Institute of Social Studies
April 2012
Consideration on China’s
Capital Controls
Dic LO (SOAS, London)
diclo@soas.ac.uk
with Guicai Li, Yingquan Jiang, and Tao Qin
POLICY ISSUES

China liberalized capital flows under the current account in 1996, and FDI
inflows much earlier, with the objective of fully liberalizing the capital
account by the year 2000.

The reality is that, today, this objective still remains one for the long-term
future (by 2015 the earliest). Portfolio inflows and outflows are still under
severe restrictions, despite some degree of limited liberalization.

Initially, shelving the achievement of the objective was just a response to
the 1997-98 East Asian crisis. This became an established policy when the
government seemed to reach the judgement that the East Asian crisis was
at least partly ascribable to premature opening of the capital account.

After the outbreak of the financial crisis in the advanced countries, the
policy has become long-term – in practice, if not yet in strategy.

Liberalization of the capital account has been a core doctrine of the
Washington Consensus since the mid-1990s. The financial crisis
emanating from the advanced countries might have pushed the IMF to
become a little bit more flexible with this stance. Yet, as far as China is
concerned, the pressure seems to remain.

The argument for China to liberalize its capital account, sooner rather than
later, is framed in two different ways.

First, it is argued that China’s continuous capital controls are to the
detriment of correcting global imbalances.
The accumulation of official foreign exchange reserves is claimed to be a
symptom of exchange rate manipulation.
Behind the demand for the appreciation of the yuan is the demand for
opening up the Chinese market for portfolio capital flows.





Second, it is argued that the controls are very costly for the Chinese
economy itself.
Again, the accumulation of official foreign exchange reserves is found to
be problematic: it leads to inflationary pressure.
More important, capital controls have become increasingly ineffective –
which has resulted in decreasing monetary policy autonomy.

The fact that China has avoided East Asian-type currency and financial
crisis has been widely cited in support for capital controls. In addition to
deterring speculative capital inflows, the prevention of capital flights in
China has formed another core argument for capital controls.

Both of these are in contrast to mainstream arguments: free capital flows
promote allocative efficiency and utilizing foreign savings, avoid rentseeking…

The purpose of this presentation is to analyse the main trends of evolution
of China’s cross-border capital flows, and, on that basis, to assess the
effectiveness and efficiency of its capital controls.

The objective is not only to assess the efficacy of the alternative policy
doctrines (and theoretical positions), but also to come out with some
policy conclusions for Chinese economic transformation in this particular
area.
MAIN TRENDS OF EVOLUTION

Opening to cross-border capital flows has become increasingly important
in shaping Chinese economic transformation since the turn of the century.

Both the current account and the capital account have registered sizeable
surpluses, with capital flows under the category “errors and omissions” –
which can be seen as an approximate indication of speculative inflows
and/or capital flights – exhibiting serious fluctuations (Figure 1).

A closer look at the flows under the capital account reveals that net FDI
has accounted for the main part of the capital account surpluses (Figure 2).
This is to be expected, an intentional policy outcome.

Yet, the scales and fluctuations of portfolio and other investment surplus
have also been very significant – albeit these have been partly accounted
for by the implementation of QFII since 2002 and QDII since 2006.
Figure 1. China’s Balance of Payment (US dollar 100 million)
5000
Current account surplus
4000
Capital account surplus
Net errors and omissions
3000
2000
1000
0
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
-1000
Sources: China Statistical Yearbook and China Financial Yearbook, various issues.
7
Figure 2. Capital Account Balances (US dollar 100 million)
2500
Net FDI
2000
Portfolio investment surplus
Other investment surplus
1500
Capital account surplus
1000
500
0
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
-500
-1000
-1500
Sources: China Statistical Yearbook and China Financial Yearbook, various issues.
8

Expressed as ratios to GDP, Figure 3 indicates the scales and fluctuations
of the “unaccounted for” capital flows (Figure 3). The measure used is
defined as the following:
change in official reserves - current account balance - net FDI
Whether or not capital flows so measured include those under QFII and
QDII, the point is that these flows have been very volatile. The flows
could reach -6.5% of GDP in 1998 and +4.4% of GDP in 2004

In this connection, and for the consideration of long-term development,
note the rising importance of short-term capital flows vis-à-vis long-term
flows since the late 1990s (Table 1).

