Information about Asia and the Pacific Asia y el Pacífico

Chapter 8. Capital Account Opening and Capital Flow Management

W. Raphael Lam, Markus Rodlauer, and Alfred Schipke
Published Date:
January 2017
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Information about Asia and the Pacific Asia y el Pacífico
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Karl Habermeier, Annamaria Kokenyne Ivanics, Salim M. Darbar, Chikako Baba, ZHU Ling and Viktoriya Zotova 

China is the world’s leading trading nation. Yet, remarkably, it is much less well integrated with the global financial system, and the country’s extensive controls on international capital flows are an important brake on its international financial integration. Will this situation remain mostly unchanged in the next decade, or will we see accelerated capital flow liberalization?1

The Chinese government has repeatedly stated its intention to achieve convertibility of the renminbi under the capital account.2 However, it has not published an official timetable or road map to achieve this. The intention to liberalize capital flows is consistent with the IMF’s institutional view, which highlights that “[c]ountries with extensive and long-standing measures to limit capital flows are likely to benefit from further liberalization in an orderly manner. There is, however, no presumption that full liberalization is an appropriate goal for all countries at all times” (IMF 2012a).

The authorities appear to have adopted a strategy of “managed convertibility.” The challenge is to flesh out the main elements of such a strategy. This chapter contributes to the discussion by attempting to shed light on the following questions: What is the current degree of capital account convertibility, and how effective are capital controls? Is there a case for China to continue to pursue capital flow liberalization? Why are pressures growing for China to quicken the pace? How can China manage the potential risks of liberalization, in particular those associated with capital outflows?

This chapter argues that China has made significant progress in removing capital controls, but that capital movements are still much more tightly controlled than in most advanced economies. The effectiveness of controls differs significantly across types of transactions, however, and there is evidence of growing circumvention. While the pace of capital flow liberalization should be fine-tuned to fit the prevailing macroeconomic environment and the health of the financial system, in the medium term China needs to adjust its approach to managing capital flows to make it more consistent with its very large cross-border trade flows and increasingly large cross-border financial flows. In the new regime, it would probably be desirable to transition from quantitative restrictions and quotas to price-based measures such as taxes and levies, from residency-based administrative controls to currency-based regulation and supervision, and from ex ante approval to ex post reporting and surveillance, as controls are gradually relaxed.3

Half Open or Half Closed? Capital Account Convertibility Today

China’s Capital Controls

China has made considerable progress over the years in liberalizing capital flows (Box 8.1), but it still has one of the world’s highest levels of de jure capital account restrictiveness.4Figure 8.1 plots the de jure measure of capital account restrictiveness against GDP per capita for 186 countries in 2015. This measure is based on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER).5 The AREAER divides capital account transactions into 56 categories: China reports on 53 of them, and 43 are reported to have some degree of control, hence the de jure measure is 43/53, or about 0.8.

Figure 8.1.Income Level and De Jure Financial Account Restrictiveness

(GDP per capita in logarithm [x-axis] and de jure index [y-axis], 2015 or latest available)

Sources: World Bank, World Development Indicators; IMF Annual Report on Exchange Arrangements and Exchange Restrictions database; and IMF staff calculations.

Note: 186 IMF member countries, including their territories where data are available.

The State Administration of Foreign Exchange (SAFE) classifies capital account restrictiveness differently. According to its classification, as of February 2015 only five out of 40 categories of transactions are unconvertible, 18 are partially convertible, seven are generally convertible, and 10 are convertible.6 A category that is considered convertible can still be subject to controls, albeit not exchange controls. For example, even though nonresidents face no currency exchange restrictions when they purchase domestic real estate, the purchases are allowed only on the basis of need and for the buyer’s own use.

Box 8.1.A Brief History of China’s Capital Flow Liberalization

China was a closed economy before DENG Xiaoping’s economic reforms in 1978. Since then, it has become a major destination for foreign direct investment (FDI). As it became more integrated with the rest of the world, China declared current account convertibility and accepted the obligations of Article VIII of the IMF Articles of Agreement in 1996.

Despite current account convertibility and steps to liberalize inward FDI, China’s capital account remained inconvertible. Most cross-border financial transactions were either heavily restricted or strictly prohibited, and restrictions on capital outflows were tightened in response to the Asian financial crisis in 1997–98.

China began to ease capital controls after joining the World Trade Organization (WTO) in 2001 to meet its commitments on financial sector liberalization as part of its WTO obligations. Foreign-funded banks, including their subsidiaries in China, have been accorded national treatment. As a first major step in portfolio investment liberalization, China introduced the Qualified Foreign Institutional Investor scheme in 2002, which gives selected foreign investors limited access to the domestic financial market.

After the shift in policy from discouraging outflows to a balanced opening of the capital account, the Qualified Domestic Institutional Investor system was launched in 2007. Since then, conditions for outward direct investments were significantly relaxed, and those for individual capital transfers were slightly eased. Given a strong reserve position and appreciation pressures, the surrender requirement of foreign exchange revenue from current transactions was eliminated, leading to fewer foreign exchange conversions from such transactions into yuan, the renminbi’s currency unit. The program for outward investments was also extended to qualified retail investors under the Qualified Domestic Individual Investors scheme to allow for outward portfolio investment in the Shanghai Free Trade Zone and will be gradually expanded.

China also tested its liberalization policy before implementing it in designated areas, by selected companies, or in free trade zones. For example, a pilot program was started in Shanghai in 2013 and expanded to other cities. The Shanghai and Hong Kong Stock-Connect Program has encouraged increased capital flows through equities between the mainland and Hong Kong SAR.

While direct investment is among the least controlled categories of flows and SAFE considers it to be convertible, it remains subject to various impediments. Outward direct investment is largely liberalized (except for sensitive countries, regions, and industries), but significant restrictions remain on inward direct investment.7 That said, administrative procedures have been simplified.

Overseas lending by domestic commercial banks is virtually unrestricted, while residents need approval from SAFE to borrow abroad, which seems somewhat at odds with the usual approach, which is generally to liberalize inflows before outflows. Overseas lending by domestic financial institutions has expanded faster than domestic loans in recent years, and nearly 90 percent of the overseas loans are denominated in foreign currencies (Figure 8.2).

Figure 8.2.Overseas Loans by Domestic Financial Institutions

Sources: State Administration of Foreign Exchange; People’s Bank of China (Sources and Uses of Credit Funds of Financial Institutions); and IMF staff calculations.

Note: Domestic financial institutions in the figure include the People’s Bank of China, depository financial institutions, and nondepository financial institutions. ODI = outward foreign direct investment.

The total value of overseas loans at the end of the third quarter of 2015 topped 4 percent of China’s annual GDP. These overseas loans appear to develop in tandem with outward foreign direct investment (FDI), suggesting that the loans finance the overseas projects of Chinese state-owned enterprises (SOEs).8 To the extent these loans represent directed lending, they potentially increase financial sector vulnerabilities.

At the other end of the spectrum, both inward and outward portfolio investments are more tightly controlled. Portfolio outflows are more restricted than inflows, and none of the related categories are convertible by the SAFE classification. The regulators’ strategy so far has been to allow portfolio inflows before outflows, to limit the size of flows using quotas and qualified investor systems, and to liberalize transactions conducted in renminbi to a greater extent than those in foreign currencies (see Box 8.2 and Table 8.1). For instance, while domestic companies can list and issue bonds abroad, foreign companies cannot be listed on Chinese stock markets, nor are they allowed to issue bonds denominated in foreign currencies in China.9 With respect to capital flows in renminbi, the Renminbi Qualified Financial Institutional Investor (RQFII) system has no cap on aggregate quotas, while the Qualified Foreign Institutional Investor (QFII) system does, and resident nonfinancial entities may also keep yuan funds received abroad on offshore accounts without any limitation. Despite the gradual increase in aggregate quotas, the total portfolio investment quota for nonresidents reached only 3 percent of Chinese stock market capitalization10 and 17 percent of the total trading volume on the China interbank bond market in September 2015. Recent liberalization steps allowing wider access to the interbank bond market and equity markets may increase foreign participation.

