Capital flows, overheating, and the nominal exchange rate regime in China.

Author:Hu, Fred

China's historic entry into the World Trade Organization (WTO) in 2001 has increased the pace of reform and opening up, and the Chinese economy has gathered further momentum with real GDP growth reaching a phenomenal 9.5 percent in 2004. That spectacular growth performance and China's status as a "world factory" have led to massive capital inflows, pushing up official foreign exchange reserves to more than $600 billion by end of 2004. While there is much to celebrate, there is also cause for concern.

The Chinese economy has begun to show signs of overheating and inflation. At the same time, the massive capital inflows and soaring reserves have put a new spotlight on the country's de facto currency peg--an increasing source of friction with leading trading partners such as the United States and Japan. Instead of moving toward greater exchange rate flexibility, the Chinese authorities have responded by stepping up sterilized intervention, easing restrictions on selected capital outflows, and tightening inward portfolio investment. Despite the success of the Qualified Foreign Institutional Investor (QFII) program introduced in December 2002, the authorities have temporarily stopped approving new applications for the QFII program mainly to limit further portfolio investment inflows. The evidence of "hot money" clearly shows that China's cumbersome system of capital controls is not as effective as officials claim. There is no doubt that the greater openness of China's economy will certainly generate growing tensions with the country's closed capital account. China must put in place a sound institutional framework and financial infrastructure to accommodate increasing freedom of cross-border capital flows. Provided China can make meaningful progress in banking reform in the next three to five years, full currency convertibility remains a highly worthwhile and realistic medium-term policy goal.

Unprecedented Openness Is Increasingly at Odds with a Closed Capital Account

Following a quarter century of economic reforms and opening up, China has emerged from economic isolation and quickly established itself as a major participant in the world economy. It has completely abandoned its traditional "import substitution" and "self-sufficiency" development model, adhered to in the era of central planning, and embraced an outward-oriented new development strategy. Foreign trade soared to $1.2 trillion in 2004 from a meager $25 billion in 1978. China's external trade has been growing much faster, on average, than world trade for more than two decades, and today China is the world's third largest trading nation.

Fast economic growth and market opening have made China a magnate for foreign investment. Inward foreign direct investment reached more than $50 billion in 2002 and 2003, and in 2004 China became the world's largest recipient of foreign direct investment (FDI), attracting nearly $61 billion. Based on standard measures of economic "openness"--such as the ratio of trade to GDP--China ranks as one of the most open among the world's large economies (Table 1).

China has undertaken sweeping trade reforms. Average tariff rates for industrial products and agricultural produce have been reduced to 11 percent and 17 percent, respectively, which are among the lowest in developing countries. A wide range of nontariff protection measures, such as import permits, licensing requirements, and quotas have been eased or eliminated altogether. In addition, China has been reducing entry barriers in the service sectors, allowing foreign participation in telecom, transportation, and retail and wholesale commerce. Significantly, WTO entry has also boosted foreign access to financial services such as commercial banking, insurance, fund management, and securities underwriting.

While China formally accepted the IMF Article III Agreements (sections 2, 3, and 4) in 1996, which provided for current account convertibility for the renminbi, China continues to maintain extensive capital and exchange controls. Despite the official reluctance to relax those controls, China's experience in recent years has shown that the effectiveness of capital controls has diminished and the system has become more difficult to sustain. In particular, current account convertibility, while bringing about massive efficiency gains, has also created numerous leakages and loopholes for illicit capital flows. The economic and social costs associated with continued draconian control over capital flows have become ever larger and better recognized. In addition to imposing a heavy administrative burden for the government, capital controls have distorted investment decisions by Chinese enterprises and households, and have led to the misallocation of capital, rampant corruption, and financial fraud.

In most aspects China is now a full-fledged member of the global economy with substantial cross-border flow of goods, services, and capital. Out of the world's 10 largest trading nations, however, only China continues to maintain extensive restrictions on the cross-border movement of...

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