All these give rise to questioning the effectiveness of China’s capital
controls – and also the opposite question as to whether the volatility would
have been even more serious if there were no capital controls.
Figure 3. “Unaccounted for” Capital Flows
6.00%
4.00%
A of GDP
B of GDP
2.00%
0.00%
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
-2.00%
-4.00%
-6.00%
-8.00%
Sources: China Statistical Yearbook and China Financial Yearbook, various issues.
Note:
A = errors and omissions;
B = change in official reserves – current account balance – net FDI.
10
Table1. Short-term and Long-term Capital Inflows (US dollar billion)
Long-term Capital Inflow
Short-term Capital Inflow
1990
6.5
-3.2
1991
7.7
0.4
1992
0.7
-0.9
1993
27.4
-3.9
1994
35.8
-3.1
1995
38.3
0.4
1996
41.6
-1.6
1997
54.8
-33.8
1998
24.7
-38.8
1999
19.6
-14.4
2000
24.9
-22.9
2001
25.2
14.5
2002
40.7
-8.4
2003
6.6
46.1
2004
78.1
-7.9
2005
102.0
-0.9
2006
41.8
11.0
2007
163.8
-68.6
2008
165.1
-118.6
2009
70.5
110.3
2010
131.2
94.7
Sources:
China Statistical
Yearbook and China
Financial Yearbook,
various issues.
11
EFFECTIVENESS

The standard method for verifying the effectiveness of capital controls is
to apply the criterion of uncovered interest rate differentials (CID). In
other words, this is to analyse the differences between the onshore and
offshore interest rates for the same financial instruments.

Define
NDF = S(1 + i)/(1 + r*)
where NDF = non-deliverable forward, S = spot rate, i = the NDF-implied
yield on the home currency offshore, and r* the dollar interest rate. From
the criterion indicated above
CID = r - i = r – [NDF(1 + r*)/S-1]
where r is the interest rate on the home currency onshore. It is postulated
that CID > 0 implies appreciation pressures on the home currency in the
present of capital controls, and vice versa.

Figure 4 applies the CID criterion by using the base rate of RMB one-year
deposit for r for the period 19th January 1999 to 31st May 2011 (Figure 4),
while Figure 5 uses the Shanghai Interbank Offered Rate (shibor) for r for
the period from 8th October 2006 to 31st May 2011 (Figure 5). In both
cases, we use the London Interbank Offered Rate (libor) for r*.

Both Figures 4 and 5 indicate a large and persistent onshore-offshore
spread (r - i), which implies the presence of effective restrictions over
cross-border capital flows.

Figure 4 also indicates that there were pressures to depreciate before 2003,
but mostly pressure to appreciate after that. Moreover, both of the two
figures indicate that the spread has not decreased even after China lifted
the yuan-dollar peg in July 2005 – there were actually very serious
fluctuations in 2007-09.
Figure 4. Onshore-Offshore Spread: One-Year Deposit Rate
1500
yield difference (basis point)
1000
500
0
2011/5/19
2011/1/19
2010/9/19
2010/5/19
2010/1/19
2009/9/19
2009/5/19
2009/1/19
2008/9/19
2008/5/19
2008/1/19
2007/9/19
2007/5/19
2007/1/19
2006/9/19
2006/5/19
2006/1/19
2005/9/19
2005/5/19
2005/1/19
2004/9/19
2004/5/19
2004/1/19
2003/9/19
2003/5/19
2003/1/19
2002/9/19
2002/5/19
2002/1/19
2001/9/19
2001/5/19
2001/1/19
2000/9/19
2000/5/19
2000/1/19
1999/9/19
1999/5/19
1999/1/19
-500
-1000
-1500
-2000
14
Figure 5. Onshore-Offshore Spread: One-Year SHIBOR
1500
yield difference (basis point)
1000
500
0
2011/4/8
2011/2/8
2010/12/8
2010/10/8
2010/8/8
2010/6/8
2010/4/8
2010/2/8
2009/12/8
2009/10/8
2009/8/8
2009/6/8
2009/4/8
2009/2/8
2008/12/8
2008/10/8
2008/8/8
2008/6/8
2008/4/8
2008/2/8
2007/12/8
2007/10/8
2007/8/8
2007/6/8
2007/4/8
2007/2/8
2006/12/8
2006/10/8
-500
-1000
15
EFFICIENCY

