Abstract
Selected Issues
China: Capital Account Liberalization1
In response to large capital outflows in 2015/16, the Chinese authorities allowed some currency depreciation, used FX intervention, and applied a wide range of measures to stem outflows and depreciation pressures.
The sequencing of past capital flow liberalization was broadly in line with the Fund’s integrated approach, but supporting reforms to build resilience to capital flow volatility did not keep pace.
Management of capital flows following liberalization has proven challenging, suggesting a need to accelerate reforms and to proceed cautiously with further liberalization.
If capital outflow pressures re-emerge, macroeconomic policies should play a key role in alleviating those pressures. Capital flow management measures (CFMs) can help and buy time, but cannot substitute for macroeconomic policy adjustment.
A. Capital Account Liberalization and Openness
1. The capital account has been opened gradually amid evolving policy priorities. High domestic savings searching for yield and diversification, interest rate differentials and exchange rate expectations have driven capital in and out of China. Also, “Going Global”, “One Belt One Road”, “RMB internationalization”, “Made in China 2025” and other policies have provided impetus for capital flows over time. Generally, capital inflows were liberalized before outflows and FDI flows before portfolio and other flows. The key liberalization milestones were as follows:
FDI into several sectors was liberalized in the early 1990s, but services and some strategic sectors remain closed to FDI. Overseas Direct Investment (ODI) was opened gradually, starting with the “Going Global” initiative in 1999, in part to secure the supply of commodities, to climb up the value chain, and to alleviate RMB appreciation pressures.
Portfolio investment liberalization was initiated with access to select Chinese stock exchanges for qualified foreign institutional investors (starting in 2002) and extended to the Chinese interbank market for foreign sovereign and private entities (in 2015 and 2016 respectively). Domestic qualified institutional investors (QDII) were permitted to make global portfolio investments starting 2007.
Cross-border lending and borrowing was partially relaxed during 2008–10. Chinese commercial banks were permitted to lend abroad in 2008. Qualified domestic enterprises were allowed to lend to their overseas subsidiaries in 2009 and to borrow short-term in 2010.
2. Notwithstanding these liberalization measures, China’s capital account remains relatively closed from a cross-country perspective. Different indicators of de-jure capital account openness have emphasized various aspects of openness. Thus, some measures (Chinn-Ito)2 show that China’s capital account is very closed, while others (Quinn)3 show that it has gradually opened. But even the indicator with the most generous interpretation of the openness of the capital account shows that China’s capital account openness still lags that of advanced economies and large emerging markets.
De Jure Capital Account Openness: Chinn–Ito Index
Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A005
Sources: International Financial Statistics (IFS); and IMF staff estimates.Quinn Capital Control Index
Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A005
Sources: International Financial Statistics (IFS); and IMF staff estimates.3. De facto, however, China’s capital account is more open than indicated by the above de jure indices as shown by the surge of capital outflows in 2015 and 2016. On a flow basis, capital flows into China (as a percent of GDP) are of similar magnitude as those into comparable emerging markets.4 However, as China commenced opening later than others, therefore on a stock basis, capital account openness still lags that of its peers. Net capital outflows reached a record of around $648 billion in 2015 (5.8 percent of GDP), mostly driven by other investments and errors and omissions. In 2016, outflows amounted to almost US$640 billion (5.7 percent of GDP), driven by all categories of the financial account and errors and omissions. These outflows resulted in significant depreciation of the RMB, which was partially cushioned by FX intervention.
Capital Flows
(In US$ billion)
Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A005
B. Assessing Capital Account Liberalization and Tightening
4. The removal of Capital Flow Management Measures (CFMs) in the sequencing of capital flow liberalization has been broadly in line with the Fund’s Institutional View.5 As described above (¶1), China first liberalized FDI inflows, which are a stable source of capital and considered to be a driver of growth resulting from technology transfer and other positive spillovers to the economy. This helped fuel the export sector after China joined the WTO in 2001. ODI was the next to be liberalized, followed by other longer-term inflows (including through mandatory holding periods of portfolio investments). Short-term flows (including external debt) were liberalized later. In general, China cautiously tested its liberalization policy on a small number of companies or in free trade zones before generalizing it to broader sets of sectors or regions.
