bond return is just the terms of trade. • The job of hedging non-tradable income risks are left to the trading of equities.

24. Steady-state portfolio after capital account liberalisation • Suppose a combination of shocks raises relative investment in US but keeps the real exchange rate unchanged. • Due to home bias in investment goods, US output rises. • (Non-tradable) labour income of US households rises. • But relative dividend payout in US falls to fund investment. • Relative wage income and relative dividend are negatively correlated, conditional on the real exchange rate, leading to equity home bias.

25. Steady-state portfolio after capital account liberalisation • Consider the bond holding if there is no equity. Households in each country will hold domestic bonds: • Relative consumption and the real exchange rate are negatively correlated. • But through holding equity with home bias, households have already hedged against some real exchange rate risk. • Under our calibration, equity holding only partly offsets the need to hedge against real exchange rate risk. As a result, households in each country will be holding domestic bonds and selling foreign bonds short.

26. Numerical results 26

27. Characteristics of the steady-state portfolios • The portfolio exhibits equity home bias all the time. • The equity home bias falls after capital account liberalisation, consistent with empirical evidence (eg. Sorensen et al. 2007). • For China, both outward FDI and portfolio investment, as well as the inward counterparts rise. • Result echoes with the empirical prediction in He et al. (2012). • Gross financial position in China will rise substantially. • Prediction of a rise in GIIP is consistent with Ma and Zhou (2009).

28. Characteristics of the steady-state portfolios • Chinese holding of US bonds reverse from a long position to a short position. • After liberalisation, Chinese households prefer US equity to US bond, because US equity has more desirable risk-sharing properties than bonds. • Chinese households short US bonds to offset excess real exchange rate exposure. • US households in return will hold a negative position in Chinese bonds, after capital account liberalisation. • One possibility is that non-Chinese residents issue renminbi-denominated bonds offshore. • Renminbi internationalisation.

29. Comparative statics:a rebalance in Chinese production • Experiment 1: China rebalances its production with a higher share of labour income. • Brandt et al. (2008) estimate that the capital share in production in China, kB, is about 0.5, much larger than the G7 average of ~ 0.35. • With a shift towards service sector, the labour share in production is expected to rise.

31. Comparative statics:A rise in Chinese productivity • Experiment 2: China experiences a sustained rise in relative productivity. • Zhu (2012) estimates that TFP in China is 13% of that of the US. • Through institutional reforms and policy changes that reduce distortions and better align economic incentives, China’s TFP may catch up gradually.

33. Conclusion • Our model shows that after Chinese capital account liberalisation: • Portfolio equity and FDI flows, both into and out of China, would increase significantly. • China as a whole would reverse its US bond holding, from a long position currently to a short position. • The US as a whole would take a short position in Chinese bonds. • Continued economic growth in China and a reduction in capital share in production could also rebalance China’s international balance sheet. • Some caveats.