Box 8.2.Liberalization Schemes on Cross-Border Portfolio Investment

The Qualified Foreign Institutional Investor (QFII) system allows qualified foreign institutional investors, including banks and nonbank financial institutions (with the exception of hedge funds), limited access to the Chinese financial markets.

The China Securities Regulatory Commission assesses the qualifications of applications. Each qualified investor is subject to a quota, which is approved by the State Administration of Foreign Exchange (SAFE). The quota is capped at $5 billion per investor except for sovereign funds, central banks, and governments. The cap on aggregate quotas is set at $150 billion. The quota cannot be transferred or traded. Within the quota limit, investors can invest only in a subset of domestic financial products such as shares, fixed-income instruments, and stock index futures approved by the commission. Each investor may buy no more than 10 percent of the total shares of any listed company, and the aggregate purchase of all QFII investors combined may not exceed 30 percent of the shares of any listed company. Investors face a minimum investment requirement of $20 million, and most investments are subject to a one-year holding period. After this period, the repatriation of principal and profits is limited: investors can repatriate at most 20 percent of the onshore Chinese assets they held at the end of the previous year. Open-end China funds are subject to less-stringent requirements. Since February 2016 a wider range of foreign investors can invest in the Chinese Interbank Bond Market without quotas.

Like the QFII, the Renminbi Qualified Financial Institutional Investor (RQFII) system allows qualified foreign institutional investors to invest in the domestic financial market. RQFII investors and QFII investors differ in three major ways. First, RQFII investors must use the renminbi to invest in Chinese financial markets, while QFII investors may use other currencies as well. The second difference is the holding period: open-end China funds are not subject to any holding period, while the rest are subject to a one-year holding period similar to QFII investors. The third difference is that no official cap is placed on RQFII quotas, while QFII quotas are subject to official caps. The total allocated quota for RQFII investments reached RMB1,210 billion in May 2016.

The Qualified Domestic Institutional Investor (QDII) system allows qualified domestic institutional investors, including banks and nonbank financial institutions such as securities firms and insurance companies, to invest in overseas financial markets. To be qualified, an investor needs approval from its relevant industry regulator. Each qualified investor is subject to a SAFE-approved quota. There is no official cap on aggregate or individual quotas. If an investor fails to use its quota within two years of approval, SAFE may reduce it. The quota cannot be transferred or traded. Qualified banks may not invest in commodity derivatives, hedge funds, or securities with credit ratings below BBB. Each investor may hold no more than 10 percent of a foreign company’s voting shares. And the aggregate of the QDII quota is small (US$90 billion), about 1 percent of China’s 2014 GDP. The program on Qualified Domestic Individual Investor (QDII2) allows qualified individual retail investors in the Shanghai Free Trade Zone to invest in overseas financial markets.

The Shanghai-Hong Kong Stock Connect gives Chinese retail investors access to the Hong Kong SAR stock market and Hong Kong SAR investors access to Chinese stock markets. There is a minimum investment requirement of 0.5 million yuan for Chinese investors, but not for Hong Kong SAR investors. Unlike other pilot schemes, investors do not need to be approved as qualified investors, nor are they subject to individual quotas. However, daily limits and an aggregate quota are imposed on gross flows. The daily limit on southbound flows (from Shanghai to the Hong Kong SAR stock market) was reached for the first time on April 8, 2015. Nonetheless, the limit had not been reached again as of October 31, 2015. In December 2015 the mutual recognition of funds was launched, allowing investors in the mainland and Hong Kong SAR to invest in qualified cross-border mutual funds.

Table 8.1.Summary of China’s Schemes to Ease Controls on Portfolio Investments, September 2015
SchemeTarget FlowsStart YearQuota LimitTotal Quotas Allotted (Billion)Cap on Individual QuotaCap on Total QuotasMinimum Investment RequiredCurrency
QDIIPortfolio outflow2006Yes$90NoNoNoAny
QFIIPortfolio inflow2002Yes$79$1 billion$150 billion$2 millionAny
RQFIIPortfolio inflow2011YesRMB412NoNoNoRMB
SHKSC Southbound2Equity outflow2014No1NoRMB250 billion1RMB0.5 millionRMB
SHKSC NorthboundEquity inflow2014No1NoRMB300 billion1NoRMB
MRFPortfolio inflow/ outflow201550% of the fund’s total assetsNoNoAny
Sources: People’s Bank of China publications; and State Administration of Foreign Exchange.Note: … = not available; MRF = mutual recognition of funds; QDII = Qualified Domestic Institutional Investor; QFII = Qualified Foreign Institutional Investor; RMB = renminbi; RQFII = Renminbi Qualified Foreign Institutional Investor; SHKSC = Shanghai Hong Kong Stock Exchange Connect.

Though SHKSC investors are not subject to individual quota limits, they are subject to a daily limit and an aggregate quota on total flows. Net southbound flows are capped at RMB10.5 billion per day and RMB250 billion in aggregate, and net northbound flows are capped at RMB15 billion per day and RMB300 billion in aggregate.

Southbound refers to investment flows from Shanghai (mainland) to Hong Kong SAR and northbound refers to investment flows from Hong Kong SAR to Shanghai.

Sources: People’s Bank of China publications; and State Administration of Foreign Exchange.Note: … = not available; MRF = mutual recognition of funds; QDII = Qualified Domestic Institutional Investor; QFII = Qualified Foreign Institutional Investor; RMB = renminbi; RQFII = Renminbi Qualified Foreign Institutional Investor; SHKSC = Shanghai Hong Kong Stock Exchange Connect.

Though SHKSC investors are not subject to individual quota limits, they are subject to a daily limit and an aggregate quota on total flows. Net southbound flows are capped at RMB10.5 billion per day and RMB250 billion in aggregate, and net northbound flows are capped at RMB15 billion per day and RMB300 billion in aggregate.

Southbound refers to investment flows from Shanghai (mainland) to Hong Kong SAR and northbound refers to investment flows from Hong Kong SAR to Shanghai.

Renminbi Internationalization

Capital flow liberalization in China and renminbi internationalization are deeply intertwined. Since the global financial crisis, the authorities have pursued renminbi internationalization as a key policy (see Chapter 9 on renminbi internationalization). A major challenge in managing this process is to delineate the relationship between renminbi internationalization and capital flow liberalization (He 2014). Even if a currency is convertible (that is, both the current and financial account are liberalized), it may not necessarily be widely used internationally. For example, the currencies of Australia, Canada, and New Zealand are not widely used even though they are fully convertible. On the other hand, the international use of a currency does not require a fully open capital account, at least in the initial stage, although some capital account openness is necessary (He and McCauley 2010). To ensure adequate liquidity in the offshore markets, the renminbi supply would need to increase further. Given the current account surplus in China, one way to inject more yuan into global financial markets would be to liberalize capital flows. Indeed, renminbi liquidity in the global financial system crucially depends on the willingness of non-Chinese residents to borrow in yuan (He and McCauley 2012). Ultimately, full internationalization of the renminbi will be a function of its scale, stability, and liquidity (Eichengreen 2013).11

The relationship between renminbi internationalization and capital flow liberalization is complex. Capital flow liberalization would, in principle, support greater internationalization. It would also tend to eventually reduce the spread between onshore and offshore exchange rates (in Hong Kong SAR, for example). However, it is possible that the influence of liberalization on the spread is not straightforward in the short term.

