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China's Road to Greater Financial Stability

Chapter 6. Capital Flows, International Use of the Renminbi, and Implications for Financial Stability

Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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China’s Twelfth Five-Year Plan identifies greater integration with the global financial system as a strategic priority. The focus and attention given to financial integration is entirely appropriate, as China will need to combine its large role in global trade with a comparatively important position in the global financial system if strong and balanced growth is to be achieved and sustained over the medium term.

Much progress has already been made. Some restrictions on the capital account have been lifted, with a particular focus on allowing increased opportunities for professional investors. International use of the renminbi has also been increasing. Both developments are closely linked, as they increase China’s integration into the global financial system and also rely on important complementarities, including the careful sequencing of reforms. Increasing openness of the financial sector is taking place against the backdrop of steady domestic financial reform and transition. For now, China’s capital control regime remains fairly comprehensive and effective, and this has limited the risks to domestic stability sometimes presented by capital flows. But flows are increasing and in net terms are becoming comparable in size relative to the economy or the financial system to those of other large, more open emerging markets. With the liberalization of flows and internationalization of the renminbi likely to continue, this will present policymakers with some financial stability challenges.

This chapter will review recent progress in the liberalization of capital flows and the internationalization of the renminbi and assess how this process may evolve in the future. In particular, it discusses what this process means for domestic financial stability. The experiences of other countries indicate that the appropriate sequencing of reforms is critical to safe navigation toward full international financial integration. China has made an excellent start on this path, and by following some important principles, prospects for successful global integration are bright.

Recent Trends in Capital Flows and Internationalization of the Renminbi

Capital Flows Now

One pressing challenge facing China is that the immediate pressures of global capital flows could run ahead of efforts to gradually open the capital account. Notwithstanding China’s tightly controlled capital account—which has proven to be very effective over a long period of time—net capital inflows to China unrelated to foreign direct investment (FDI) have been increasing and now appear to be large (as estimates later in this chapter will show). China faces the same challenges posed by increasing capital flows as do many emerging market economies. A number of structural developments are driving these capital flows, including wider economic growth and interest rate differentials, and a structural reallocation in the portfolios of institutional investors (IMF, 2004, Chapter 4; IMF, 2011, Chapter 2). While these factors suggest that China and other emerging economies will have to manage higher net inflows over a sustained period, historical experience also suggests that these flows can reverse rapidly. However, from a medium-term perspective, a sustained flow of capital to large emerging markets is likely to remain a feature of global finance in the post–global crisis world. This would necessitate a shift in emerging market policies and financial sector frameworks to effectively manage this trend.

Capital flows unrelated to direct investments are not all speculative and potentially destabilizing, although a large proportion typically is. Speculative capital flows are often defined by the motivation of the investor to earn a return over a short horizon and the ease with which such investments can be liquidated and transferred. In China, such flows are sometimes measured indirectly due to the possibly large volume of unrecorded capital flows evading capital controls.

One common approach to estimating the total flow of non-FDI capital is to subtract the trade balance, FDI, and estimated currency valuation effects from the monthly change in foreign exchange reserves. Although an approximation, this provides some guide as to the scale and high frequency pattern of speculative flows. In recent years, there is evidence that the size of these flows has picked up, with annual net flows of between US$60 billion and US$80 billion (or 1 to 1.5 percent of GDP) per year from 2008–11 (Figure 6.1). Importantly, the volatility of these flows has also increased, with very large net reversals that often coincide with changes in global financial conditions, including in 2008 and late 2011. This provides strong evidence that net flows to China are strengthening linkages with global financial markets.

Figure 6.1China: Estimated Unrecorded Capital Flows

(In billions of U.S. dollars, net)

Sources: The People’s Bank of China; and authors’ estimates.

