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### I. Introduction and overview
- Reviews issues involved in moving toward greater exchange rate flexibility and capital account liberalization in China.
- Main conclusions:
  - Greater exchange rate flexibility is in China’s own interest because it allows a more independent monetary policy and better buffers against domestic and external shocks.
  - Capital account liberalization poses significant risks given weaknesses in China’s financial system and should be a lower short-term priority.
  - Exchange rate flexibility should precede substantial capital account liberalization; a more stable and robust financial system is a prerequisite for opening the capital account fully.
- Key distinctions:
  - Exchange rate flexibility and capital account liberalization are related but distinct and need not be implemented simultaneously.
  - “Learning to float” and maintaining some capital controls can be appropriate transitional arrangements instead of a one-time revaluation.
- Evidence and debate:
  - IMF (2004) and Funke and Rahn (2004) find no strong evidence of substantial undervaluation.
  - Goldstein (2004) and Frankel (2004) argue for undervaluation of at least 30–35 percent.
  - Speculative capital inflows more important since 2001; about half of the increase in international reserves in 2003 can be accounted for by non-FDI capital inflows.

### II. Rationale for earlier exchange rate flexibility
- Structural and policy rationales:
  - Global integration increases exposure to internal and external shocks, heightening need for autonomous monetary policy and market-based instruments (e.g., interest rate changes).
  - Capital inflows since 2001 increased liquidity and complicated domestic monetary management; rapid growth of bank credit contributed to surge in investment growth and possible buildup of excess capacity and nonperforming loans.
  - Increased exchange rate flexibility would create incentives to develop foreign exchange markets, hedging instruments, and forward markets.
- Transition considerations:
  - Maintaining capital controls (even if porous) can support gradual move to flexibility by limiting instability from capital flows while institutions develop.
  - Delaying flexibility risks forcing future adjustments under less favorable circumstances as capital controls erode.

### III. Concerns about greater exchange rate flexibility (and responses)
- Concern: Appreciation could hurt export growth and FDI inflows.
  - Counter-evidence:
    - High import content of Chinese exports and strong productivity growth and low labor costs mute direct impact of moderate appreciation.
    - 1999–2002: China’s total exports (in value terms) rose by 37 percent despite a 7 percent real effective appreciation.
    - Over 50 percent of Chinese export operations involve final assembly using intermediate inputs produced by other countries.
    - Domestic value-added content of exports: about 30 percent to the rest of the world and about 20 percent to the United States.
    - A 10 percent real appreciation of the renminbi would increase the cost of Chinese exports to the United States by only about 2 percent (estimate cited from Lau, 2003).
- Concern: Appreciation could adversely affect agriculture and rural employment.
  - Points:
    - Chinese authorities estimate about 150 million surplus rural workers.
    - Concern that lower domestic food prices from appreciation could harm rural incomes.
    - Research (Rosen, Rozelle, and Huang, 2004) suggests agricultural competitiveness has improved and the sector coped well with WTO-induced opening.
- Concern: Exchange rate flexibility could harm banking system health.
  - Observations and data:
    - Banks have a positive net foreign asset position; appreciation could have costs for some institutions.
    - 2003 aggregates: banks’ net foreign assets accounted for 3 percent of broad money and 6 percent of GDP; foreign currency lending constituted about 5 percent of domestic credit and 9 percent of GDP.
    - 2001–03 trends: banks’ foreign currency loans to domestic residents increased by over 60 percent; net foreign currency liabilities rose by nearly 50 percent; total short-term external debt rose by over 50 percent.
    - Latest data (as of end-September 2004): total short-term external debt was 29 percent higher than its end-2003 level.
  - Caveats:
    - Aggregate figures may mask institution-specific exposures; detailed information on currency composition and maturity needed.
    - Little information on corporate hedging practices; anecdotal evidence suggests limited use of hedging instruments.

### IV. Policy sequencing and implications
- Recommended sequencing:
  - Prioritize move toward greater exchange rate flexibility before substantial capital account liberalization.
  - Use a cautious and gradual approach to capital account liberalization that reinforces domestic financial liberalization and allows institutional capacity building.
  - Treat exchange rate flexibility and a more stable financial system as prerequisites for fully opening the capital account.
- Transitional exchange rate options:
  - Widen the renminbi trading band.
  - Peg to a currency basket.
  - Combination of the above.
- Risks of current path:
  - Gradual liberalization of capital outflows under a pegged regime could be counterproductive because capital controls erode and a fixed exchange rate with an open capital account has posed risks in other emerging markets.

### Foreign currency exposures of financial and corporate sectors (key statistics)
- Net foreign assets of People’s Bank of China: 234 (2001), 276 (2002), 370 (2003) (in billions of U.S. dollars)
- Net foreign exchange-denominated assets of the banking system1/: 31 (2001), 60 (2002), 67 (2003)
  - Of which, net foreign assets: 85 (2001), 108 (2002), 85 (2003)
  - (in percent of broad money): 4.6 (2001), 4.8 (2002), 3.2 (2003)
  - (in percent of GDP): 7.3 (2001), 8.5 (2002), 6.1 (2003)
  - Net domestic foreign currency assets: -54 (2001), -48 (2002), -19 (2003)
- Banks’ foreign currency loans to domestic residents: 81 (2001), 103 (2002), 130 (2003)
  - (in percent of total credit): 5.0 (2001), 4.9 (2002), 5.2 (2003)
  - (in percent of GDP): 6.9 (2001), 8.1 (2002), 9.2 (2003)
- Net foreign currency exposure of corporate sector: -103 (2001), -121 (2002), -150 (2003)
  - Corporates' foreign currency assets2/: 45 (2001), 52 (2002), 52 (2003)
  - Corporates' foreign currency liabilities3/: 149 (2001), 172 (2002), 202 (2003)
- Total external debt: 170 (2001), 171 (2002), 194 (2003)
  - Of which: short-term: 44 (2001), 48 (2002), 73 (2003)
  - Of which: corporate: 68 (2001), 70 (2002), 82 (2003)

Sources: CEIC; and IMF staff estimates.
- 1/ Sum of net foreign assets (net claims against foreign residents) and net foreign currency-denominated assets against domestic residents.
- 2/ The estimates are based on corporate foreign currency deposits in domestic banks.
- 3/ Sum of corporate external debt and domestic foreign currency loans.