The basically effective capital controls have been achieved at heavy cost,
at least in the short term. This in the first takes the form of heavy
inflationary pressure, arising from the accumulation of official reserves in
foreign exchange

It is found that, for the quarterly data from 1999 fourth quarter to 2011
third quarter,
ln BMt = 1.712 + 0.764*ln FCRt + 0.937AR(1) + ut (1)
(1.153) （4.061）***
(15.682) ***
Adj R-square = 0.992
DW = 1.907
where BM = base money, FCR = foreign exchange reserves, and numbers
in parentheses are t statistics. Unit-root tests confirm this result. It can
thus be inferred that the money supply is influenced by the change in
official foreign exchange reserves, i.e., a constraint on the autonomy of
monetary policy.

To act against this influence, the People’s Bank of China (PBC) has had to
resort to either increasing the issuance of central bank debts or raising the
reserve requirement ratios on commercial banks. Both measures involve
costs for the PBC.

Figure 6 indicates the massive increases in central bank debts in recent
years, a leap of more than 26 times between 2002 and 2008 (Figure 6).
Table 2 provides the data of the reserve requirement ratios on commercial
banks after successive adjustments, from November 1999 until December
2011(Table 2). There is a clear trend of progressive increases.

Taking into account of the interest rates on the debts and required reserves
of commercial banks, and given the low yield rates of the foreign
exchange reserves, it is estimated (by CASS-IWPE) that the resulting,
actual rate of returns to official reserves was 3.5% in 2002-05, -1.64% in
2006-09 and 1.49% in 2010.
Figure 6. Central Bank Debts (RMB billion)
5000
4500
央行票据
4000
3500
3000
2500
2000
1500
1000
500
0
2002
2003
2004
2005
2006
2007
2008
2009
2010
Sources: PBC official web.
18
Table 2. Adjustments in Reserve Requirement Ratios (post-adjustment ratios)
Post-adj Ratios
Post-adj Ratios
1999-11-21
6.0%
2008-5-20
16.5%
2003-9-21
7.0%
2008-6-7
17.5%
2004-4-25
7.5%
2008-9-25
17.5%①
16.50%②
2006-7-5
8.0%
2008-10-15
17.0%
16.0%
2006-8-15
8.5%
2008-12-5
16.0%
14%
2006-11-15
9.0%
2008-12-25
15.5%
13.50%
2007-1-15
9.5%
2010-1-18
16.0%
13.50%
2007-2-15
10.0%
2010-2-25
16.50%
13.50%
2007-4-16
10.5%
2010-5-10
17.0%
13.50%
2007-5-15
11.0%
2010-11-16
17.50%
14%
2007-6-5
11.5%
2010-11-29
18.0%
14.50%
2007-8-15
12.0%
2010-12-20
18.50%
15%
2007-9-25
12.5%
2011-1-20
19.0%
15.50%
2007-10-25
13.0%
2011-2-24
19.50%
16%
2007-11-26
13.5%
2011-3-25
20.0%
16.50%
2007-12-25
14.5%
2011-4-21
20.5%
17%
2008-1-25
15.0%
2011-5-18
21.0%
17.50%
2008-3-18
15.5%
2011-6-20
21.5%
18%
2008-4-25
16.0%
2011-12-5
21.0%
17.50%
Sources: PBC official web.
19

Are these costs – for the Chinese economy as a whole – worthwhile?
From the perspective of long-term economic development, we seek to
analyse the impact of capital controls by applying the following:
(1)
yt  1  1ct  
yt  2   2trt  
yt  3  3ct   3trt  
yt  4  4ct  4 fdt  
yt  5   5trt  5 fdt  
yt  6  6ct   6trt  6 fdt  
(2)
(3)
(4)
(5)
(6)
yt  7   7trt  7 fdt  7 kt  
(7)
yt  8  8ct   8trt  8 fdt  8kt  
(8)
where y = annual growth rate per capita real GDP; c = ratio of outflows
plus inflows to GDP; tr = ratio of export plus import to GDP; fd = ratio
of total outstanding loans plus total market capitalisation of shares and
bonds plus broad money supply to GDP; and k = annual growth rate of
capital per person.

