The authors are IMF’s Tamim Bayoumi and Franziska Ohnsorge. The views below do not represent the views of the IMF
China’s 12th Five-Year Plan pledges to accelerate capital account liberalization. This would be a major event in the global financial architecture.
Despite steps to ease restrictions and some circumvention over the past decade, much of China’s capital account and, especially, portfolio investment flows, remain severely restricted.
First, China’s inward foreign direct investment and its liquidation remain subject to approval requirements in several areas;
Secondly, portfolio investment is controlled by quotas.
Under this category, there are multiple restrictions. Inward investment is channeled through Qualified Foreign Institutional Investors (QFII) program. QFIIs are subject to a 3-month lock-in period for most shares, and an aggregate ceiling of US$150 billion as of July 2013.
Outward portfolio investment for overseas securities purchased by residents is channeled through Qualified Domestic Institutional Investors program. This is subject to institution-specific ceilings that amounted to US$86 billion by the end of 2012.
In 2011, an RQFII scheme was introduced that allows qualified firms to invest offshore Renminbi back into China. This is subject to an overall ceiling that was raised to RMB270 billion by end-2012.
In addition, cross-border issuance of securities requires approval.
Thirdly, other investments. Foreign short-term borrowing is subject to a ceiling. Long-term foreign borrowings needs approval requirements. Lending abroad is largely unrestricted. The holding of cross-border accounts requires State Administration of Foreign Exchange (SAFE) approval.
Outside of these restrictions, there are substantial non-FDI capital flows into and out of China. In particular, "other" investment flows are similar in absolute magnitude to those of a fully liberalized country such as Australia.
These other investment flows include the buildup or draw down of foreign currency deposits at domestic banks. These deposits have tended to fluctuate with exchange rate expectations as state-owned enterprises have adjusted their profit repatriation.
Many capital flows also pass through the current account. Previous research has concluded that capital flows through mis-invoicing of trade flows amounts to 5.5% to 5.9% of GDP in 2007.
As China’s authorities speed up steps to open the capital account, historical experience in other countries serves as caution. Capital account liberalization has historically often been followed by exchange rate or banking crises.
In some cases, the crises take a long time to occur. For example, the financial crises in the U.K. and Japan occurred about a decade after capital account liberalization. In Denmark, the crisis happened two decades later.
Generally, researchers believe in order to achieve a successful capital account liberalization, a country needs to have a stable macroeconomic environment, a sound banking system, and developed financial markets.
These criteria has not been fulfilled in China. Its interest rates have not been liberalized. Parts of the Chinese financial system, especially the corporate bond market, are profoundly under-developed. China’s exchange rate remains non-market based.
Our analysis shows that capital account opening in China will likely be followed by substantial gross portfolio flows. There may be net outflows from both equity and bond markets as domestic investors seek to diversify large domestic savings. A buying spree of international assets by Chinese residents could have significant repercussions for global asset prices.
But, capital account liberalization is likely to proceed gradually in China. The net outflows could be spread out over several years, and will be partially offset by net FDI inflows.
(The article has been edited for clarity)