Progress in Internationalizing the Renminbi

China also faces the unique challenge that comes with the internationalization of its currency. Internationalization refers to a currency’s use outside the issuer’s borders, including for purchases of goods, services, and financial assets in transactions by nonresidents (Kenan, 2009). By its very nature, currency internationalization will involve an increase in the flow of capital into and out of China. It is essentially an organic, evolutionary, and market-driven process in which there emerges progressively wider use of a currency as a unit of denominating cross-border trade and as a global store of value. While currencies from a number of advanced and emerging market countries have achieved a significant degree of international use, it is widely recognized that China’s currency has the potential to evolve into a “global” currency (Maziad and others, 2011). Broadly speaking, the renminbi already meets the prerequisites for cross-border use in terms of potential demand for the currency. International demand for the renminbi exists due to China’s large economic size and strong growth prospects, its central role within the Asian supply chain, and its role as a very large global exporter of a diverse range of goods.

The Chinese authorities have begun to advance the renminbi’s role as an international currency. Renminbi cross-border trade settlement expanded fourfold during the first nine months of 2011 to reach almost RMB 200 billion, supporting a rapid rise in renminbi deposits in Hong Kong SAR. In addition, the People’s Bank of China (PBC) is facilitating access to the renminbi through currency swap lines with other central banks within and outside Asia, while several countries have announced plans to add the renminbi to their foreign exchange reserves.1

Since the start of renminbi internationalization efforts, foreigners have been able to develop and trade a wide range of renminbi-denominated financial instruments in Hong Kong, making it the first financial center for renminbi investments offshore. The following are some of the other recent highlights in renminbi internationalization:

  • Renminbi deposits and financial instruments. Once offshore, renminbi liquidity is reclassified as “CNH” without restrictions on its end use as long as it remains offshore.2 Renminbi deposits offshore have increased rapidly and by end-2011 accounted for 10.4 percent of total deposits in Hong Kong. The first offshore renminbi mutual fund was created in 2010, and the list of offshore renminbi products has already become substantial. Beyond active spot and forward foreign exchange markets, renminbi cross-currency swaps, certificates of deposit, interbank lending, and some structured products are available in Hong Kong. In 2010, the PBC expanded the channels through which offshore renminbi could flow back to the mainland. In pariticular, central banks and qualified financial institutions were allowed to invest renminbi directly in the onshore interbank bond market, subject to individual quotas.

  • Renminbi bonds. The supply of the renminbi-denominated assets offshore has lagged demand and the rapid growth of the pool of renminbi deposits in Hong Kong. Issuers of renminbi bonds or “Dim-Sum” bonds benefit from this excess demand and are able to raise funds offshore at much lower yields in comparison with onshore issuers, as shown in Figure 6.2 for government bond yields. This is an important channel for renminbi funds to be transferred back onshore, creating a feedback loop between onshore and offshore renminbi markets. This market has grown rapidly with the stock of outstanding renminbi bonds, reaching about RMB 167 billion by end-2011, while market structure shifted from sovereigns to banks and corporates. Issuance is mostly by businesses with a natural renminbi hedge that take advantage of lower yields offshore compared with renminbi or dollar funding on the mainland (Maziad and Kang, 2012). The dominant role of domestic issuers in the offshore renminbi market is very unusual compared with other offshore markets. The absence of alternatives for offshore renminbi investments and appreciation expectations has caused offshore renminbi bondholders to maintain their position, limiting secondary market volume. Plans are in place to expand the issuance of Treasury bonds in Hong Kong, in part to support market development and establish a benchmark risk-free interest rate.

  • Renminbi FDI. In October 2011, the authorities formalized the use of offshore renminbi for FDI on the mainland. This development would make renminbi-denominated FDI more transparent under a standardized framework, giving foreign enterprises greater incentive to use the renminbi in their cross-border transactions and potentially speed up two-way circulation of renminbi funds both in and out of the mainland. In the longer run, this should further spur the development of offshore renminbi products in Hong Kong and increase the confidence of enterprises to raise funds there for investments on the mainland. Under the rules, FDI flows have to be backed by actual settlement or business needs to be settled within three months of the transaction, and applications for renminbi FDI totaling more than RMB 300 million will be subject to approval by the Ministry of Commerce, while those of lesser amounts will be subject to approval by branches of the ministry at the provincial level.