Conversely, internationalization can complicate liberalization, because it creates more opportunities for the circumvention of capital controls. The safe liberalization of capital flows requires that remaining controls are effective. The use of the renminbi in cross-border transactions provides carry trade and arbitrage opportunities to both residents and nonresidents through trade channels (Yu 2014; Zhang 2015). Internationalization will thus also have an effect on spreads between offshore and onshore rates: the larger the offshore renminbi market becomes, the easier it will be to structure transactions for arbitraging any material deviations between the two exchange rates. Consequently, each liberalization step needs to be considered in light of how the international use of the renminbi will affect capital flows.

The removal of controls thus needs to be pursued on two tracks whose paces must remain consistent. Capital flow liberalization needs to progress by lifting controls on cross-border transactions in foreign exchange but also in yuan, which raises the question of whether liberalization on one track can progress faster than liberalization on the other. Inconsistency between the pace of renminbi liberalization and foreign exchange could lead to adverse outcomes. For example, if renminbi liberalization progresses faster, it may undermine controls on transactions in foreign exchange. Conversely, if controls are removed faster on foreign exchange transactions, resulting in increased access of nonresidents to the onshore foreign exchange market and investment opportunities, it may adversely affect the spread between onshore and offshore exchange rates.

Are Controls Still Binding?

A wide range of views has been expressed about the effectiveness of China’s capital controls. It has been argued that controls are not binding or are losing their effectiveness because they have become easier to circumvent under current account convertibility, ongoing renminbi internationalization, and capital flow liberalization. The opposite view holds that the low share of portfolio inflows in China—compared with emerging markets with open capital accounts—is a result of strict capital controls on portfolio flows (IMF 2011a). China is, indeed, among the least financially open countries in its income range (Figure 8.3), based on one important measure of financial integration.12 It is also much less open than advanced economies, and Figure 8.4 shows that it ranks with India as the least open among the BRICS (Brazil, Russia, India, China, and South Africa).13 Data on foreign portfolio investment into China show that investment in the domestic debt market is much lower than in advanced economies with liberalized capital accounts (Table 8.2).

Figure 8.3.Income Level and De Facto Financial Integration

(GDP per capita in logarithm [x-axis] and de facto financial integration [y-axis], as of 2014 or latest available)

Sources: World Bank, World Development Indicators, updated and extended version of the Lane and Milesi-Ferretti (2007) data sets; and IMF staff calculations.

Note: De facto financial integration is measured by the sum of external assets (excluding official foreign exchange reserves) and liabilities in percent of GDP. Countries with a ratio exceeding 700 are not shown in the chart.

Figure 8.4.China: De Facto Financial Integration, 1990–2014

(Percent of GDP)

Source: Updated and extended version of the Lane and Milesi-Ferretti (2007) data set.

Note: De facto financial integration is measured by the sum of external assets (excluding official foreign exchange reserves) and liabilities in percent of GDP. BRICS = Brazil, Russia, India, China, and South Africa.

Table 8.2.Portfolio Investments in Selected Economies, December 20151(Percent of GDP)
Short-Term DebtLong-Term DebtEquityTotal
Czech Republic3.714.32.521.2
Korea, Republic of1.810.420.631.0
New Zealand1.622.610.436.2
Slovak Republic0.229.90.630.8
United Kingdom6.247.561.7117.6
United States3.331.921.656.8
OECD excluding Ireland, Luxembourg, and Netherlands4.236.427.568.1
Sources: Coordinated Portfolio Investment Survey; IMF, International Financial Statistics database; and IMF staff calculations. Note: OECD = Organisation for Economic Co-operation and Development.

The Coordinated Portfolio Investment Survey (CPIS) provides data on economies’ cross-border holdings of portfolio investment securities. This table shows the aggregate investments from 82 economies (that participated in the CPIS) in the countries listed in the rows as of end-2015. The countries shown in the rows belong to the OECD, plus China. Total may not equal the sum because of rounding or data being unavailable or not disclosed to preserve confidentiality.

Sources: Coordinated Portfolio Investment Survey; IMF, International Financial Statistics database; and IMF staff calculations. Note: OECD = Organisation for Economic Co-operation and Development.

The Coordinated Portfolio Investment Survey (CPIS) provides data on economies’ cross-border holdings of portfolio investment securities. This table shows the aggregate investments from 82 economies (that participated in the CPIS) in the countries listed in the rows as of end-2015. The countries shown in the rows belong to the OECD, plus China. Total may not equal the sum because of rounding or data being unavailable or not disclosed to preserve confidentiality.

Assessing the effectiveness of China’s capital controls is also difficult owing to their complexity and recent changes. The regulatory framework includes many layers and types of controls, combined with qualitative and quantitative limitations. Moreover, controls such as approval requirements or tight monitoring of investments are not fully transparent, and their effect is hard to assess. In recent years, China has simplified its regulations. It reduced the number of regulations by more than 60 percent from 700 in 2009, lowered the number of transactions that require administrative approval by 44 percent, and shifted the focus of new regulations to mitigating risks in the financial sector. The full effect of these changes will become apparent only in the next few years.

Capital flow data show developments in line with progress in capital flow liberalization. The volume of capital inflows to China has grown rapidly since the early 2000s, while it became volatile after the global financial crisis (Figure 8.5). In 2014 the volume of capital inflows was about 4 percent of GDP. Although flows are traditionally tilted toward FDI inflows, in line with the design of capital controls, recently that has been changing with a steady increase in portfolio inflows and generally more volatile debt flows. As a result of the asymmetric liberalization, outflows lagged behind inflows, and picked up only in the mid-2000s (Figure 8.5). FDI and portfolio outflows represent less than 1 percent of GDP and outward portfolio investments are small while FDI outflows accelerated in 2015. The remaining outflows are large and volatile. Prominent components contributing to their growth in the past five years are trade credit and advances, loans by banks, and the nonbank sector’s investments in currency and deposits. In part, these outflows consist of increases in residents’ foreign currency deposits after the annual ceiling was eased in 2007. Non-FDI capital flows tend to fluctuate because enterprises adjust their profit repatriation with exchange rate expectations (Bayoumi and Ohnsorge 2013).

Figure 8.5.China: Capital Inflows and Outflows, 1990–2015

(Percent of GDP)

Source: IMF, International Financial Statistics database.

Note: Gross inflows are defined as the sum of inward foreign direct investment, portfolio liabilities, and other investment liabilities in the balance of payment statistics. Gross outflows are defined as the sum of outward foreign direct investment, portfolio assets, and other investment assets.

More generally, trends in capital flows also depend on factors other than capital flow liberalization, such as macroeconomic conditions and incentives. For example, a change in macroeconomic conditions, such as expectations of economic slowdown, may trigger capital outflows through channels that had been liberalized before, but macroeconomic conditions did not create incentives for outflows through such channels until recently. It is therefore difficult to gauge the effectiveness of capital controls using only the volume of flows.

At the same time, leakage is apparent. On the inflow side, rapid growth of inward remittances and weak current investment income transfers by foreign companies are evidence of circumvention through current account transactions when expectations for exchange rate appreciation are strong (Ma and McCauley 2008). In addition, swings in net flows of errors and omissions in the balance of payments can be interpreted as unrecorded capital inflows to China (Prasad and Wei 2007). Similarly, leakage leading to outflows takes place through false invoicing of trade payments and delays in repatriations.14 A study estimated that between 2000 and 2005, average annual trade mis-invoicing flows were $48 billion (2.2 percent of 2005 GDP) on a net basis, and $236 billion (10.6 percent of 2005 GDP) as an absolute sum of under- and overrecording (Beja 2008). And since about 2009, net errors and omissions in China’s balance of payments have turned negative, potentially indicating increasing net capital outflows (Figure 8.6).