### Exchange rate volatility, trade, and FDI
- Recent studies find little evidence that exchange rate volatility has a significant adverse effect on trade flows (Clark, Tamirisa, and Wei, 2004).
- Observations:
  - By maintaining an effective peg to the dollar, China’s currency is stable relative to the United States but still fluctuates relative to most other trading partners; this has not appeared to hurt China’s trade expansion in other industrial country markets.
  - Literature shows little evidence that exchange rate volatility is a significant determinant of FDI levels; primary FDI determinants include market size, GDP growth, productivity growth, political and macroeconomic stability, the regulatory environment, and ability to repatriate profits.
  - Given China’s strong productivity growth, increasing access to world markets, and rapidly expanding domestic demand, an exchange rate appreciation is unlikely to have a substantial negative effect on FDI inflows.

### Net and distributional effects of renminbi appreciation
- Net effects:
  - Net adverse effects on the Chinese economy of any appreciation would be quite modest.
  - Significant distributional effects are possible; some sectors (e.g., agriculture) could face larger adjustment costs.
- Persistence matters:
  - Costs depend on the persistence of any appreciation.
  - Near-term appreciation is "widely regarded as a sure thing."
  - Medium-term trend depends on offsetting forces:
    - Forces for appreciation: continuing strong productivity growth in traded goods, structural reforms, improved access to world markets.
    - Forces for depreciation: further domestic market liberalization (WTO commitments), expected gradual capital account liberalization leading to more outflows.
  - Recent upward pressure largely reflects strong capital inflows driven in part by speculative inflows that are likely transitory and could reverse.

### Potential costs of not having exchange rate flexibility
- General considerations:
  - Fixed regimes provide a nominal anchor and can discipline macroeconomic policies but benefits tend to erode as economies mature and integrate globally.
  - Fixed regimes can mask policy and institutional weaknesses and lead to buildup of imbalances, exacerbated by open capital accounts.
  - Large amounts of short-term external debt denominated in foreign currencies are a key risk factor for balance of payments crises.
- China-specific considerations:
  - Sterilization costs: traditional net costs of sterilization are absent because domestic interest rates on central bank bills have been lower than interest rates on medium- and long-term industrial country treasury bonds where much of China’s reserves are presumed held.
  - Low domestic interest rates (recently negative in real terms) require domestic financial repression, creating large distortions and efficiency losses.
  - Depreciation of the U.S. dollar since 2003 suggests terms of trade for China have worsened, acting as an implicit tax on consumption given China’s high trade openness.
  - Persistent pressures for real exchange appreciation due to relative productivity growth will eventually force adjustment; preferable to adjust via the nominal exchange rate rather than inflation.
- Policy implication:
  - Movement toward an independent monetary policy (with exchange rate flexibility) should not be delayed.
  - Institutional and operational improvements are needed to establish a credible monetary policy framework and improve transmission.

### Capital account liberalization — benefits, risks, and policy stance
- Theoretical expectations:
  - Liberalization can promote efficient international allocation of capital, boost growth, and reduce consumption volatility via income risk sharing.
- Empirical reality:
  - Little conclusive evidence of a strong robust causal relationship between financial integration and growth.
  - Evidence that financial integration could increase relative volatility of consumption growth for emerging markets.
- Risks of opening capital account with inflexible exchange rate:
  - Opening the capital account while maintaining an inflexible exchange rate, especially with inconsistent domestic macro policies, has often preceded crises (examples include 1995 tequila crisis; 1997–98 Asian/Russian/Brazilian crises).
  - Emerging markets with greater exchange rate flexibility generally fared better during external pressures (examples: Chile, Mexico, Peru, South Africa, Turkey).
  - China’s and India’s relatively closed capital accounts helped limit contagion vulnerability in the 1997–98 Asian crisis.
- Domestic financial sector risks:
  - Inflows in presence of weak banking systems can be misallocated, creating currency, maturity, and duration mismatches and unsustainable external debt structures.
- Recommended approach:
  - Adopt a cautious approach to capital account liberalization.
  - China’s strategy of opening to FDI rather than other capital inflows has helped insulate it, but the dominance of FDI in total inflows has declined.

### Capital controls and their erosion over time
- Role of controls:
  - Provide protection from volatile international capital flows and help contain risks from weak domestic financial sectors.
  - Prevent excessive external borrowing by corporates and banks in weak financial systems.
  - In inflexible exchange rate regimes, controls help preserve monetary policy autonomy and reduce exchange rate volatility from short-run capital swings.
  - Controls can perpetuate inefficiencies and financial repression.
- Channels to evade controls:
  - Under- and over-invoicing of export and import contracts.
  - Transfer pricing by multinationals.
  - Leads and lags in settlement and variation in trade credit terms.
  - Remittances, family transfers, and tourist expenditures.
- Empirical evidence:
  - Effectiveness of controls tends to diminish over time, especially when strong exchange rate pressures are resisted by official intervention.
- China’s experience:
  - Controls are extensive and were reasonably effective historically; credited with helping withstand the Asian financial crisis though China’s exposure differed.
  - Despite controls on outflows, sizable amounts of financial capital appear to have flowed out during 1997–2000; Gunter (2004) estimates capital flight exceeded US$100 billion a year during 1997–2000.
  - Since 2001, expectations of renminbi appreciation and a positive Chinese-U.S. interest differential resulted in substantial net inflows of non-FDI capital despite extensive controls.
  - Recorded transactions: foreign currency loans from domestic banks to residents increased by almost 30 percent during 2003, while residents’ foreign currency deposits declined slightly.
  - Empirical work (e.g., Cheung et al, 2003) corroborates that controls have become less effective, limiting room for an independent monetary policy.
  - Continued rapid trade expansion and WTO-related commitments imply controls likely to become more porous.