  • Portfolio flows. Prior to August 2011, a narrow set of qualifying institutions, including renminbi–trade settlement banks, qualifying central banks, and the Bank of China in Hong Kong and Macau (the offshore clearing bank for trade settlement), were able to invest in the interbank bond market onshore. In the package of measures announced in August 2011, the long-awaited “mini QFII” (Qualified Foreign Institutional Investor) scheme was finally given the official green light with an initial quota of RMB 20 billion (and the relevant administrative rules were announced by the Chinese authorities in December 2011). This is effectively a renminbi-settled version of the current U.S. dollar–settled QFII. Although the size of the quota is small, reflecting concerns over capital inflows, it is nevertheless an important step toward greater RMB internationalization.

Figure 6.2Government Bond Yield

(In percent)

Sources: Bloomberg; and IMF staff.

Note: The acronym CNY is used to represent onshore renminbi within China. CNH is used to represent the exchange rate of the renminbi that trades offshore in Hong Kong.

Domestic Financial Sector Absorption

The absorptive capacity of China’s financial system will need to be upgraded to ensure that structural demand by global investors for Chinese assets does not become a destabilizing force. In turn, this will require sustained effort over the medium term to develop and deepen the financial sector to ensure stability and economic resilience.

Despite progress in financial development and allowing some access (within specified quotas) under the QFII and capital outflows under the Qualified Domestic Institutional Investor (QDII) program, China’s financial markets remain comparatively less developed and largely closed according to traditional measures of financial depth. However, China fares better using a new proxy for financial depth, measured as an index of total financial claims (both domestic and external) over GDP for individual countries and for the world as a whole (Table 6.1). The index shows that advanced economies (United States, euro area, Japan, and United Kingdom) contribute most to “global financial depth,” followed closely by China (Goyal and others, 2011). However, this measure only captures total financial stocks as one proxy for depth and needs to be augmented with additional information on capital account openness and international tradability. On this front, China’s capital account remains largely closed.

TABLE 6.1Top Five Contributors to Global Financial Depth(In percentage share of global financial depth weighted by GDP)
Advanced countries92.8Advanced countries82.4
United States32.5United States29.4
United Kingdom5.7United Kingdom7.8
Emerging markets7.2Emerging markets17.6
Hong Kong SAR0.7Hong Kong SAR1.6

Impact on Financial Stability

How might capital flows, increasing capital mobility, and renminbi internationalization affect the prospects for financial stability in China? Some lessons can be learned from the experiences of other emerging economies over the last 30 years. In many cases, large net capital flows have had broad effects, affecting bank lending, corporate leverage through bond market issuance, asset prices, and real estate markets. There are some key sources of financial instability that could be identified, and each of these can interact with capital flows. These include disturbances arising from the linkages between the financial sector and macro economy and structural weaknesses in the financial sector.

Broad Risks

The direct macroeconomic impact of capital flows does not yet appear to be a major financial stability risk for China. International experience has shown that large capital inflows can fuel domestic demand, real exchange rate appreciation, current account deficits, and a sharp expansion in bank credit (e.g., Mexico in 1994 and Thailand in 1997). When the perceived risk-return profile of exposure to these countries then unexpectedly worsens, inflows can reverse sharply, swamping offsetting changes in private and government savings. In turn, this can lead to large adverse changes in financial conditions—including vanishing liquidity, collapsing asset prices, and shrinking credit—that inflict significant real economic damage.

These direct linkages between capital flows and the macro economy in China are much weaker than they were in other notable cases, including Southeast Asia in the late 1990s. In particular, consumption (and consumer credit) has not taken off and reached excessively high levels and the current account remains in surplus. The impact of capital inflows on monetary aggregates has been relatively modest compared to the effect of very large current account surpluses. In fact, China faces the challenge of reorienting the economy toward domestic consumption to rebalance the drivers of economic growth away from relying on external demand for its exports.

