L-8 Part II. Managing Capital
Flows in China
Presenter
Ray Brooks
Joint China-IMF Training Program
Course on Macroeconomic Management
and Financial Sector Issues
CT
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Outline
• What was the experience with capital flows?
• How were capital flows managed in the past?
• Were capital controls effective?
• What will happen to with capital flows with
liberalization?
• Experience of liberalization in other countries
• Benefits and risks of opening the capital
account in China
• Steps toward successful liberalization in
China
China’s Experience: Forex inflows were
sizable, but mainly from the current account
surplus.
A
s
pe
rc
en
t o
f G
D
P
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
0
2
4
6
8
10
12
14
-2
-4
China: Current Account and Overall Balance of Payments
(as percent of GDP)
Current Account Balance
"Overall Balance"
Sources: International Financial Statistics database
…the capital and financial account
was also in surplus and volatile.
A
s
pe
rc
en
t o
f G
D
P
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
0
1
2
3
4
5
6
-1
China: Capital and Financial Balance
(as percent of GDP)
Capital and Fianancial A/C
Sources: International Financial Statistics database
FDI flows were large
FDI and other Capital Flows were
large in a global context too
Gross Capital Flows were also
large
How were capital flows managed in
the past?
• A combination of policies managed the
flows:
– Exchange rate policy (gradual appreciation)
– Sterilization of forex inflows
– Reserve requirements on banks
– Capital controls
– Improved prudential and supervisory policies
Nominal and Real Effective
Exchange Rates appreciated since
2005 reform
1998Q4 2000Q4 2002Q4 2004Q4 2006Q4 2008Q4 2010Q4 2012Q4
80
90
100
110
120
130
140
80
90
100
110
120
130
140
Nominal Effective Exchange Rate and Real Effective Exchange Rate (Index, 2005=100)
Nominal Effective Exchange Rate Real Effective Exchange Rate
Sources: International Financial Statistics database
Sterilization: Official Reserves
increased considerably
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
0
2
4
6
8
10
12
14
0
10
20
30
40
50
60
China: Overall Balance of Payments and Official Reserves
(as percent of GDP)
Overall Balance (LHS)
Official Reserves (RHS)
Sources: International Financial Statistics database
With considerable variation in the
extent of forex intervention
The reserve requirement on banks was increased
to manage the liquidity impact of forex inflows
Capital Account controls were
eased in past decade but remain
restrictive
China remains relatively closed
Were capital controls effective?
Flows do not appear sensitive to interest rate
differential
Franziska Ohnsorge and Steven Barnett, IMF March, 2013
But sensitive to US interest rate
Franziska Ohnsorge and Steven Barnett, IMF 2013
What will happen to capital flows
with liberalization?
What happened in other countries?
20+ episodes of capital account liberalization
(Kaminsky and Schmukler, 2003) in AM and EM
since 1979.
The increase in net capital inflows from the year
before to the year after liberalization depended on:
• State of domestic versus world business cycle
• Time since financial sector liberalization
Gross international assets and liabilities increased
on average by 19-20 percentage points of GDP over
the following five years.
Portfolio inflows increased and..
Bayoumi and Ohnsorge, IMF WP 2013
… as did other investment flows.
Bayoumi and Ohnsorge, IMF WP 2013
Capital account liberalization was almost
always followed by increases in gross
foreign assets
Bayoumi and Ohnsorge, IMF WP 2013
..and often also increases in gross foreign
liabilities.
Bayoumi and Ohnsorge, IMF WP 2013
Recent IMF study predicts rise in
Chinese assets with liberalization of
capital account
Bayoumi and Ohnsorge, IMF WP 2013
Experience of other countries: liberalization often
followed by exchange rate or banking crisis
Bayoumi and Ohnsorge, IMF WP 2013
Some country cases
Korea: liberated capital controls before exchange
liberalization: led to currency mismatches on balance
sheets and 1997 crisis
Israel: Unsuccessful “big bang” liberalization in 1977, large
inflows that reversed. Controls reintroduced 1 ½ years
later. Subsequent reform better managed.
Sweden: capital account liberalization in 1989 and financial
liberalization led to credit boom. Could not defend fixed
exchange rate.
Turkey: capital account liberalization with fiscal
dominance: destabilizing capital flows and two crises
(1994 and 2001).
Emerging markets with more flexible exchange rates
have generally fared better in face of external pressures
(Chile, Peru, South Africa)
Benefits of opening the capital
account in China
• Better allocation of capital and risk diversification
• Wider use of RMB as international currency
• Would help rebalance growth away from reliance on
exports and investment, with supporting financial and
exchange rate reforms
• Would facilitates financial sector reform and
development by:
– Improving liquidity in domestic equity markets
– Introducting competition
• Banking sector, with foreign bank entry bringing benefits to
savers and borrowers
• Insurance sector currently protected, would face greater
competition
• Capital controls less effective over time in face of
expanded trade and more sophisticated investors
Risks of opening the capital
account
in China• Gross capital flows could be large after
liberalization
• Potential problems:
– Asset bubbles
– Capital flight
– Currency and maturity mismatches in bank and
corporate balance sheets
• Problems could lead to crisis as seen in other
countries
• Underlines need for cautious and integrated
approach to liberalization, with accompanying
reforms ……
Steps toward successful Capital
Account Liberalization (IMF A4
2012)
• Aim to harness benefits of open capital flows while
mitigating the risks.
• Sequencing important—but plans should be
flexible and tuned to changing circumstances
• Some prerequisites:
Exchange rate reform—greater flexibility would
reduce capital flows and allow for independent
monetary policy
New monetary framework—objectives of growth,
inflation and financial stability
Regulation and supervision—improve supervision,
regulation, and risk monitoring
Steps toward Capital Account
Liberalization cont.
• Interest rate liberalization—move to
market-determined loan and deposit rates
should not involve loosening of monetary
policy
• Full liberalization, esp. short-term capital
flows, wait until bulk of above reforms in
place
Use qualified foreign and domestic institutional
investor framework to gradually open capital
account
group
(5 minute discussion in groups of 5
or 6 and report back)
• What are the main risks for China
with liberalization of the capital
account?
Summary
• China has experienced sizable capital
inflows
• Macro impact limited by sterilization,
controls and some appreciation of
exchange rate
• As goal of liberalization is pursued:
– Important to learn from other’s experience
where crises followed liberalization
– Take an integrated approach, with
accompanying structural reforms
– Consider implications for the monetary policy
framework (“impossible trinity” again)