### The foreign exchange market and readiness for flexibility
- Arguments and counterpoints:
  - Some argue absence of a well-functioning foreign exchange market will inhibit greater exchange rate flexibility and that capital account controls prevent a fully functioning market.
  - Counterpoint: An open capital account is not necessary for deepening the foreign exchange market; large trade volumes and current account convertibility provide potential for a deep market even without full capital account openness.
  - The notion that the foreign exchange market must be perfected before moving to flexibility is characterized as a red herring.

### Improving the functioning of the foreign exchange market within the existing regime
- Practical measures to improve market functioning:
  - Allow enterprises access to the China Foreign Exchange Trading System through a licensed broker system to increase trading volume and reduce official intervention.
  - Within a narrow de facto peg band, relax bid-offer spreads to encourage two-sided positions.
  - Further reduce foreign exchange surrender requirements.
  - Ease requirement that enterprises need “real commercial demand” to enter forward contracts so they can hedge based on future needs.
- Policy implication:
  - A phased approach toward flexibility should not pose major risks even if hedging instruments are limited; it would give economic agents stronger incentives to hedge foreign exchange risks.
  - Shifting some risk away from monetary authorities toward market participants would nurture a deeper and more sophisticated FX market.

### Considerations of timing for greater exchange rate flexibility
- Comparative finding:
  - Countries generally have better medium-term outcomes if they introduce exchange rate flexibility before fully liberalizing the capital account, especially when financial sector weaknesses exist.
- China-specific observation and risks:
  - Authorities have eased controls on capital and current account transactions to alleviate appreciation pressures; such measures risk getting sequencing wrong.
  - Easing outflow controls may be counter-productive because removing outflow controls can stimulate further inflows and be perceived as commitment to sound policies, inducing more inflows.
  - Historical examples of rapid inflows after removal of outflow controls: Italy in 1984, New Zealand in 1984, Spain in 1986, Uruguay in 1970.
- Recommendation on timing:
  - Consider early move toward exchange rate flexibility while capital account controls are still relatively effective and structural problems manageable.
  - Capital controls provide some protection but are likely to become less effective over time.
- Favorable context:
  - Move is best during relative tranquility in exchange markets; next-best when domestic economy is strong and pressures are for appreciation.
  - Such windows of opportunity should be taken advantage of to avoid changing regimes under far less desirable conditions later.

### Concluding remarks — sequencing, policy priorities, and implications
- Strategic conclusion:
  - Gaining experience with greater exchange rate flexibility and achieving a more stable financial system should be prerequisites to fully opening the capital account.
- Benefits of greater flexibility:
  - Improves macroeconomic control and reduces vulnerabilities to shocks.
  - Can be introduced before all prerequisites for full capital account convertibility are met.
  - Exchange rate can respond to supply and demand for foreign exchange even if constrained by capital flow restrictions.
- Caution on capital account liberalization:
  - Historical experiences highlight risks when liberalization occurs without exchange rate flexibility.
  - Easing controls on capital outflows to alleviate exchange rate pressures could be counter-productive and induce larger inflows.
  - Capital account liberalization should be a lower priority and not a substitute for exchange rate flexibility.
- Financial stability:
  - Greater flexibility can be introduced without creating disruptions in the financial sector.
  - Maintenance of capital controls can support the transition while institutional arrangements for convertibility develop.
  - A period of “learning to float” can help overcome “fear of floating.”
- Timing urgency:
  - Capital controls will become increasingly ineffective as integration continues.
  - Early move toward greater exchange rate flexibility would be in China’s best interest; long delays could entail significant costs.

### China’s steps toward liberalization of cross-border foreign exchange transactions

Background and policy stance
- Full renminbi convertibility has been the stated goal since 1993; authorities emphasize it will take a long time.
- Current account convertibility in place since 1996.
- Extensive controls remain on most capital account transactions for monitoring and policy purposes.
- FDI encouraged but closely regulated; WTO accession further liberalized FDI procedures.
- Foreign portfolio flows hindered by segregation of China’s stock markets between residents and nonresidents.
- Restrictions on other external borrowing are pervasive and subject to strict ceilings.
- Capital outflows by residents tightly regulated.