Table 3 gives the results of the regression analyses. It can be seen that:
(1) Openness of capital account is found to be insignificant or only
weakly significant in its correlation with per capita GDP growth.
(2) Openness of foreign trade is persistently found to be significant in
terms of its positive correlation with per capita GDP growth.
(3) Financial development is mostly found to be significant in terms of
its negative correlation with per capita GDP growth.
(4) The substantial increases in the value of the adjusted R-square when
k is included as an explanatory variable suggests that domestic
accumulation has remained the main driving force of output growth.
Table 3. Finance and Economic Growth, 1985-2010
Independent
Variables

ct
EQ.3.1
EQ.3.2
EQ.3.3
EQ.3.4
EQ.3.5
7.547
0.082
(1.718)*
6.819
6.887
0.046
(0.647)
0.032
(0.694)
8.167
0.110
(1.772)*
7.243
0.054
(1.739)*
trt
-0.331
(-0.715)
fdt
kt
R2  adj
0.072
0.075
0.052
0.053
DW
.
1.033
0.984
0.990
1.123
EQ.3.6
Eq.3.7
EQ.3.8
7.302
3.104
3.060
0.042
-0.004
(0.637)
(-0.071)
0.165
0.143
0.102
0.103
(2.795)** (2.100)** (1.749)* (1.715)*
-1.445
-1.433
-1.099
-1.097
(-2.154)** (-2.108)** (-1.783)* (-1.738)*
0.609
0.615
(2.575)** (2.416)**
0.197
0.175
0.355
0.324
1.192
1.201
1.326
1.334
Note: Figures in parentheses are t-statistics; ***, ** and * indicate statistical significance at 1%, 5% and 10%
confidence levels, respectively.
22

To further analyse the impact of short-term capital flows – as opposed to
long-term capital flows on economic development, a simply causality
test can be applied.

Define lci = the ratio of long-term capital net inflows to GDP, and sci =
the ratio of short-term capital net inflows to GDP. From Table 4,
(a) y Granger causes lci, but not vice versa; and
(b) sci Granger causes y, but not vice versa.

These results suggest that long-term economic development has been
mainly a cause, rather than a consequence, of long-term capital inflows.
This is consistent with finding (1) as indicated earlier, as well as our
previous work on FDI and Chinese economic growth. Meanwhile, the
above results also suggest that short-term capital inflows have the effect
of causing fluctuations in economic growth.
Table 4. Granger Causality Tests: Per Capital GDP Growth, Long-term and
Short-term Capital Flows
Null Hypothesis
lci does not Granger Cause y
y does not Granger Cause lci
sci does not Granger Cause y
y does not Granger Cause sci
F-Statistic
Probability
0.256
0.618
6.309**
0.020
2.887*
0.072
0.397
0.840
Note: ***, ** and * indicate statistical significance at 1%, 5% and 10% confidence levels, respectively.
24

Since the series of y, lci and sci are all I (0), we can construct the
following VAR model for analysis.
 yt  p 
 yt 
 yt 1 
lci   A1 lci   ...  Ap lci    t
 t  p 
 t
 t 1 
 yt  p 
 yt 
 yt 1 
 sci   B1  sci   ...  B p  sci    t
 t  p 
 t
 t 1 

(9)
(10)
Set the maximum lag period as 1 in accordance with the criteria of
minimising AIC and SC. Table 5 gives the results of the analysis. It is
confirmed that
(a) y has a significant effect on lci, but not vice versa; and
(b) the effect of y on sci, or vice versa, are not significant.
Table 5. VAR Analyses: Per Capital GDP Growth, Long-term and Short-term
Capital Flows
Model 3.9
Model 3.10
yt
lcit
lcit 1
4.421
0.548
(2.968)**
-0.153
(-0.506)
-0.337
0.281
(2.512)**
0.234
(1.279)
F-statistic
4.493
5.464
c
yt 1
AIC
SC
8.393
8.685
yt
scit
scit 1
4.590
0.497
(2.832)**
0.295
(0.908)
0.402
-0.081
(-0.706)
0.256
(1.205)
F-statistic
4.889
0.871
c
yt 1
AIC
SC
8.478
8.770
26
CONCLUDING REMARKS
The policy regime governing China’s cross-border capital flows has
remained a mixed regime. Its attributes of effectiveness and efficiency
thus can in no sense be simply inferred from economic theories.
Economic theory, of course, has also been equivocal, or controversial, for
this issue.