5. However, progress in implementing necessary supporting reforms has been slower than desirable (Appendix II). In recent years, there has been limited progress in reforms that would improve the resilience to capital flow volatility. In particular, financial stability risks have accumulated and are now complicating the conduct of monetary policy, as even modest interest rate increases have the potential to create stress for smaller and over-leveraged financial institutions. Gaps in supervision/regulation and in the macro prudential framework, as well as high corporate debt and insufficient progress in reforming state-owned enterprises (SOEs), also raise potential systemic risk concerns. Quasi-fiscal pressures from local governments have also contributed to increasing debt and vulnerabilities. Faster progress on increasing exchange rate flexibility and further developing the monetary policy framework would have strengthened the ability of the economy to manage better capital flows following their liberalization.
6. Given the limited progress on reforms and associated growing vulnerabilities, China has relied heavily on tighter enforcement of existing restrictions during recent bouts of capital outflows (Appendix I). Amid persistent depreciation expectations, the inability of exchange rate and monetary policy to help materially absorb shocks has placed the burden on CFMs and FX intervention to deal with capital flow volatility. Since mid-2016, the authorities stepped up enforcement of existing CFMs and tightened a few others, which has contributed to curbing outflow pressure since late 2016.6 Subsequently, intervention by the PBC has subsided and headline reserves have increased modestly to stabilize at slightly above USD 3 trillion. While the authorities’ measures have contributed to the reduction of outflows, other factors (e.g. a better growth outlook in early 2017, anchored exchange rate expectations) appear to have played an important role as well.
7. While the recent tightening of CFMs is in line with the IMF’s institutional view on capital flows, there are several concerns to consider. As necessary supporting reforms have not kept pace with the liberalization of capital flows, a tightening in CFMs is a possible policy response to capital outflows. Nonetheless, macroeconomic policies should play a more central role in managing outflows and structural reforms should be accelerated;7 in addition, tightening of CFMs will likely lose effectiveness over time, adversely affect the business climate and could reduce incentives for reforms.
Role of macroeconomic policies. Notably, interest rate and exchange rate adjustment – as well as financial policies—should play a primary role in addressing capital flow pressures. Given that the exchange rate is fairly valued, reserves are assessed as adequate, and balance sheet FX exposure is limited, the room for additional macroeconomic policy actions should be explored and CFMs should not be used as a substitute.
Effectiveness and costs. First, the effectiveness of CFMs over a long period is questionable, as outflows are driven largely by Chinese residents who have proven adept at moving capital in and out as evidenced by the surge of errors and omissions in the BOP (2 percent of GDP in 2016 against an annual average of 0.7 percent of GDP in 2010–14). Second, the cost of monitoring and enforcing extensive CFMs represents a heavy administrative burden that could be difficult to sustain. Third, administrative measures could impede economic efficiency (for example, by curtailing ODI in non-core businesses the government could be making sub optimal decisions in areas where it lacks expertise).
Inconsistent enforcement over time and across locations and the resulting impact on the business climate. During times of large capital inflows and pressures for exchange rate appreciation, the enforcement of CFMs appeared more relaxed. Amid capital flow reversals, enforcement has been stepped up. In addition, the extent of enforcement varies by location, depending on how local officials interpret regulations. This inconsistent enforcement, along with the broad reach of recent enforcement measures has created uncertainty in the market as to the authorities’ intentions and strategy to deal with depreciation pressures. Uncertainty related to the ability to repatriate FDI earnings and conduct other current account transactions is not conducive to attracting new capital into China. Also, CFMs should be enforced in a way that does not result in a breach of China’s obligations to the IMF to not restrict current international payments and transfers. More generally, the perception that the authorities use moral suasion to modulate the enforcement of measures could erode confidence in the regulatory system and damage the business climate. Recognizing these challenges, the authorities recently took steps to improve their communication and to further liberalize inflows.
Incentives for further reform. There is also a risk that the use of CFMs would lead to delays in reforms and increase risks of asset price bubbles and financial instability.
C. Policy Recommendations
8. When imposing CFMs is warranted, they should be implemented consistently and transparently. First, CFMs should be implemented consistently over time and across locations, and clearly communicated to market participants. Loosening or tightening implementation in response to capital flows creates the perception that rules are enforced in ways that are uneven and unpredictable. Second, CFMs should be implemented transparently, preferably through written rules. Even a perception that new CFMs are introduced through window guidance could give rise to unintended consequences (e.g. corporations could switch from transacting in RMB to transacting in FX if they perceive cross-border RMB transactions might be constrained, thereby reversing progress in RMB internationalization). Finally, even when CFMs are warranted, they should be designed and implemented such that they not restrict current international payments and transfers.