Major liberalization steps (chronological)
- 2001:
  - Restrictions liberalized on purchases of foreign exchange for advance repayments of domestic and foreign currency loans, loans converted from foreign debt, and other foreign debts.
  - Purchase of foreign exchange authorized for investments abroad in strategic foreign projects.
  - Persons paying for their own studies abroad (college level or higher) were allowed a one-time purchase of foreign exchange of up to the equivalent of US$20,000 (previously US$2,000); effective January 2005, this amount will be raised to US$20,000 in addition to tuition fees.
- 2002:
  - Qualified Foreign Investor Initiative (QFII) introduced, permitting nonresidents to invest in the domestic stock market (A shares), subject to some restrictions.
  - As of November 2004, 23 foreign investors had received approval for an amount totaling US$3.2 billion.
  - All enterprises authorized to conduct current account transactions obtained the right to retain foreign exchange equivalent to 20 percent of their current account foreign exchange earnings in the previous year (ratio raised to 30–50 percent in 2004).
- 2003:
  - Registration with, and permission from, the government to repay loan principal was no longer required for residents wishing to borrow foreign exchange from domestic Chinese financial institutions.
  - Domestic companies allowed to retain foreign currency revenue from overseas contracted projects, overseas shipping and commissions, and international bidding projects in foreign exchange accounts.
  - In some provinces and regions, limit on outward investment increased to the equivalent of US$3 million from US$1 million.
  - Maximum amount of foreign exchange residents may export without a License for Carrying Foreign Currencies Abroad (LCFCA) increased to the equivalent of US$5,000 from US$2,000; SAFE verification threshold increased to US$10,000 from US$4,000.
  - Maximum amount of foreign currency residents may import without declaration increased to the equivalent of US$5,000 from US$2,000.
- 2004:
  - National Social Security Fund (manages about US$17 billion) and domestic insurance firms given approval in principle to invest a small portion of their portfolios offshore; amounts not public.
  - Authorities permitted international financial institutions to raise funds domestically in renminbi for use offshore.
  - Domestic members of multinationals allowed to collect foreign exchange funds together and redistribute domestically as trust loans or extend loans to overseas affiliates.
  - Transfer of personal assets abroad by Chinese citizens emigrating or by nonresidents receiving inheritances is now permitted.

Policy implications and objectives
- Liberalizations targeted current-account facilitation and specific capital-account-related transactions while preserving broad capital control frameworks.
- Measures aimed to:
  - Facilitate exporters’ ability to finance imports by allowing retention of a share of foreign exchange earnings (20 percent initially; raised to 30–50 percent in 2004).
  - Channel selected portfolio and institutional investors into domestic markets (QFII).
  - Provide controlled avenues for outward investment and personal transfers (education, emigration, inheritances).
  - Enable limited offshore investment by large domestic institutional investors (National Social Security Fund, domestic insurance firms).

Remaining constraints and segmentation
- Extensive capital account controls persist across most transaction types.
- Segregation between resident and nonresident access to stock markets continues to hinder foreign portfolio flows.
- External borrowing and many forms of capital outflow remain subject to strict ceilings and regulatory oversight.
- Many liberalizations were incremental and conditional, with specific ceilings and approval processes retained.

*Prepared by Eswar Prasad, Thomas Rumbaugh, and Qing Wang (IMF Policy Discussion Paper PDP/05/1, January 2005).*

### Section 1

### _pdp01 - Section 1

### I. Introduction and overview
- The paper reviews issues involved in moving toward greater exchange rate flexibility and capital account liberalization in China.
- Main conclusions presented:
  - Greater exchange rate flexibility is in China’s own interest because it allows a more independent monetary policy and better buffers against domestic and external shocks.
  - Capital account liberalization poses significant risks given weaknesses in China’s financial system and should be a lower short-term priority.
  - Exchange rate flexibility should precede substantial capital account liberalization; a more stable and robust financial system is a prerequisite for opening the capital account fully.
- Key distinctions emphasized:
  - Exchange rate flexibility and capital account liberalization are related but distinct and need not be implemented simultaneously.
  - A move toward flexibility is preferable to a one-time revaluation; “learning to float” and maintaining some capital controls can be appropriate transitional arrangements.
- Evidence and debate summarized:
  - Views differ on whether the renminbi is substantially undervalued: IMF (2004) and Funke and Rahn (2004) find no strong evidence of substantial undervaluation, while Goldstein (2004) and Frankel (2004) argue for undervaluation of at least 30–35 percent.
  - Speculative capital inflows have become more important since 2001; about half of the increase in international reserves in 2003 can be accounted for by non-FDI capital inflows.

### II. Rationale for earlier exchange rate flexibility
- Structural and policy rationales:
  - As China integrates globally, exposure to internal and external shocks increases, heightening the need for autonomous monetary policy and market-oriented instruments (e.g., interest rate changes).
  - Capital inflows since 2001 have increased liquidity and complicated domestic monetary management; rapid growth of bank credit contributed to a surge in investment growth and possible buildup of excess capacity and nonperforming loans.
  - Increasing exchange rate flexibility would create incentives to develop foreign exchange markets, hedging instruments, and forward markets that are currently underdeveloped.
- Transition considerations:
  - Maintaining capital controls (even if porous) can support a gradual move to flexibility by limiting instability from capital flows while institutions develop.
  - Delaying flexibility risks forcing future adjustments under less favorable circumstances, especially as capital controls erode over time.

### III. Concerns about greater exchange rate flexibility (and responses)
- Concern: Appreciation could hurt export growth and FDI inflows.
  - Counterpoints and evidence:
    - High import content of Chinese exports and strong productivity growth and low labor costs mute direct impact of moderate appreciation on exports.
    - 1999–2002: China’s total exports (in value terms) rose by 37 percent despite a 7 percent real effective appreciation.
    - Over 50 percent of Chinese export operations involve final assembly using intermediate inputs produced by other countries.
    - Domestic value-added content of exports: about 30 percent to the rest of the world and about 20 percent to the United States.
    - A 10 percent real appreciation of the renminbi would increase the cost of Chinese exports to the United States by only about 2 percent (estimate cited from Lau, 2003).
- Concern: Appreciation could adversely affect agriculture and rural employment.
  - Points noted:
    - Chinese authorities estimate about 150 million surplus rural workers.
    - There is concern that lower domestic food prices from appreciation could harm rural incomes.
    - Recent research (Rosen, Rozelle, and Huang, 2004) suggests agricultural competitiveness has improved and the sector coped well with WTO-induced opening, implying reduced sensitivity to external shocks.
- Concern: Exchange rate flexibility could harm banking system health.
  - Observations and data:
    - Unlike countries vulnerable to devaluation, current pressures in China are for appreciation; nonetheless, banks have a positive net foreign asset position, so appreciation could have costs for some institutions.
    - 2003 aggregates: banks’ net foreign assets accounted for 3 percent of broad money and 6 percent of GDP; foreign currency lending constituted about 5 percent of domestic credit and 9 percent of GDP.
    - Trends during 2001–03: banks’ foreign currency loans to domestic residents increased by over 60 percent; net foreign currency liabilities rose by nearly 50 percent; total short-term external debt rose by over 50 percent.
    - Latest data (as of end-September 2004): total short-term external debt was 29 percent higher than its end-2003 level.
  - Caveats:
    - Aggregate figures may mask institution-specific exposures; detailed information on currency composition and maturity of assets/liabilities is needed.
    - Little information is available on corporate hedging practices; anecdotal evidence suggests limited use of hedging instruments, though natural hedges may be common.