Perhaps the more critical channel of risk in China lies in the remaining structural weaknesses of the broader macroeconomic framework and the institutional and regulatory framework of financial sector oversight. China has made significant progress in developing and strengthening its financial sector, but remaining structural weaknesses mean that capital flows could contribute to the buildup of excessive risks. One weakness is the broader monetary framework and reliance on administered interest rates (notably ceilings on deposit rates) to manage liquidity, along with the limited investment opportunities available to market participants.

These features of the macro framework, interacting with increased capital flows, may lead to capital seeking higher returns in specific and possibly unproductive sectors of the economy, leading to large price distortions and volatility in these areas (e.g., the real estate market). Shortcomings in some of China’s asset markets may also impede price discovery and risk management, and lead to excessive price volatility. For example, the equity market lacks liquidity and is extremely volatile, due in part to the lack of transparency in terms of regulation and corporate governance. Capital flows can amplify this volatility and increase the impact of mispriced risks.

Capital Flows and Risks for China’s Banks

Notwithstanding these shortcomings, Chinese banks, which dominate the financial system, appear fairly well insulated against the effects of capital flows. This reflects a number of factors. First, strict capital controls have helped keep capital flow volumes modest relative to the size of the banking sector. Net flows are rising but remain dwarfed by the size of banking system assets and deposits. Other factors have been more important than capital flows in contributing to the growth in bank deposits and liquidity, notably large current account surpluses and precautionary saving by households with few investment alternatives.

Second, foreign exchange risks are concentrated at the central bank, rather than at commercial banks. China is exposed to a large currency mismatch on its balance sheet as a result of its current account surplus, its monetary policy and exchange rate regime, and the renminbi’s fledgling status as an international currency. However, strict quantitative controls on offshore foreign currency borrowing by commercial banks ensure that this mismatch is concentrated on the balance sheet of the PBC.

Linkages across Exchange Rate Markets

What risks could stem from the flourishing offshore market for renminbi? Given heavy management of the onshore spot market and capital controls, linkages between onshore and offshore exchange rates should be limited. However, both rates have tracked each other quite closely, with the exception of some divergence in late 2010 and again in late 2011, suggesting some de facto links. For example, market participants offshore might extract policy signals from onshore markets, though onshore market participants might believe that price developments offshore better reflect global market conditions due to closer global financial integration.

Empirical results using a bivariate generalized autoregressive conditional heteroskedasticity (GARCH) model to capture mean and volatility spillovers across onshore and offshore markets suggest that cross-market spillovers exist (Maziad and Kang, 2012). In particular, the analysis shows that (1) developments in the offshore spot market could influence the onshore spot market in terms of both level and volatility during a period of offshore market dislocation, and (2) the onshore market drives price movement offshore under normal market conditions, while developments in the offshore market could still affect the volatility of price movement in the onshore market. In contrast to the pattern of influence in the spot markets, the offshore forward market moves ahead of the onshore forward market. In particular, as shown in more detail in Maziad and Kang (2012), today’s offshore forward rates have a predictive impact on tomorrow’s onshore forward rates, but not vice versa, and the offshore forward market also has an influence on the onshore forward market through the channel of volatility spillover.

There is also evidence that the offshore market could influence onshore markets through volatility channels. Given that volatility in the offshore market has been higher than that in the onshore market,3 these findings imply that offshore market developments should be monitored carefully, as they could affect exchange rate volatility on the mainland. In addition, during a period of offshore market dislocation, developments in the offshore market could influence the onshore exchange rate in terms of level and volatility. This is perhaps because market participants believe that price developments offshore more adequately reflect global market conditions.

Linkages with Asset Markets

Perhaps the most active transmission channel from capital flows to financial conditions is through domestic asset markets. For many investors, the potential for large returns provided by domestic Chinese real estate and equity markets may provide a sufficiently large incentive to evade capital controls. In recent years, domestic equity markets in China have been highly volatile and have experienced sustained periods of rising prices. Real estate prices have been less volatile, but prices have risen significantly since 2005. In both cases, the returns to investors during price upswings have been significant, providing strong incentives for those investors that extrapolate investment returns from the past and are considering evading capital controls to gain exposure to China.

