How would Capital Account Liberalization Affect China's Capital Flows and the Renminbi Real Exchange Rates?

Abstract

In this paper we study the determinants of gross capital flows, project the size of China's international investment position in 2020, and analyze the implications for the renminbi real exchange rate if China liberalizes the capital account. We assume in this exercise that the renminbi will have largely achieved capital account convertibility by the end of the current decade, a timetable consistent with recent proposals by the People's Bank of China. Our analysis shows that if the capital account were liberalized, China's gross international investment position would grow significantly, and inflows and outflows would become much more balanced. The private sector would turn its net liability position into a balanced position, and the official sector would reduce its net asset position significantly, relative to the country's GDP. Because of the increasing importance of private sector foreign claims and the decreasing importance of official foreign reserves, China would be able to earn higher net investment income from abroad. Overall, China would continue to be a net creditor, with the net foreign asset position as a share of GDP remaining largely stable through this decade. These findings suggest that the renminbi real exchange rate would not be particularly sensitive to capital account liberalization as capital flows are expected to be two-sided. The renminbi real exchange rate would likely be on a path of moderate appreciationas China is expected to maintain a sizeable growth differential with its trading partners.

Financial Openness of China and India

“…Bayoumi and Ornsorge (2013) analyse portfolio stocks only and find the increase in net private assets could result from an increase in gross portfolio assets of 10-25 per cent of GDP and gross liabilities of 2-10 per cent of GDP (Table 12.4). The resulting increase in net portfolio assets of 11-18 per cent of GDP exceeds the 8 per cent estimate of He et al (2012 Policymakers, however, have to be concerned about not only the mediumterm resting place or steady state, but also the dynamic path, as well as the volatility realised along it. Both papers neglect the banking flows, which can be huge and volatile.…”

“…Both He et al (2012) and Bayoumi and Ohnesorge (2013) argue that when China fully opens up its capital account, there will be not only larger external positions, but also, on balance, larger net private assets. By contrast, Bayoumi and Ohnesorge (2013) expect India to experience little net private capital outflows.…”

“…Limits on outward portfolio investment were eased just before the GFC and to this day the limits do not bind; but the upshot is that private portfolio claims on the rest of the world's stocks and bonds remain low, and the potential increase appears huge as the capital account opens up and the income level rises. He et al (2012) and Bayoumi and Ohnsorge (2013) present reasonable medium-term outlooks for a rise in net private external assets in the event of a full capital account liberalisation in China. Both project big increases in gross positions, assets and liabilities alike, and both predict private assets would increase more than liabilities.…”

“…He et al (2012) examine both direct investment and portfolio stocks, and their result is driven by the legacy of asymmetric capital controls (with acquisition of external assets by private Chinese more tightly controlled, especially in direct investment), financial market development in China and higher growth there. They project a larger step-up in direct investment net assets of 10 per cent of GDP than that in net portfolio assets, of 8 per cent of GDP (Table 12.4).…”

China's Capital Controls Through the Prism of Covered Interest Differentials

“…For alternative points of view, see, for example, Cheung, Chinn and Fuji (2007) and Schnatz (2011) on the RMB undervaluation and He, et al (2012) on capital account liberalization and the RMB real exchange rate.…”