### IV. Policy sequencing and implications
- Recommended sequencing:
  - Prioritize a move toward greater exchange rate flexibility before substantial capital account liberalization.
  - Use a cautious and gradual approach to capital account liberalization that reinforces domestic financial liberalization and allows institutional capacity building.
  - Regard greater exchange rate flexibility and a more stable financial system as prerequisites for fully opening the capital account.
- Transitional options for exchange rate reform noted:
  - A widening of the renminbi trading band, a peg to a currency basket, or a combination of these could constitute initial moves toward flexibility.
- Risks of current path:
  - Gradual liberalization of capital outflows under the current pegged regime could be counterproductive, since capital controls tend to erode and a fixed exchange rate with an open capital account has posed risks in other emerging markets.

*Prepared by Eswar Prasad, Thomas Rumbaugh, and Qing Wang (IMF Policy Discussion Paper PDP/05/1, January 2005).*

### Section 2

### _pdp01 - Section 2

### Foreign currency exposures of financial and corporate sectors (key statistics)
- Net foreign assets of People’s Bank of China: 234 (2001), 276 (2002), 370 (2003) (in billions of U.S. dollars)
- Net foreign exchange-denominated assets of the banking system1/: 31 (2001), 60 (2002), 67 (2003)
  - Of which, net foreign assets: 85 (2001), 108 (2002), 85 (2003)
  - (in percent of broad money): 4.6 (2001), 4.8 (2002), 3.2 (2003)
  - (in percent of GDP): 7.3 (2001), 8.5 (2002), 6.1 (2003)
  - Net domestic foreign currency assets: -54 (2001), -48 (2002), -19 (2003)
- Banks’ foreign currency loans to domestic residents: 81 (2001), 103 (2002), 130 (2003)
  - (in percent of total credit): 5.0 (2001), 4.9 (2002), 5.2 (2003)
  - (in percent of GDP): 6.9 (2001), 8.1 (2002), 9.2 (2003)
- Net foreign currency exposure of corporate sector: -103 (2001), -121 (2002), -150 (2003)
  - Corporates' foreign currency assets2/: 45 (2001), 52 (2002), 52 (2003)
  - Corporates' foreign currency liabilities3/: 149 (2001), 172 (2002), 202 (2003)
- Total external debt: 170 (2001), 171 (2002), 194 (2003)
  - Of which: short-term: 44 (2001), 48 (2002), 73 (2003)
  - Of which: corporate: 68 (2001), 70 (2002), 82 (2003)

Sources: CEIC; and IMF staff estimates.
- 1/ Sum of net foreign assets (net claims against foreign residents) and net foreign currency-denominated assets against domestic residents.
- 2/ The estimates are based on corporate foreign currency deposits in domestic banks.
- 3/ Sum of corporate external debt and domestic foreign currency loans.

### Exchange rate volatility, trade, and FDI
- Empirical evidence cited: recent studies find little evidence that exchange rate volatility has a significant adverse effect on trade flows (see Clark, Tamirisa, and Wei, 2004).
- Observations:
  - By maintaining an effective peg to the dollar, China’s currency is stable relative to the United States but still fluctuates relative to most of China’s other trading partners; this has not appeared to hurt China’s trade expansion in other industrial country markets.
  - Literature shows little evidence that exchange rate volatility is a significant determinant of FDI levels; primary FDI determinants include market size, GDP growth, productivity growth, political and macroeconomic stability, the regulatory environment, and ability to repatriate profits (United Nations, 1999; Lim, 2002).
  - Some recent papers suggest maintenance of an undervalued exchange rate is important for China’s strong FDI inflows; however, the assessment here is that given China’s strong productivity growth, increasing access to world markets, and rapidly expanding domestic demand, an exchange rate appreciation is unlikely to have a substantial negative effect on FDI inflows.

### Net and distributional effects of renminbi appreciation
- Assessment:
  - Net adverse effects on the Chinese economy of any appreciation in the renminbi from greater flexibility would be quite modest.
  - Significant distributional effects are possible; some sectors (e.g., agriculture) could face larger adjustment costs.
- Persistence matters:
  - Costs depend on the persistence of any appreciation.
  - Near-term appreciation is "widely regarded as a sure thing."
  - Over the medium term, the trend in the real exchange rate is harder to predict and depends on offsetting forces:
    - Forces for appreciation: continuing strong productivity growth in China’s traded goods sector, structural reforms, improved access to world markets.
    - Forces for depreciation: further liberalization of the domestic market (WTO commitments), expected gradual liberalization of the capital account leading to more outflows for international diversification.
  - Recent upward pressure largely reflects strong capital inflows driven in part by speculative inflows in anticipation of appreciation; such inflows are likely transitory and could reverse.