Real estate exposures of Chinese banks have expanded rapidly at the same time that net speculative inflows have increased. The real estate market accounted for just under one-fifth of total domestic loans at the end of the first quarter of 2010. There are a number of channels through which real estate can affect commercial banks in China. For example, increases in the price of real estate may increase both the value of bank capital (to the extent that banks own real estate) and the value of real estate collateral, leading to a decline in the perceived risks of property-related lending. Higher prices can also lead to higher volumes of activity, both in the resale market and in new developments, which in China are largely bank financed. Both effects would increase the exposure of bank balance sheets to the real estate sector, all else being equal. The real estate market could also affect China’s banks more indirectly. For example, a real estate price correction could trigger a negative spillover to local government financing vehicles, as banks adjust down land collateral valuations, recall loans, or halt debt rollovers.

Capital flows can contribute to overshooting real estate prices and, in the event of a sharp reversal in flows, expose financial sector vulnerabilities that had built up during the upswing. There are two features of capital flows that could contribute to excessive price moves in domestic real estate markets. First, capital flows are driven in part by external factors, including global interest rates, exchange rates, and risk appetite. This can cause flows to be volatile and less sensitive to local real estate market conditions, such as affordability, and often more volatile than domestic sources of real estate demand. It can also lead to periods of sharp reversals in the direction of speculative flows. Second, capital flows are often associated with financial cycles triggered by waves of optimism underpinned by favorable developments in the real side of the economy. This optimism contributes to the underestimation of risk and the overextension of credit. The real estate market plays a central role in such cycles because increases in real estate prices tend to boost banks’ willingness and capacity to lend. This was a notable feature of the Asian financial crisis in the 1990s.

Capital flows could also influence domestic equity market prices. Capital flows, in part, are driven by global financial conditions. Global liquidity conditions could affect equity market returns in those emerging economies that receive capital inflows, including China. The effects of global liquidity on equity returns and reserve accumulation are particularly strong for economies with fixed exchange rate regimes, and the volatility of liquidity is also transmitted to flow-receiving economies.

The equity market is a relatively accessible investment for cross-border investors, including speculators with large volumes to invest. Competition among brokerages has kept commissions very low and provided retail investors with easy access to the equity market. There is evidence that retail equity brokerage accounts are used by nonretail participants to gain easy access to the market and avoid the strict oversight of institutional investors, a route to the market that can also facilitate the investment of capital inflows. Gray market money managers, corporates, and rich individuals, along with average individual retail investors, may all play some role in diverting net inflows into equities.

The direct linkages between the equity market and the rest of the financial sector are weaker than for the real estate market. This has insulated banks and other financial institutions from the effects of equity market volatility. In particular, banks have been prohibited from participating in the equity market, either as investors, asset managers, or brokers. Weak equity-bond return correlations have also insulated the valuation of bonds on bank balance sheets from the effects of equity price declines. Finally, equity markets also play a minor role in the intermediation of capital. This limits the feedback from the equity market through the real economy and back to the financial sector (e.g., through the impact of the cost of equity on capital expenditures and economic growth).

The most likely linkage between capital flows, equity markets, and the rest of the financial sector is through wealth effects, which could influence the supply-demand balance for real estate or encourage increased demand for credit. Equity markets can provide a signaling function, given the timely way they respond to macroeconomic news and their forward-looking perspective, which can also increase linkages across the financial sector. However, Chinese markets have a very low signal-to-noise ratio, which may be partly explained by the markets’ structural weaknesses. Looking ahead, the linkages between equity markets and banks may strengthen in the future if banks are permitted to diversify away from lending and to participate in equity markets, either directly or indirectly.

The effects of capital flows on China’s equity and real estate markets may involve quite complicated dynamics, in part due to the interrelations between these markets. Very little is known about the relationships between capital flows and domestic asset markets, in part because these linkages have been evolving as China’s macroeconomic policy regime and financial system develops, new policies are introduced, and the private sector broadens the exposures of its wealth portfolio. Capital control evasion also means that many of these capital flows are not recorded in official data and are therefore difficult to track and follow through the financial system. Any empirical analysis should be sufficiently flexible to allow for complicated dynamics and linkages.