Figure 8.6.China: Net Errors and Omissions, 1997–2015

Source: IMF, World Economic Outlook database.

More recently, from 2015, increased capital outflows have been reported against the backdrop of weakening market confidence in China’s growth. Some interpret these episodes as evidence that capital controls are not binding. Data show that, in 2015, gross outflows continued at a steady pace ($389 billion, or 3.6 percent of GDP) while inflows fell, mostly because of declines in external loans and nonresidents’ deposits (by $352 billion or 3.2 percent of GDP), which was cushioned by inward FDI (see Figure 8.5). As a result, official foreign exchange reserve holdings dropped by $514 billion, or 4.9 percent of GDP, between December 2014 and December 2015.15 In part, this drop can also be attributed to Chinese residents converting their domestic currency deposits into foreign currency deposits.16

Evidence using price data shows that arbitrage between onshore and offshore renminbi markets has been imperfect, supporting the notion that certain capital controls in China are still effective. Because of the difficulties in measuring variations in the openness of the rather complex capital control system, researchers often measure the effectiveness of market arbitrage in exchange rates or interest rates to gauge how strict capital controls actually are. Studies show that significant spreads between onshore and offshore interest rates and deviations from covered interest parity exist (Ma and McCauley 2008), and that the renminbi-covered interest differential is not shrinking (Cheung and Herrala 2014).

Likewise, for exchange rates, the spread expanded significantly during times of market pressure, indicating market segmentation (Figure 8.7). A recent study confirms the persistent deviations between onshore and offshore renminbi exchange rates. It also shows that the volatility of the deviations is reduced by policy measures liberalizing cross-border renminbi outflows, while less of an effect was found from measures allowing renminbi funds to flow back onshore (Funke and others 2015). Although there is evidence that links between onshore and offshore yuan forward rates have strengthened recently (Maziad and Kang 2012), the lack of full integration is still attributed to capital controls (Craig and others 2013). Nonetheless, because capital flow liberalization is ongoing, the effectiveness of controls and their effect on the spread may change over time.

Figure 8.7.China Onshore and Offshore Exchange Rates, 2010–16

Source: Bloomberg L.P.

Note: Daily midday spot exchange rates for yuan per dollar for August 2010 through June 2016. The spread is calculated in percent of the onshore exchange rate.

Overall, studies have shown that remaining controls on capital transactions in China continue to have an effect, but not uniformly across different types of transactions, and that there is evidence of circumvention. Recent spillovers from turbulence in the Chinese stock market and pressure on the yuan following the change in exchange rate policy in August 2015 indicate that financial integration may be deeper than previously thought. Further analysis is needed, however.

The Case for and Against Further Liberalization

In recent years, there has been a heated debate in China about the pros and cons of further opening up the capital account, the relationship between capital flow liberalization and capital flow management, and the sequencing of financial sector reforms with capital flow liberalization.17

Proponents of liberalization argue that existing capital controls are becoming less binding, and that large and volatile short-term inflows are increasingly destabilizing the domestic financial system and rendering monetary policy ineffective. They see an urgent need for the private sector to diversify the country, credit, currency, and market risks of their portfolios as China moves toward upper-middle-income status. They argue that China’s international balance sheets are extremely lopsided at present, with assets being mostly low-yielding foreign reserves and liabilities mostly high-yielding foreign direct investments. Such a lopsided international balance sheet has important macroeconomic and financial stability implications—self-fulfilling expectations of currency appreciation and bubble-prone domestic financial markets.

Opponents, on the other hand, see no compelling evidence that capital flow liberalization contributes to economic growth or welfare, and point instead to signs that openness to increasingly volatile capital flows is detrimental to domestic monetary and financial stability. They further argue that liberalization is self-destructive because capital controls are the last line of defense against financial crises. Specifically, China weathered the Asian financial crisis well because it had a largely closed capital account. They also emphasize that capital flow liberalization should happen only after domestic financial reforms (including interest rate liberalization) have been completed and exchange rate flexibility has been achieved. In addition, some recent literature argues that monetary policy is constrained when capital flows have been liberalized (Rey 2016).

While the arguments in opposition have some merit, it is difficult to imagine that one of the world’s largest economies and trading nations will maintain tight controls on capital flows indefinitely as it becomes an upper-middle-income economy. Most, if not all, upper-middle- to high-income economies have ultimately liberalized capital flows. At the same time, persuasive arguments have been made against hasty or premature liberalization, and an emerging consensus in the literature sees an open capital account as beneficial when certain conditions have been met. Eichengreen, Gullapalli, and Panizza (2011) show that benefits are limited to countries with relatively well-developed financial systems, good accounting standards, and strong creditor rights and rule of law. Similarly, IMF (2012b) finds that capital flow liberalization is positively correlated with economic growth, and the result is more pronounced for countries with an income level above a certain threshold. Klein and Olivei (2008) also find that capital flows can benefit growth and increase financial depth for countries with adequate institutions and sound macroeconomic policies.

Perhaps reflecting the lack of consensus on the desirability and pace of further liberalization, the government has not published any comprehensive road map or timetable, while reiterating that capital account convertibility remains the objective. Nevertheless, the authorities have continued to implement incremental liberalization of specific transactions (Box 8.2) and announced plans for further liberalization. These more recent plans include the liberalization of individual investments of residents and nonresidents and further two-way opening of capital markets. Some liberalization of inflows in derivatives transactions is also envisaged, together with establishment of a unified bank account system for both local and foreign currencies. A sweeping revision of the regulatory framework for foreign exchange and cross-border transactions is also foreseen. The revision aims at establishing a unified framework for international payments and transfers in renminbi and foreign currencies, simplifying the approval requirements, and establishing and reinforcing balance of payments reporting and statistical surveillance of cross-border capital flows. The new framework would include a negative list (transactions related to money laundering and the financing of terrorism, tax evasion, national security, and international obligations), a strengthening of the macroprudential management of capital flows, and provision for a crisis response mechanism (Liu 2015).

Based on the track record, the authorities seem likely to push forward with capital flow liberalization, although the pace will be fine-tuned according to the prevailing domestic and international macroeconomic and financial conditions and the experiences with specific liberalization measures. The “going global” strategy, confirmed at the Third Plenary Session in November 2013, will probably lead to more liberalization of outward FDI and transactions related to the operation of Chinese companies abroad.18 More recently, China’s 13th Five-Year Plan reiterates its commitment to an orderly transition toward capital account convertibility, including steady internationalization of the renminbi (see also Chapter 9 on RMB internationalization), improving the prudential regulatory framework, and further two-way opening of capital markets.19

The authorities’ plans appear to be largely in line with the integrated approach to capital flow liberalization (IMF 2012a). The integrated approach is made up of successive and often overlapping phases, accompanied or preceded by supporting legal, accounting, financial, and corporate reforms, and a strengthening of financial regulation and supervision. In general, FDI inflows would be liberalized first, followed by FDI outflows and long-term portfolio flows. Finally, controls on short-term portfolio flows would be removed. Within this general framework, the integrated approach stresses that the path taken and the extent of liberalization need to be based on a country’s circumstances.

The Way Forward: Possible Options

Given the size of the Chinese economy and the potential global effect of liberalization, it is generally agreed that the removal of controls should be gradual and sequenced with supporting policies. Missteps can have significant consequences for China and the global financial system. Therefore, the process should be carefully designed to avoid backtracking that could undermine both the credibility of the authorities’ policies and confidence in the liberalization strategy.