### Potential costs of not having exchange rate flexibility
- General considerations:
  - Fixed exchange rate regimes provide a well-defined nominal anchor and can impose discipline on macroeconomic policies, benefiting countries with institutional and policy weaknesses.
  - Benefits of fixed regimes tend to erode over time as economies mature and integrate with global markets; exchange rate flexibility becomes more valuable.
  - Maintaining a fixed regime can mask policy and institutional weaknesses and lead to buildup of imbalances, exacerbated by an open capital account.
  - Large amounts of short-term external debt denominated in foreign currencies are a key risk factor for balance of payments crises.
- China-specific considerations:
  - Sterilization costs: traditional net costs of sterilization are absent because domestic interest rates on central bank bills have been lower than interest rates on medium- and long-term industrial country treasury bonds where much of China’s reserves are presumed held.
  - Low domestic interest rates (recently negative in real terms) require domestic financial repression, creating large distortions and efficiency losses.
  - Depreciation of the U.S. dollar since 2003 suggests terms of trade for China have worsened, acting as an implicit tax on consumption with potentially significant welfare losses given China’s high trade openness.
  - Persistent pressures for real exchange appreciation due to relative productivity growth will eventually force adjustment; preferable to adjust via nominal exchange rate rather than inflation to avoid entrenched inflation expectations.
- Policy implication:
  - Movement toward an independent monetary policy (with exchange rate flexibility) should not be delayed.
  - Institutional and operational improvements are needed to establish a credible monetary policy framework and improve monetary policy transmission mechanism.
  - While the present regime could be maintained for a long period, explicit and implicit costs are potentially large and likely to grow over time, especially given increasing global integration and stated objectives to liberalize the capital account.

### Capital account liberalization — benefits, risks, and policy stance
- Theoretical expectations:
  - Capital account liberalization in theory promotes efficient international allocation of capital, can boost growth, and can reduce consumption volatility by income risk sharing.
- Empirical reality:
  - Little conclusive evidence of a strong and robust causal relationship between financial integration and growth.
  - Evidence that financial integration could increase relative volatility of consumption growth for emerging markets (Prasad, Rogoff, Wei, and Kose, 2003).
- Risks of opening capital account with inflexible exchange rate:
  - Opening the capital account while maintaining an inflexible exchange rate, especially with inconsistent domestic macro policies, has often preceded crises (examples: 1995 tequila crisis; 1997–98 Asian/Russian/Brazilian crises).
  - Emerging markets with greater exchange rate flexibility generally fared better during external pressures (examples given: Chile, Mexico, Peru, South Africa, Turkey).
  - China and India were less affected by the Asian crisis of 1997–98; relatively closed capital account regimes credited with limiting contagion vulnerability, alongside other factors such as comfortable foreign reserves.
- Domestic financial sector risks:
  - Inflows of foreign capital in presence of weak banking systems can be misallocated, creating currency, maturity, and duration mismatches and unsustainable external debt structures (Ishii and Habermeier, 2002).
- Recommended approach:
  - Adopt a cautious approach to capital account liberalization.
  - China’s strategy of opening to FDI rather than other capital inflows has helped insulate it from many risks, but the dominance of FDI in total capital inflows has declined markedly in recent years; composition of inflows likely to be increasingly market-driven.

### Capital controls and their erosion over time
- Role of capital controls:
  - Can provide protection from volatile international capital flows and help contain risks from weak domestic financial sectors.
  - Can prevent excessive external borrowing by corporates and banks in countries with weak financial systems.
  - In inflexible exchange rate regimes, controls help preserve monetary policy autonomy and reduce exchange rate volatility from short-run capital swings.
  - Controls can also perpetuate inefficiencies and financial repression, redirecting domestic savings to government or priority sectors.
- Channels to evade controls:
  - Under- and over-invoicing of export and import contracts.
  - Transfer pricing by multinational companies.
  - Leads and lags in settlement of commercial transactions and variation in short-term trade credit terms.
  - Remittances, family transfers, and tourist expenditures used as vehicles for acquiring or repatriating foreign assets.
- Empirical and historical evidence:
  - Effectiveness of capital controls tends to diminish over time, especially when strong exchange rate pressures are resisted by official intervention (examples: post-Bretton Woods Japan; Latin America during 1980s debt crisis).
- China’s experience:
  - Capital controls in China are extensive and were reasonably effective historically; they are widely cited as helping China withstand the Asian financial crisis, though China’s crisis exposure differed (capital flight was triggered by external shocks while domestic confidence remained intact).
  - Despite controls on outflows, sizable amounts of financial capital appear to have flowed out during the Asian crisis and aftermath; Gunter (2004) estimates capital flight exceeded US$100 billion a year during 1997–2000 and notes stricter controls were offset by trade mis-invoicing.
  - Since 2001, expectations of renminbi appreciation and a positive Chinese-U.S. interest differential resulted in substantial net inflows of non-FDI capital despite extensive controls on non-FDI inflows (Prasad and Wei, 2004).
  - Recorded capital account transactions show foreign currency loans from domestic banks to residents increased by almost 30 percent during 2003, while residents’ foreign currency deposits declined slightly.
  - Anecdotal evidence: early collection of export receipts and increased use of trade credit for imports consistent with expectations of appreciation.
  - Empirical work (e.g., Cheung et al, 2003) corroborates that controls have become less effective, increasingly limiting room for an independent monetary policy.
  - Continued rapid trade expansion and WTO-related liberalization commitments imply capital controls are likely to become more porous over time.