Empirical analysis based on vector autoregressions (VARs) indicates that capital flows can help predict equity and real estate prices.4 Granger causality tests based on VAR models provide strong evidence that current and past net capital flows affect future equity and real estate prices. There is also evidence that Granger causality runs in the opposite direction; in particular, past changes in equity and real estate prices can help to predict future capital flows, which suggests that capital can be “pulled” by domestic market developments as well as “pushed” by global financial conditions.

How large an effect can capital flows have on asset markets? For equities, the effects are modest and dissipate quickly, but a larger impact is felt by the real estate market. The effects of capital flows were quantified by tracing out the estimated dynamic response to a standard deviation shock to net capital flows, which accounted for about US$15 billion. The effects of a change in exchange rate expectations were computed in a similar way, with a standard deviation shock representing a change of about 1 percentage point. The results described below, as shown in Figure 6.3, are based on a VAR model including real estate prices estimated over the 2005–10 period.5 The results show that:

Figure 6.3Impulse Responses from Vector Autoregressions, 2005–10

(In percent)

Source: IMF staff estimates.

Note: Variables included are the log level of capital flows (FLOW), the change in the 12-month log nondeliverable forward-spot exchange rate spread (NDF), the change in the log equity price (DLEQ), and the change in the log property price (DLPY). Dotted lines represent 95 percent confidence intervals.

  • The impact of a shock to net capital flows is either modest or short-lived (real estate prices) or insignificant (equity prices). Shocks to flows also tend to dissipate quickly, with the cumulative change in flows close to the initial shock.

  • Exchange rate expectations have large and statistically significant effects on both capital flows and asset markets. For example, a 1 percentage point increase in anticipated renminbi appreciation leads to an additional capital inflow of over US$20 billion, an increase in equity prices that peaks at 7 percent (but dissipates thereafter), and a near 1 percent sustained increase in real estate prices. This effect can work in reverse, with expectations for a weaker renminbi leading to lower net inflows and declining asset prices.

  • Linkages between markets could amplify the effects of capital flows. A standard deviation 8 percent shock to equity prices leads to an increase in real estate prices that is sustained and significant, with a cumulative impact of 1.25 percent.

Overall, the results indicate that capital flows to and from China affect domestic asset prices, but the dynamics are complex and work through a number of channels. In particular, the impact of capital flows is higher and significant when driven by exchange rate expectations. A change in market perceptions regarding the path of the renminbi has large and significant effects on capital flows, and this in turn feeds through to asset prices. In contrast, direct shocks to capital flows have more modest and generally insignificant effects on asset prices. This suggests that anticipated currency gains, underpinned by past perceptions of a “one-way bet,” have provided important incentives even though asset price volatility may be significantly higher than exchange rate volatility (i.e., equity market losses could easily wipe out currency gains).

In addition, linkages between asset markets, particularly from domestic equities to real estate, may be key transmission channels for capital flows. Although the impact of capital flows on equities is modest and dissipates quickly, rising equity prices lead to relatively persistent increases in real estate prices. This may reflect wealth effects, with higher equity prices bolstering balance sheets and encouraging or allowing potential real estate investors to increase real estate–related borrowing. It may also be due to switching between markets. If capital flows initially go into equity markets, due in part to their higher liquidity, then this may have knock-on and long-lasting effects on real estate prices. Until now, effects on financial stability appear to be limited, but they are likely to grow with financial openness.

The Road Ahead

Sequencing the Reform Process

As international experience suggests, there is no “one-size-fits-all” approach to sequencing financial sector liberalization (Johnston and Sundararajan, 1999). This consideration is particularly important given the unique characteristics of China’s financial system. Reforms should be tailored to each country’s unique circumstances and the prevailing macroeconomic and financial conditions. However, some broad principles of international best practice can be identified. A key overarching precondition throughout the process of change is the presence of adequate legal, regulatory, and supervisory frameworks to monitor financial institutions and manage risks.