The Role of Supporting Policies

A domestically oriented and independent monetary policy is a desirable goal for a large economy like that of China. In this case, capital flow liberalization needs to be supported by greater exchange rate flexibility. Indeed, the removal of capital controls will reduce the authorities’ ability to control the exchange rate and monetary policy simultaneously. New arrangements for monetary and exchange rate policies will be needed. The authorities recognized this and have moved toward greater exchange rate flexibility. In August 2015 China adopted a more market-based approach to the exchange rate by setting the central parity of the yuan to the U.S. dollar with stronger reference to the closing spot rate of the previous day. However, depreciation pressures and capital outflows intensified during the ensuing months and, in late 2015, China indicated that it would aim to keep the renminbi stable through reference against a basket of currencies.

Moving to greater exchange rate flexibility would require development of a credible monetary framework. A new policy target is needed to replace the exchange rate anchor, and the instruments used to achieve this target would need to be clearly defined before abandoning the current de facto soft peg.20 The new monetary and exchange rate policy framework would help market participants understand the overall direction of policy and also underpin their expectations about the exchange rate. The authorities have already started the transition from the use of direct levers by removing the ceiling on de jure interest rates and enhancing short-term management of the rate. However, further decisions are needed to prevent reliance on directed lending and other nonmarket tools to firmly establish a market-based monetary framework that uses interest rates effectively. Increased operational independence of the People’s Bank of China (PBC) in the conduct of monetary policy would be another important component of the new framework, with the government continuing to set the key medium-term monetary policy goals (see Chapter 7 on the monetary policy framework).

Although a flexible exchange rate can act as a shock absorber to volatile capital flows, excessive exchange rate movements may produce adverse economic effects. The onshore foreign exchange market is relatively deep and liquid, and capital flow liberalization may stimulate further deepening and enhance the ability of the market to safely cope with capital flow volatility. However, there is a risk that increased capital flows after controls are removed may prove too large for the market to absorb and could lead to high exchange rate volatility or misalignments. If liberalization is followed by depreciation pressures and the exchange rate is allowed to adjust, currency risk on the balance sheets of firms and banks may materialize. Firms may be unable to honor debt denominated in foreign exchange, nonperforming loans may increase, and banks’ capital may shrink. Depreciation may also trigger a shift in corporate borrowing as firms may be inclined to refinance their external loans with domestic renminbi loans, resulting in additional outflows and further depreciation. In 2015 corporates have repaid part of their external debt in light of depreciation and increased volatility in the exchange rate. International reserves are still ample, but they are not unlimited, and this imposes a constraint on the authorities’ ability to intervene in the longer term. Accordingly, the removal of capital controls needs to be tailored to the economy’s ability to deal with the potential effects on the exchange rate.

Capital flow liberalization may also pose risks to the financial sector, especially for countries with insufficiently developed institutional capacity. Cross-country experience suggests that in most cases where financial crises coincided with or followed capital flow liberalization, financial sector policies were inadequate (Ishii and others 2002). Hence, the sophistication and effectiveness of the domestic financial prudential framework and financial sector policies need to match the pace of capital flow liberalization.

Capital and liquidity buffers and other macroprudential measures to increase the resilience of the financial system are particularly important—and should be in place before controls on cross-border capital transactions are liberalized. Once capital controls have been removed, macroprudential tools can help deal with the risks associated with surges in inflows and their reversals. Some of these macroprudential tools may at the same time be capital flow management measures (IMF 2012a, 2013).

To ensure that macroprudential policy is effective, China needs to build a strong institutional framework. The current institutional framework for financial stability in China has multiple layers, involving the State Council at the top, the PBC and financial regulatory commissions in the middle, and communication between the regulators and the regulated institutions below (IMF 2011b; Wang and Sun 2013). In addition, the sector-based regulatory and supervisory framework in China requires strong coordination to limit supervisory “blind spots” (IMF 2011b). One important and desirable feature of any institutional framework is its ability to overcome the bias in favor of inaction that reflects, among other things, difficulties in quantifying the benefits of macroprudential action (IMF 2013). Put differently, the framework needs to foster the ability to act so that a macroprudential policymaker has access to information; include instruments with appropriate range and reach; define a clear objective; and provide strong accountability, including through clear communication. It is also important that the macroprudential mandate be clearly assigned, say to a specific institution or a committee, preferably with the central bank playing an important role.

In addition to macroprudential policy, contingency plans are needed in the event that liberalization triggers large and destabilizing capital flows. In many countries, the central bank has authority to introduce temporary emergency measures when there are threats to macrofinancial stability. In China, the establishment of the Financial Crisis Response Group and the Joint Ministerial Committee to assess and act on systemic risks is a significant move toward developing a coherent macroprudential and crisis management framework. To further strengthen the framework, the PBC could be authorized to introduce temporary measures to address the destabilizing effects of inflows or outflows.

How Should Controls Be Removed?

China is in the second phase of liberalization, according to the IMF’s integrated approach (IMF 2012a). FDI has been largely liberalized and some long- and short-term portfolio investments partially liberalized. The next steps in the approach would involve gradual further easing of controls on these investments, moving to transactions that typically imply greater volatility in capital flows (see Table 8.3). The supporting policies related to this phase include modernizing the frameworks for monetary and exchange rate policies; strengthening systemic liquidity arrangements and related monetary and exchange operations; enhancing prudential regulation, supervision, and risk management; restructuring the financial and corporate sectors; and developing capital markets and long-term investors, including pension funds. These supporting policies need to be adequately sequenced with liberalization of controls to prevent macroeconomic and systemic risks. Key reforms also include addressing high corporate sector debt, reforming SOEs, and establishing hard budget constraints (IMF 2012a, 2015a).

Table 8.3.Potential Sequence of Capital Flow Liberalization with Supporting Policies
Capital Flow LiberalizationSupporting PoliciesFinancial Sector Policies
(1) Gradual increase of quotas and relaxing qualification requirements on inflow and outflow of foreign direct investment and portfolio investment

Gradual increase of yearly limit on individuals’ investments abroad

Selective liberalization of cross-border derivative transactions

Relaxing controls on external loans
Modernizing the monetary and exchange rate policy framework:
  • Establishing new monetary target, increasing flexibility of exchange rate

  • Strengthening systemic liquidity arrangements and related monetary and exchange operations

Establishing hard budget constraints

Reforming state-owned enterprises

Addressing the high debt of the corporate sector

Revision of the legal, accounting, financial, and corporate frameworks to the extent necessary
Deepening domestic financial markets by introducing new financial instruments

Strengthening financial regulation and supervision in advance of liberalization to improve the financial sector’s ability to withstand the effect of volatile capital flows

Building up capital and liquidity buffers before controls are liberalized

Introduction of macroprudential tools on credit, liquidity, and exchange rate risk (for example, sectoral capital requirements on specific loans, constraints on lending, liquidity tools—separate or tighter liquidity requirements on foreign currency liabilities)

Implementing adequate investment regulations on pension funds’ and other institutional investors’ investments abroad

Designing a contingency plan to address potential threats to macro-financial stability
(2) Replacing quotas and qualification requirements with price-based controls such as unremunerated reserve requirement (URR) or tax. Adjusting the calibration of the URR/tax to changing conditions. Removal of mandatory holding period on nonresidents’ portfolio equity and fixed-income investments

Relaxing controls on resident and nonresident individuals’ investments

Further relaxing controls on external loans
Further strengthening of the monetary and exchange rate policy framework

Continued reform of state-owned enterprises and the corporate sector

Enhancing the monitoring of capital flows
Continued deepening of the financial markets

Introducing net stable funding ratio and/or liquidity charges on noncore funding

Implementing higher risk weights on foreign exchange loans

Eliminating directed lending

Expanding the regulatory perimeter to shadow banking and the corporate sector
(3) Gradual move from preapproval to registration and notification requirement followed by reporting requirement. As a first step, the ex ante approval requirements could be replaced by a registration requirement under which the transaction is deemed to have been registered (and thus allowed) if the authorities do not object to it in a certain and relatively short time (for example, three or four days)

Replacing residency-based controls with currency-based controls, if possible
Continued improvement of the monetary and exchange rate policy framework

Adequate capital flow monitoring framework in place
Continued deepening of the financial markets

Further strengthening of the supervisory and financial sector regulatory framework
(4) Removal of most of the controlsTrack record of well-defined credible monetary policy and full exchange rate flexibilityAdequate supervisory and micro-and macroprudential framework in place
Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions; and IMF staff.
Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions; and IMF staff.