9. The authorities should expeditiously implement key reforms that would help strengthen the resilience of the economy and financial system to capital flows. Financial sector reforms (including to supervision and the macro prudential policy framework) and further strengthening of the monetary policy framework are vital to ensuring an efficient allocation of capital. In this respect, the regulatory/supervisory tightening in the financial sector, starting early 2017, is critically important and should continue. SOE reforms are also critical to increase efficiency of resource allocation and contain financial sector vulnerabilities. Hard budget constraints would help dispel the wide-spread perception of state guarantees, which leads to mispricing of assets and risks.
10. Further liberalization should proceed cautiously by assessing benefits and costs, while pushing ahead with supporting reforms. Liberalization should be paced and phased appropriately in tandem with the necessary reforms. Further liberalization of inflows for the purpose of providing immediate relief against outflow pressure could increase risks of disruptive outflows in the future, should depreciation expectations resume. However, in areas where capital flows are less volatile and where China would benefit from more openness, the benefits of liberalization may outweigh risks. Liberalization could proceed in these areas, potentially including FDI in service sectors, where there is room for rapid efficiency and productivity gains. Not only does FDI provide a stable source of capital, but entry of high-quality investors could help raise sectoral productivity. Financial services and health are areas where carefully crafted liberalization could also be beneficial. In the financial sector, the recent envisaged opening to foreign entities, including credit rating agencies, could help improve capital allocation and boost the overall efficiency of the financial sector. To help support a more flexible exchange rate, consideration should also be given to eliminating or gradually reducing the reserve requirement for onshore FX hedging. If derivative transactions give rise to financial stability concerns, appropriate macro prudential measures should be considered.
11. The challenges of the “impossible trinity” are becoming apparent. Among other reasons, the size of the Chinese economy makes it desirable to move towards an independent monetary policy. This implies that the authorities must choose between the extent of capital account openness and exchange rate flexibility. Exchange rate flexibility will help absorb the impact of shocks, including those resulting from capital flows surges, while relaxing the necessity to impose or maintain a wide range of CFMs. Thus, deep reforms, including those which allow for greater macroeconomic policy adjustment should be expedited to allow the country to benefit from greater financial openness while mitigating the associated risks.
Appendix I. Measures Taken by China Since Mid-2016 to Stem Capital Outflows
Key areas of tighter enforcement of existing CFMs since mid-2016:
ODI, where the authorities are paying closer attention to certain activities (e.g., investment in non-core businesses). In addition, SAFE issued in January 2017 a circular requiring companies to explain to banks the sources and purposes of the investment funds, and present the resolutions of board of directors. The PBC also urged commercial banks to tighten their verification of the authenticity of certain ODI.
Offshore RMB lending by non-financial institutions: commercial banks were urged to enforce strictly existing rules (including the prudential lending limit of 30 percent of lender’s equity). Banks must strictly examine whether the business operating scale of the overseas borrower is suitable for the loan size, and the authenticity and reasonableness of the use of outbound loan.
Appendix II. Chart of the IMF’s Integrated Approach to Capital Account Liberalization
Prepared by Calixte Ahokpossi (SPR)
The Chinn-Ito index is the first standardized principal component of four binary indicators built from AREAER (The IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions).
The Quinn index measures the intensity of controls in each category, not merely whether it is open or not. It scores (0, 0.5, 1, 1.5, or 2) based on the severity of restrictions (existence of approval requirements and frequency of approval).
See “Outlook for Net Capital Flows”, in China – Selected Issues Paper, IMF 2016.
For a comprehensive summary of the IV, see: Box 1 in “Capital Flows—Review of Experience with the Institutional View”, IMF 2016 and Box 1 in “Managing Capital Outflows—Further Operational Considerations”, IMF 2015.
There have also been reports of the use of window guidance to tighten the enforcement of existing CFMs or to temporarily introduce new ones.
Per the Fund’s Institutional view (IV), capital outflows should be handled primarily with macroeconomic, structural, and financial sector policies, with CFMs only being useful in certain circumstances, i.e. as part of a broader policy package in crisis-type situations or when liberalization has outpaced the capacity of the economy to safely handle the resulting flows.