In China, the appropriate pace and ordering of reforms will involve balancing trade-offs. For example, greater exchange rate flexibility would allow for more effective handling of monetary policy and lessen the steady injection of liquidity into the system from the balance of payments surplus. However, such reform could also weaken corporate profitability, worsen the quality of bank credit, and increase foreign exchange risk on financial and corporate sector balance sheets. Similarly, the regime of capital controls allows liquidity to be absorbed and interest rate reform to be phased in, while allowing for the management of the pace of inflows that may be attracted by rising nominal interest rates. However, a phased opening up of the capital account should not proceed ahead of developing domestic capital markets and strengthening their regulatory foundations.

In this context, a broad sequencing for reforms can be surmised by adapting international experience to China’s specific circumstances. This suggests the need to absorb liquidity from the financial system, adjust relative prices, and increase reliance on indirect monetary tools before interest rates are liberalized and quantitative restrictions are lifted. Initially the banking system is likely to continue to play a dominant role, but over time the conditions should fall into place for the rest of the financial sector to take a larger share of the intermediation function. Advancing the reform agenda, particularly financial deepening and the development of robust macroeconomic and regulatory frameworks, would provide the necessary preconditions for full capital account liberalization.

Indeed, capital account opening should be sequenced after the bulk of financial sector reform has been achieved. Although some countries have successfully opened the capital account before financial sector reform, the current scale of global capital flows and the increasing sophistication and interconnectedness of global financial markets imply much larger risks for this strategy now than in past decades. Capital account reform should proceed in stages, based on the relative stability and maturity of flows. The early stages of capital account liberalization should focus on stable long-term sources of financing such as direct investment inflows. The intermediate stage should liberalize longer-term portfolio flows, with full liberalization—including short-term flows—achieved when the bulk of financial sector reform has been implemented.

Unique Risks from Further Liberalization of the Renminbi6

An international currency requires a robust financial system and an open capital account. As international experience suggests, failing to supply internationally traded stores of value to the rest of the world limits the scope for currency internationalization. Rapid developments in the offshore market reflect the prospects for the Chinese currency as a global currency and the strong cross-border linkages that would accompany the process, particularly the potential for increased capital inflows. Promoting cross-border use of the renminbi poses additional risks to financial stability, especially at a time of transformation in China’s financial system. Potential risks could be broadly divided into two types: market development risks and financial stability risks.

  • Market development risks: Part of investors’ interest in an offshore renminbi has been driven by expectation of renminbi appreciation. Thus, in the absence of a sufficient supply of renminbi-denominated assets, there is a risk that market development may lose momentum or stagnate as appreciation expectations are met or become less one-sided. In late 2011, market expectations of currency appreciations moderated in light of lower growth projections and generalized risk aversion due to the debt crisis in Europe, resulting in lower demand and deleveraging of CNH-denominated investments, while the accumulation of renminbi deposits in Hong Kong decelerated and the stock actually shrank for the first time in October 2011. To keep the momentum for market development beyond appreciation expectations, the channels to invest renminbi funds productively onshore would have to be expanded. Similarly, two-way currency movements would foster the development of a well-functioning offshore renminbi bond market and facilitate balanced demand for the currency, both for funding and investing. A major deterrent for non-Chinese firms to issue CNH-denominated bonds despite low yields is the risk of currency appreciation. If issuers perceived a two-way currency movement, it would encourage non-Chinese firms to take on renminbi-denominated liabilities, and thus contribute to expanding the stock of renminbi-denominated assets offshore. Recent measures to allow renminbi-denominated inward FDI and the launch of the mini-QFII are steps in this direction.