Generally, any given control should be eased only when the conditions for its removal have been met. This approach helps reduce the risk of destabilizing flows and also reduces the potential need to reverse earlier liberalization steps: reversals tend to hurt investor confidence and should be avoided if at all possible. Policies should generally seek to enhance macro-financial resilience to capital flow volatility. However, in some cases the temporary reimposition of controls may be necessary if a premature liberalization step leads to instability (see IMF 2012a).

China’s current quota system appears to provide a suitable framework for gradual and well-sequenced liberalization. Quotas can be increased incrementally to give the authorities some control over total inflows and outflows until they are eventually removed. On the inflow side, as part of the recent liberalization steps, the PBC abolished the quota for qualified foreign financial institutions to enter the domestic bond markets in February 2016. Looking forward, similar steps could be implemented for equity investments, and the range of institutions eligible for investments could be gradually expanded by lowering the qualification thresholds (by allowing retail investors), while maintaining an overall quota. It is unlikely that such easing would expose China to significantly more risk. In fact, large institutional investors (qualified investors under the current regime) may be able to move significantly larger amounts than retail investors, and they are often bound by prudential or industry-specific regulations that require them to limit certain country positions. By contrast, retail investors do not face such limits on their positions. Managing quotas for a large number of small investors can, however, give rise to a higher administrative burden.

Since the quotas are currently biased toward inflows, it would be advisable to increase quotas on outflows to achieve greater balance. That said, any significant easing of outflow controls would need to account for the effect of the ensuing outflows on the exchange rate and the financial system. Removing the ceiling on interest rates on deposits was an important step toward establishing the conditions for easing outflow controls. However, outflows may initially be large even if domestic interest rates are higher than foreign rates, owing to pent-up portfolio rebalancing pressures. Over the longer term, once the stock adjustments are completed, investment decisions will be mostly motivated by risk-return considerations (Box 8.3). The outflows may result in depreciation pressures, which the authorities may want to smooth with intervention, provided that reserves are adequate.21 The global implications of portfolio rebalancing by Chinese residents following liberalization may also be significant.

In addition to the easing and rebalancing of quotas, the administration of controls could gradually be shifted away from ex ante approval to ex post monitoring. As a first step, ex ante approval requirements could be replaced by a registration requirement under which the transaction is deemed to have been registered and allowed if the authorities do not object to it in a relatively short time (for example, three or four days). This change would significantly ease the administrative burden on investors and the authorities and increase the predictability and transparency of the control system. Several countries that liberalized their foreign exchange regimes in the past 20 years (Korea, for example) took a similar route by gradually replacing preapproval with registration, followed by simple reporting requirements. Such reports allow for close monitoring of capital flows, and are generally prepared by financial intermediaries participating in the cross-border transactions for their clients.

In the process of gradual relaxation of controls, the current administrative and quantity-based controls could be replaced with price-based controls. Since high volatility in capital flows could result from the removal of administrative and quantitative controls, the switch to price-based controls would be an appropriate intermediate step. For example, a mandatory holding period for specific portfolio and FDI investments is a useful tool for reducing capital flow volatility. However, both could be changed over time to a price-based instrument such as an unremunerated reserve requirement (URR) or a tax. Given that FDI is more stable than other capital flows, its mandatory holding period could be removed first, followed by portfolio equity and fixed-income investments.

Box 8.3.Domestic and International Impact of China’s Capital Flow Liberalization

The impact on global financial markets of liberalizing capital flows will likely depend on the speed with which it is undertaken. The IMF (2011a) examined the spillover and external effects of policies in China from various aspects, including savings, its financial flows to emerging markets, and the potential impact on global bond markets from the reallocation of reserves. It noted that gradual liberalization would likely lead to offsetting effects on inflows and outflows. The size of these flows will depend on the sequencing and timing of reforms. One scenario estimates that even a relatively large outflow from China would not offset the reallocation of global assets from non-S5 countries to China.1 As a result, net flows into China could lead to declining asset valuations in the rest of the world. The IMF study also found that if China rebalances its reserve assets away from U.S. assets into emerging markets, say by US$100 billion, U.S. yields could increase by as much as 12 basis points and emerging market yields drop by as much as 48 basis points.

Experience from other countries shows that capital flow liberalization has led to large capital flows in both directions. However, the net direction of capital flows after liberalization depends on many factors and is difficult to predict. Bayoumi and Ohnsorge (2013) find that gross flows both into and out of China would be substantial, and the likely direction of net flows would be outward, with significant repercussions for global financial markets, resulting in Chinese investors accumulating net international assets of about 11–18 percent of GDP. Saadi Sedik and Sun (2012) estimate a 2–3¼ percentage point increase in inflows and outflows, with outflows dominating in 2012–16. He and others (2012) show that China’s gross international investment position would grow significantly, and inflows and outflows would be more balanced, following a stock adjustment, particularly in outward portfolio investments. A similar exercise by Hooley (2013) concludes that full liberalization would lead the capital account balance to turn negative, with net capital outflows. Smaller reserves accumulation would be associated with this swing. He and Luk (2013) construct a two-country general equilibrium model to predict the portfolio choice of Chinese residents after capital flow liberalization, with outcomes broadly in line with those in the empirical literature.

It is unlikely that China’s liberalization would have any parallels to past experience, given the size of potential capital flows following liberalization. According to Hooley (2013), China’s international investment position could increase from about 5 percent to 30 percent of world GDP by 2025. In contrast, the change in the international investment position following liberalization has been quite modest in previous episodes (see Table 8.3.1). Considering the advancements in financial instruments and technology and the increased interconnectedness of global markets today, the potential for volatile capital flows from liberalization in China affecting global markets cannot be ruled out. The IMF 2011a study also showed the potential for China’s capital flow liberalization to affect global asset prices. Given the potential magnitude of flows, even a gradual liberalization may have significant effects on global markets.

Overall, studies indicate that outflows may dominate in the short term as a result of liberalization. However, caution is advised in interpreting these results as they are sensitive to assumptions, including those about the speed of liberalization.

1The S5 (Systemic 5) includes China, the euro area, Japan, the United Kingdom, and the United States.
Table 8.3.1.Average of External Assets (excluding reserves) and Liabilities(Percent of global GDP)
Year of Liberalization1Five Years after Liberalization
Chile (1998)0.10.2
Finland (1989)0.20.3
France (1990)3.14.5
Germany (1981)1.93.0
Italy (1992)1.82.6
Norway (1988)0.20.2
Spain (1992)0.81.0
Sweden (1989)0.60.7
Sources: IMF, International Financial Statistics and World Economic Outlook databases.

As shown in parentheses next to the country; based on Kaminsky and Schmukler 2003.

Sources: IMF, International Financial Statistics and World Economic Outlook databases.

As shown in parentheses next to the country; based on Kaminsky and Schmukler 2003.

Price-based controls may have advantages over administrative or quantity-based controls, notably in more-transparent and less-arbitrary implementation. The literature suggests that such controls can tilt capital flows toward the longer term even if they do not appreciably reduce their overall volume.22 Price-based controls are also more flexible than administrative controls because the “tax rate” can be adjusted relatively easily to changes in interest rate differentials or global liquidity conditions. However, it is often difficult to calibrate price-based measures appropriately, as shown by the frequent adjustments of such measures (in Brazil and Chile, for example).