### The foreign exchange market and readiness for flexibility
- Arguments and counterpoints:
  - Some commentators argue absence of a well-functioning foreign exchange market will inhibit greater exchange rate flexibility; also that capital account controls prevent a fully functioning market since much demand is excluded.
  - Counterpoint: An open capital account is not necessary for deepening the foreign exchange market; China’s large volume of trade transactions and few restrictions on current account convertibility provide potential for a deep and well-functioning foreign exchange market even without a fully open capital account.
  - The notion that the foreign exchange market must be perfected before moving to greater flexibility is characterized here as a red herring.

*Source: _pdp01 - Section 2 (PDF chapter) — China: Foreign Currency Exposures of Financial and Corporate Sectors*

### Section 3

### _pdp01 - Section 3

### Improving the functioning of the foreign exchange market within the existing regime
- Finding: The functioning of the foreign exchange market can be greatly improved even within the context of the present exchange rate regime.
- Practical measures cited:
  - Allow enterprises access to the China Foreign Exchange Trading System through a licensed broker system to increase trading volume and reduce the dominant role of official intervention.
  - Within a narrow band of a de facto peg, relax bid-offer spreads to encourage participants to take positions on both sides.
  - Further reduce foreign exchange surrender requirements.
  - Ease the requirement that enterprises need “real commercial demand” to enter forward contracts so they can hedge based on future needs.
- Policy implication: A phased approach toward flexibility should not pose major risks even if existing financial instruments to hedge foreign exchange risks are limited; it would give economic agents stronger incentives to hedge foreign exchange risks that have so far been borne entirely by the monetary authorities.
- Supporting point: Development of a deeper and more sophisticated foreign exchange market would be nurtured by shifting some risk away from monetary authorities and toward market participants.

### V. Considerations of timing for greater exchange rate flexibility
- Comparative finding: International experiences vary in the sequencing of exchange rate flexibility and capital account liberalization; countries generally have better medium-term outcomes if they introduce exchange rate flexibility before fully liberalizing their capital account, especially when financial sector weaknesses exist.
- China-specific observation:
  - The Chinese authorities have attempted to alleviate recent appreciation pressures by easing controls on capital as well as current account transactions to provide more channels for capital outflows.
  - Such measures, while aligned with long-term objectives of full capital account convertibility, risk getting the sequencing wrong.
- Risk highlighted:
  - An increasingly open capital account without exchange rate flexibility has been the root cause of many recent emerging market financial crises.
  - Easing controls on capital outflows may be counter-productive because:
    - Removing controls on outflows can stimulate further inflows by making it easier to take capital out when desired (Labán and Larraín, 1993).
    - Easing outflow controls, if perceived as commitment to sound domestic macroeconomic policies, can induce more capital inflows (Bartolini and Drazen, 1997).
  - Historical examples of rapid inflows after removal of outflow controls: Italy in 1984, New Zealand in 1984, Spain in 1986, Uruguay in 1970.
- Recommendation on timing:
  - Consider an early move towards exchange rate flexibility while existing capital account controls are still relatively effective and underlying structural problems remain manageable.
  - Rationale: Capital controls provide some degree of protection to the domestic financial system but are likely to become less effective over time.
- Contextual factors favoring a move:
  - The current strength and stability of the economy and existing capital account controls have contributed to reasonably high confidence in the banking system despite weak financial positions.
  - Domestic banks will face increasing competitive pressure, especially once foreign banks enter under WTO accession commitments.
- Optimal conditions for exiting a fixed regime:
  - An orderly exit to greater flexibility is best accomplished during relative tranquility in exchange markets.
  - Given rarity of tranquil periods, the next-best circumstances are when the domestic economy is strong and pressures are for appreciation of the currency (Eichengreen and Mussa, 1998a; Agénor, 2004).
  - Such windows of opportunity should be taken advantage of to avoid changing regimes under far less desirable conditions later.

### VI. Concluding remarks — sequencing, policy priorities, and implications
- Strategic conclusion: Gaining experience over time with greater exchange rate flexibility and achieving a more stable financial system should be prerequisites to fully opening the capital account given China’s objectives of more trade integration and gradual capital liberalization.
- Benefits of greater exchange rate flexibility:
  - Helps improve macroeconomic control.
  - Reduces vulnerabilities to shocks.
  - Can be introduced before all prerequisites for full capital account convertibility are met.
  - Exchange rate can be allowed to move in response to supply and demand for foreign exchange even if constrained by capital flow restrictions.
- Caution on capital account liberalization:
  - Historical experiences highlight risks associated with capital account liberalization in the absence of exchange rate flexibility.
  - Easing controls on capital outflows to alleviate exchange rate pressures could be counter-productive and induce larger inflows.
  - Capital account liberalization should be given a lower priority and not regarded as a substitute for greater exchange rate flexibility.
- Financial stability considerations:
  - Greater flexibility can be introduced without creating disruptions in the financial sector.
  - Maintenance of capital controls can, to some degree, support the transition by providing protection from potential instability arising from capital flows while institutional arrangements needed for convertibility (including a stronger domestic banking sector) develop.
  - Movement toward more flexibility does not necessitate immediate adoption of a free float; a period of “learning to float” can be useful in overcoming “fear of floating.”
- Timing urgency:
  - Capital controls will become increasingly ineffective as integration with the global economy continues.
  - Historical experiences show the merit of moving toward flexibility when domestic growth is rapid and the external position is strong.
  - Conclusion: A relatively early move toward greater exchange rate flexibility would be in China’s best interest and long delays could entail significant costs.