  • Stability risk: Generally speaking, financial stability risks due to offshore market development would be limited, given the size of the offshore market of about 10 percent of onshore base money, and the effectiveness of controls on the flow of capital onshore. However, going forward the process of renminbi internationalization and the strong demand for renminbi assets would expand the channels of feedback and arbitrage across onshore and offshore markets. Particularly, as mainland businesses gain greater access to credit through offshore subsidiaries of mainland banks or issue renminbi bonds offshore, some of the effectiveness of the credit rationing onshore could be undermined. In the long run, this could lead to disintermediation of large Chinese firms from the banking system onshore as they forge ties with banks offshore or borrow directly in the offshore bond market. Eventually, as the offshore market grows, larger cross-border flows could undermine the effectiveness of credit controls and administered interest rates onshore as offshore banks extend credit directly to firms onshore. This could potentially lead to some loss of monetary control due to access to credit offshore at unregulated interest rates, and to exchange rate pressure on the renminbi offshore that would lead to currency appreciation. Bearing these potential risks in mind, greater strides toward currency internationalization should be phased in as part of the process of financial sector reform and gradual capital account liberalization.


The paths toward greater capital account openness and internationalization of the renminbi share many similarities. At the broadest level, both involve increasing integration into the global financial system, which can bring rewards but also import risks, particularly from increased international use of the currency and associated volatile capital flows. From a financial stability perspective, both require careful sequencing to ensure that China’s domestic financial stability is not compromised. China has already shown that a dual strategy of increasing international use of its currency, while at the same time gradually opening up the financial system to greater capital flows, can succeed. One component of increased openness need not come before the other; indeed, in many cases they must proceed simultaneously. In part, success so far reflects the steady application of the important principle that domestic financial sector reforms—including deepening and liberalizing domestic financial markets, enhancing regulation and supervision, and bolstering legal frameworks—are prerequisites for large-scale international liberalization. This principle should continue to guide the reform process in China, particularly as the largest challenges, including adapting the monetary and exchange rate policy framework to increased global integration, remain to be fully addressed.


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    International Monetary Fund (IMF)2004Institutional Investors in Emerging Markets,Global Financial Stability ReportApril (Washington: International Monetary Fund).

    International Monetary Fund (IMF)2011Long-Term Investors and Their Asset Allocation: Where Are They Now?Global Financial Stability ReportSeptember (Washington: International Monetary Fund).

    JohnstonR. Barry and VasudevanSundararajan1999Managing Financial Sector Liberalization: An Overview,” in Sequencing Financial Sector Reforms: Country Experiences and Issuesed. by B. Johnston and V. Sundararajan (Washington: International Monetary Fund).

    KenanPeter B.2009Currency Internationalization—An Overview (Princeton, New Jersey: Princeton University).

    MaziadSamar and JoongShik Kang2012RMB Internationalization: Onshore/Offshore Links,IMF Working Paper 12/133 (Washington: International Monetary Fund).

    MaziadSamarPascalFarahmandShengzu WangStephanie Segal and FaisalAhmed2011Internationalization of Emerging Market Currencies: A Balance Between Risks and Rewards,IMF Staff Discussion Note No. 11/17 (Washington: International Monetary Fund).

Between December 2008 and July 2010, the PBC established currency swap lines of about RMB 800 billion with eight central banks, including those of Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Singapore, and South Korea. In November 2011, Premier Wen Jiabao proposed expanding the use of swap lines with countries that belong to the Shanghai Cooperation Organization, including Russia, Kazakhstan, Kyrgyzstan, Tajikistan, Uzbekistan, and China. India, Iran, Mongolia, and Pakistan take part as observers. In January 2012, China signed the first currency swap agreement with an Arab nation, the United Arab Emirates, worth RMB 35 billion.

The acronym CNH is used to represent the exchange rate of the renminbi that trades offshore in Hong Kong.

In 2011, Standard Chartered Bank reported that volatility of offshore spot exchange rates was higher than that of the onshore spot rate by 40 to 50 percent (based on daily data).

A natural way to investigate the possibly complicated dynamics between capital flows and assets markets is by using VARs. In this framework, capital flows, asset market returns, and the expected appreciation of the renminbi implied by nondeliverable forwards—found to be associated with flows—are taken to be endogenous variables. In other words, each of these variables is assumed to be affected by changes in the other variables.

The results for a model excluding real estate prices and estimated over a longer sample period (1997–2010) are qualitatively similar.

This section is based on Maziad and Kang (2012).

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