The most frequently used price-based measures are URRs (in Chile and Thailand) and taxes (Brazil). While implementation is different, the two measures are economically similar given that each URR has a tax equivalent (a function of the URR as a proportion of the investment and the opportunity cost of those funds). However, they also differ in that the URR—in contrast to the tax—has an effect on domestic liquidity if deposited in local currency, and may give rise to appreciation pressures; conversely, it may reduce appreciation pressures if deposited in foreign exchange.23 Legal issues can be a factor in the choice: in many countries the central bank cannot impose taxes, and the measure out of necessity has to be a URR.

Currency-based controls are often preferable to residency-based controls. They can be equally effective and less distortionary,24 and IMF advice has favored them (IMF 2012a).25 In recent years, emerging market economies, including OECD countries, have increasingly used currency-based measures, especially to manage capital inflows (De Crescenzio, Golin, and Ott 2015). Cross-country studies show that currency-based controls are effective at reducing domestic financial risks and helped countries improve their economic resilience during the 2007 global financial crisis (Ostry and others 2012). Currency-based controls could therefore gradually replace residency-based controls as part of China’s liberalization process.

Addressing Risks from Capital Flow Liberalization

Following capital flow liberalization, macroeconomic and financial sector risks often increase. Inflow surges may heighten macroeconomic volatility through rapid currency appreciation, leading to a loss of competitiveness, distortions in money markets, disruptions in monetary policy transmission, asset price bubbles, credit booms, and loose fiscal discipline (IMF 2011a, 2012a). Surges can be followed by sudden stops or reversals. When reversals of inflows (or outflows) are large or sustained, they pose macroeconomic policy challenges—even absent a crisis—through their effects on exchange rates, interest rates, credit, and output.

Risk of Inflow Surges

Inflow surges typically require adjustments in the policy mix.26 Appropriate macroeconomic policy responses include rebalancing the monetary and fiscal policy mix consistent with inflation and growth objectives, allowing the currency to strengthen if it is not overvalued, and building foreign reserves if they are not more than adequate. Capital flow management measures are also warranted in certain circumstances (IMF 2012a). During liberalization, structural reforms can increase the capacity to absorb inflows and channel them toward productive investments, although such reforms typically have a long lead time.

Inflow surges may also result in systemic financial instability (IMF 2015b):

  • Capital inflows can contribute to a credit boom and increases in local asset prices, which can erode lending standards and raise credit risks. Tian and Gallagher (2015) show a link in China between short-term capital flows and rising house prices. Channels include the effect of capital inflows on the domestic banking system, and foreign investors pushing up local asset prices, forcing domestic investors to borrow larger amounts to keep up with increasing prices for local real estate.

  • Easier access to foreign capital can lead to increases in short-term wholesale funding of the financial system. During credit booms, banks often face difficulties finding domestic retail funding and turn to lower-cost foreign funds. This tendency was observed ahead of many financial crises, including the Asian crisis in 1997 (Ishii and others 2002; Lane and others 1999) and the global financial crisis of 2007. As banks increasingly resort to short-term wholesale funding, the system becomes exposed to funding and liquidity shocks. Currently, in China, this type of risk is mitigated by ceilings on banks’ borrowing and ample retail deposits, supported by controls on outflows by individuals. However, even though China’s regulations reduce risk, they also produce other costs and distortions.

  • Cross-border funding often carries foreign exchange risk, which can create procyclical feedback between exchange rates and domestic credit. In emerging market economies that have liberalized these flows, wholesale funding is often denominated in foreign currency. When capital flows reverse, rollover and currency mismatch risks may materialize because of incomplete hedging. Capital inflows can also lead to local currency appreciation and strengthen the banking sector’s local currency balance sheet, which in turn allows more risk taking by banks and creates procyclical feedback between domestic credit and exchange rates.

  • Foreign-currency-denominated loans may involve high currency mismatch and credit risks. The corporate or household sector may borrow without sufficient hedging when their borrowing is motivated by large interest rate differentials from global rates, or when the local currency is expected to appreciate. In addition, incentives and skills to manage currency risks may not be present when exchange rate flexibility has been limited or is nonexistent. When capital flows reverse and a currency depreciates, unhedged borrowers may be unable to service their foreign exchange loans, impairing banks’ capacity to lend and aggravating the effects of the initial shocks.

A number of these systemic risks can be addressed by well-designed macroprudential measures, some of which may also be considered capital flow management measures (IMF 2013, 2014).27 For example, risks from excessive credit growth and asset price appreciation could be mitigated by macroprudential tools targeted at specific credit categories, including sectoral capital requirements on specific loans or constraints on lending.28 Macroprudential liquidity tools, notably minimum standards for the liquidity coverage ratio and the net stable funding ratio in the Basel III framework, can promote both longer-term and more-stable funding. Liquidity charges on noncore funding can be useful for promoting more-stable funding and to reduce the risk of capital flow reversals.29 Increases in foreign currency funding can be contained by macroprudential policy measures, such as separate or tighter liquidity requirements in foreign currency, constraints on open foreign exchange positions, or measures targeting foreign-currency-denominated funding. Risks stemming from foreign currency loans can be addressed by targeted tools on foreign exchange exposures, including higher risk weights.

Such policies and measures will be particularly important, as the Chinese authorities have abolished the quota restrictions for qualified foreign institutional investors to participate in domestic bond markets and have initiated measures to promote their investments in the stock markets. These may raise asset prices and lead to appreciation pressures. In addition, regulatory arbitrage can motivate credit provision to move to the nonbank sector or to foreign banks. Hence, there is a need to ensure that the regulatory perimeter of macroprudential policy extends to important providers of credit and liquidity other than banks.

Risk of Outflow Surges

Capital outflows are among the natural consequences of capital account openness. In many cases, outflows are moderate and benign and do not require significant policy action. However, given China’s unbalanced international investment position, outflows are expected to be significant for some time as residents diversify their portfolios.

Outflows, absent a crisis, should be primarily managed with sound macroeconomic policies, strong financial supervisory frameworks, and structural reforms to deepen financial markets, taking into account country-specific circumstances (IMF 2012c, 2015c). For instance, macroeconomic policy responses could include allowing the exchange rate to absorb the external shock by letting it depreciate. However, if the exchange rate adjustment would be excessively damaging to balance sheets, and if reserve levels allow, foreign exchange intervention may be helpful. The still-sizable official reserves in China would permit such interventions if necessary, while still maintaining adequate reserve coverage. If necessary, monetary or fiscal policy could also be tightened (for instance, if outflows were fueled by macroeconomic imbalances).

Other policies and measures can also help countries prepare for large outflows and weather their impact. Stronger financial regulation (such as liquidity requirements) and supervision can be implemented in advance of liberalization to strengthen the financial sector’s ability to withstand the effect of large capital outflows, for example, if depositors withdraw their deposits to invest abroad. Expanding the regulatory perimeter to the shadow banking and corporate sectors could further reduce the negative effect of capital outflows. Deepening the domestic financial markets by introducing new financial instruments could reduce the incentive for residents to invest their deposits abroad. Adequate regulations on overseas investments by pension funds and other institutions would also reduce outflows.30

When outflows threaten to lead to a crisis, capital controls may also be needed. However, experience shows such measures are unlikely to have the expected results unless they are part of a broader policy package that addresses the fundamental causes of capital outflows.31 Capital controls can help provide breathing space until more fundamental policies take effect, but they should not substitute for warranted macroeconomic adjustments. Implementation of outflow measures should also avoid the accumulation of external payment arrears or default, and the least discriminatory measures that are effective should be preferred.


