The management of cross-border capital flows and macroeconomic stability in China

China’s gradual approach to financial liberalisation and capital account openness is a key element contributing to its rapid and highly stable growth. Capital controls in China have been gradually relaxed, as part of its efforts to integrate into the global financial system. Now with the rise in inflation, the role that the regulation of cross-border capital flows can play in China’s macroeconomic management has become one of the most debated policy issues. This paper demonstrates why the Chinese government still imposes capital controls, highlighting that China’s financial system is fragile. The paper thinks that shocks created by sudden changes in the direction of cross-border capital flows can destabilise its economy severely.

The paper summarises the major recent changes in China’s capital control measures:

• Chinese enterprises are allowed to keep their foreign exchange earnings
• residents are allowed to open foreign exchange accounts
• non-residents are allowed to open RMB accounts in China
• the "extra-national treatment" previously granted to foreign banks has been abolished
• a new foreign exchange settlement system has been established
  

The new thinking of Chinese monetary authorities emphasised the need to attract international strategic investors to consolidate the Chinese banking system. Foreign exchange reserves used to raise banks’ capital adequacy were made available via a newly created state company. The paper notes that China’s commercial banks have become more up to the international standards.However, it finds it difficult to say whether adequate progress has been made in the more fundamental characteristics of China’s banking system.

China’s monetary tightening could well be achieved by interest rate tightening.There is no doubt that China needs to continue its policy of monetary tightening because of inflation. Thus, it has to maintain a relatively high interest rate to control inflation. At the same time, it should continue to allow the RMB to appreciate to eliminate twin surpluses. The paper indicates that the real problem is China’s continued accumulation of foreign exchange reserves. Nevertheless, the paper underscores that it is already too late for China to avoid the risks.

The paper deems that attention should be paid on reducing banks’ fragility by implementing prudential measures. In addition, it suggests that the utmost care should be excised in the liberalisation of resident capital outflows. The paper points that the following policy instruments should be adopted:

• China should improve its management of cross-border capital flows to discourage unwanted capital inflows
• the RMB should be allowed to appreciate in order to absorb the pressure
• sterilisation policy should be maintained to mop-up remaining excess liquidity
• interest rates on households’ deposits should be increased
• interest rates on credits should also be increased

Nonetheless, despite the severe challenges China is facing, the paper believes that the prospects of the Chinese economy remain bright.