Even as China has made significant progress in liberalizing its capital account, capital transactions remain largely controlled. The country’s preeminent role in global trade indicates room for more significant integration into the global financial system. In light of the potentially large global effects, it is important that liberalization be well managed and not give rise to undue volatility in capital flows.

While the authorities have specific plans to liberalize capital flows as set out in the 13th Five-Year Plan, coordinated actions are needed to ensure the safe removal of controls without increasing the risk of reversal.

In particular, liberalization needs to be coordinated with supporting macroeconomic, financial, and structural policies to create a virtuous circle for continuing safe liberalization. A new monetary policy framework and a more flexible exchange rate regime will be essential to dampen the effect of larger and more volatile capital flows on the economy, and to anchor market expectations. Existing structural rigidities may prevent the financial sector from making smooth adjustments to a liberalized environment and may lead to excessive risk taking. Upgrading the regulatory and supervisory framework, including enhanced macroprudential policies, will be essential to mitigating the risks that capital flow liberalization can pose to the financial sector.

China’s liberalization has broadly followed the advised sequence for removing controls laid out in the IMF’s “integrated approach.” However, the gradual removal of capital controls in China has displayed several unique features not often seen in other countries: (1) the combination of quotas and specific investor groups (qualified institutional investors), (2) the removal of specific controls in parts of the country (that is, location-specific policy experiments) to test liberalization before more general implementation, and (3) efforts to expand the international use of a heavily controlled currency. This unique approach to liberalization allows the authorities to liberalize gradually and adjust the pace flexibly to match prevailing conditions, but also poses challenges owing to the existence of a large offshore deliverable renminbi market and the several channels through which the offshore renminbi market is connected to the onshore market.

Liberalization needs to ensure a balanced approach to inflows and outflows. Existing controls appear largely effective, although there is evidence of leakages, which are likely to increase as liberalization advances. Orderly liberalization will thus require an effort to maintain the effectiveness of controls until they are removed. To this end, capital flows need to be closely monitored during the liberalization process, and policies adjusted as needed. There would also be advantages to changing the methods used to manage the capital account: replacing administrative and quantitative controls with price-based controls, gradually shifting to registration and ex post monitoring of transactions instead of preapproval, and using currency-based measures instead of residency-based controls.

The effects of China’s capital flow liberalization on the global economy and financial system are uncertain. That said, there appears to be broad agreement in the literature that in the short term, outflows will dominate as a result of residents’ pent-up demand for portfolio rebalancing. Over the longer term, capital flows are likely to become more balanced, although gross capital flows will increase significantly.


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Capital flow and capital account liberalization are used interchangeably to describe the removal of controls on inward and outward flows on the financial account.

Suggestions for the 13th Five-Year Plan for National Economic and Social Development (dated October 29, 2015) state that “China will realize the renminbi’s convertibility under capital accounts in an orderly way.”

The authors are grateful to SAFE for helpful comments provided on this chapter.

De jure measures of capital controls are based on the laws and regulations governing capital controls.

Various indices measure the degree of capital account openness, and each has its own imperfections. Most indices of de jure controls on capital accounts, including the one used in this chapter, draw on the IMF’s AREAER as a primary source of information on rules and regulations related to capital transactions. Many indices indicate extensive controls for China, although minor variations across indices reflect differences in the coverage of underlying transactions and subjective judgments (see IMF 2010 for a comparison of these indices).

In SAFE’s classification, unconvertible refers to those items forbidden by legislation or de facto practice, partially convertibk refers to the situation where some subitems are permitted and others are not, generally convertible refers to those items permitted after registration or report, and convertible refers to those items without exchange restrictions (SAFE presentation, February 2015).

A minimum offshore asset requirement of $100 million is imposed on foreign investors, who also must be financially sound and have good credit and mature management experience to invest in China. Strategic inward direct investments are subject to a three-year holding period, during which acquired shares cannot be traded or transferred. The repatriation of funds from liquidation of direct investment requires SAFE registration (except for investment and repatriation in renminbi), while the repatriation of profits requires only verification by the bank conducting the transfer.

SOEs dominate China’s outward FDI. For example, private firms accounted for only 9.5 percent of China’s outward FDI in 2012 (Alon and others 2014).

Yuan-denominated bond issuance by foreign companies was allowed from September 2014.

For example, foreign holdings of U.S. corporate equities were about 20 percent as of end September 2015.

The IMF has agreed to add the renminbi to the special drawing rights basket starting October 1, 2016. Although its inclusion in the basket is not likely to have an immediate impact, in the medium to long term it is expected to make the renminbi more international. Importantly, central banks are likely to include the currency in their reserve assets.

The sum of external liabilities and assets (excluding official reserves) in percent of GDP.

External liabilities and assets are measured as a stock that depends on historical flows, and therefore may not be a good reflection of the existing capital controls. Moreover, the level of financial integration not only is determined by the degree of capital controls, but depends on other factors, such as trade openness, GDP per capita, and stock market capitalization (Lane and Milesi-Ferretti 2003).

According to an article by the vice president of the People’s Bank of China and the president of SAFE (Yi 2015), regulators found 1,776 Chinese companies that exported goods but reported no export revenue in 2014, amounting to 6 percent of total exports.

In an attempt to curtail outflows, in September 2015 China announced that from October 15, 2015, banks would have to hold an unremunerated reserve requirement of 20 percent on all their forward sales of foreign exchange and similar derivative transactions. The reserve requirement would have to be met in U.S. dollars and be frozen for a year.

In a press conference on October 22, 2015, the deputy administrator of SAFE indicated that Chinese residents bought foreign exchange to increase foreign exchange deposits or repay domestic foreign exchange loans.

These arguments are summarized in a collection of essays titled “Capital Account Liberalization: Strategy, Timing and Roadmap” (Chen and Qian 2014).

”Decision of the Central Committee of the Communist Party of China on Some Major Issues Concerning Comprehensively Deepening the Reform,” November 12, 2013. The going global strategy was included in both the 10th and the 11th Five-Year Plans, with emphasis on SOE investments abroad in strategic sectors, such as energy (oil and gas) and minerals.

The IMF has classified China’s de facto exchange rate regime as a crawl-like arrangement since June 21, 2010, and as “other managed” since December 24, 2014.

Garber (2013) suggests that the proper response would be for the authorities to accommodate the outflows and accept the loss imposed by the preliberalized regime.

The tax is usually paid in local currency and thus further increases appreciation pressures when the foreign exchange is converted to local currency.

Not all currency-based measures are capital controls or capital flow management measures in the most recent terminology of the IMF. They are often prudential measures, such as a net open foreign exchange position limit.

The preference for nondiscriminatory measures mainly reflects a regard for the general standard of fairness and equal treatment that IMF members expect their nationals will enjoy as a result of members’ participation in a multilateral framework like the IMF (IMF 2012c).

See IMF 2011c for country experiences with capital inflows.

In this case, the use of such measures needs to be appropriate under both frameworks (macro-prudential and capital flow management [IMF 2012a]).

In fact, China implemented several macroprudential tools in 2010–12 to contain excessive growth in credit and house prices (Wang and Sun 2013). The measures include lowering the loan-to-value ratio, prohibition of mortgages for third homes, and adjustments in provisioning requirements and the reserve requirement ratio.

For example, Korea introduced a levy on banks’ noncore foreign currency liabilities (macroprudential stability levy) in 2011 to mitigate systemic risks from short-term foreign borrowing (IMF 2013, 2014).

For example, if future pension payments are in yuan, the investment of the pension funds’ assets should not be overwhelmingly in U.S. dollars, or at least should be properly hedged.

See IMF 2012b for country experiences with capital flows during a crisis.

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