### Selected illustrative international experiences and lessons (summary points from Appendix I)
- Industrial economies:
  - After Bretton Woods, many countries initially maintained pegs and capital controls; floating exchange rates and gradual capital liberalization followed as controls became harder to enforce.
  - Examples of liberalization timing: United Kingdom removed controls in 1979; Japan in 1980; Germany in 1981; Australia in 1983; New Zealand in 1984; Sweden in 1989; France in 1989; Italy in 1990; Spain in 1992; Iceland in 1995.
  - New Zealand floated and liberalized concurrently in 1984, which led to substantial inflows and a sharp appreciation; contributed to an asset price boom and later bust.
- Developing economies:
  - Chile’s controls on short-term inflows were effective when supported by broad economic reforms; managed exchange rate flexibility was used within a band of +/- 5 percent before moving to full flexibility.
  - Brazil’s extensive controls on short-term inflows were circumvented in the presence of sophisticated markets and unaddressed fiscal imbalances.
  - Korea’s uneven sequencing and regulatory bias toward short-term external borrowing contributed to vulnerabilities leading up to the 1997–98 crisis.
  - Taiwan Province of China introduced a flexible regime in 1978 with subsequent extensive intervention; QFII program grew to $3 billion and entry criteria liberalized in 2001; repatriation and remittance allowances increased to $5 million in 1992.
  - Thailand effectively pegged the baht starting November 5, 1984, and capital account liberalization after 1993 increased short-term inflows; forced float in July 1997 amid heavy pressures triggered a financial crisis.
  - India has practiced limited exchange rate flexibility since 1993 within a managed float and has pursued gradual and uneven capital account liberalization; accepted IMF Article VIII obligations in 1994.

*Source: _pdp01 - Section 3*

### Section 4

### China’s Steps Toward Liberalization of Cross-Border Foreign Exchange Transactions

### Background and policy stance
- Full renminbi convertibility has been the stated goal of the authorities since 1993, with the authorities emphasizing that it would take a long time to achieve that objective.
- Current account convertibility has been in place since 1996.
- Extensive controls remain on most capital account transactions.
- Capital controls are maintained for both monitoring and policy purposes.
- Foreign direct investment (FDI) is encouraged but closely regulated; WTO accession has resulted in further liberalization of procedures for FDI (foreign investment approvals are no longer subject to mandatory requirements such as on technology transfer or local content).
- Foreign portfolio flows are hindered by the segregation of China’s stock markets between residents and nonresidents.
- Restrictions on other forms of external borrowing are pervasive and generally subject to strict ceilings.
- Capital outflows by residents (e.g., foreign currency accounts and purchase of securities abroad) are tightly regulated.

### Major liberalization steps (chronological)
- 2001:
  - Restrictions were liberalized on purchases of foreign exchange for advance repayments of domestic and foreign currency loans, loans converted from foreign debt, and other foreign debts.
  - The purchase of foreign exchange was authorized for investments abroad in strategic foreign projects.
  - Persons paying for their own studies abroad (college level or higher) were allowed a one-time purchase of foreign exchange of up to the equivalent of US$20,000 (previously US$2,000); effective January 2005, this amount will be raised to US$20,000 in addition to tuition fees.
- 2002:
  - The Qualified Foreign Investor Initiative (QFII) was introduced, permitting nonresidents to invest in the domestic stock market (A shares), subject to some restrictions.
  - As of November 2004, 23 foreign investors had received approval for an amount totaling US$3.2 billion.
  - All enterprises authorized to conduct current account transactions obtained the right to retain foreign exchange equivalent to 20 percent of their current account foreign exchange earnings in the previous year (and this ratio was raised to 30–50 percent in 2004), making it easier for exporters to finance imports.
- 2003:
  - Registration with, and permission from, the government to repay loan principal was no longer required for residents wishing to borrow foreign exchange from domestic Chinese financial institutions.
  - Domestic companies were allowed to retain foreign currency revenue from overseas contracted projects, overseas shipping and commissions, and international bidding projects in foreign exchange accounts.
  - In some provinces and regions, the limit on outward investment was increased to the equivalent of US$3 million from US$1 million.
  - The maximum amount of foreign exchange that residents may export without a License for Carrying Foreign Currencies Abroad (LCFCA) was increased to the equivalent of US$5,000 from US$2,000, and the limit at which State Administration of Foreign Exchange (SAFE) verification is required was increased to US$10,000 from US$4,000.
  - The maximum amount of foreign currency that residents may import without declaration was increased to the equivalent of US$5,000 from US$2,000.
- 2004:
  - The National Social Security Fund (which manages about US$17 billion) and domestic insurance firms were given approval in principle to invest a small portion of their portfolios offshore; details of the amounts involved have not yet been made public.
  - The authorities permitted international financial institutions to raise funds domestically in renminbi for use offshore.
  - Domestic members of multinational corporations were allowed to collect their foreign exchange funds together and redistribute them domestically in the form of trust loans, or to extend loans to their overseas affiliates.
  - The transfer of personal assets abroad by Chinese citizens emigrating overseas or by nonresidents receiving inheritances is now permitted.

### Policy implications and objectives
- Liberalizations targeted both current-account facilitation (already convertible since 1996) and specific capital-account-related transactions while preserving broad capital control frameworks.
- Measures aimed to:
  - Facilitate exporters’ ability to finance imports by allowing retention of a share of foreign exchange earnings (20 percent initially; raised to 30–50 percent in 2004).
  - Channel selected portfolio and institutional investors into domestic markets (QFII).
  - Provide controlled avenues for outward investment and personal transfers (education, emigration, inheritances).
  - Enable limited offshore investment by large domestic institutional investors (National Social Security Fund, domestic insurance firms).

### Remaining constraints and segmentation
- Extensive capital account controls persist across most transaction types.
- Segregation between resident and nonresident access to stock markets continues to hinder foreign portfolio flows.
- External borrowing and many forms of capital outflow remain subject to strict ceilings and regulatory oversight.
- Many liberalizations were incremental and conditional, with specific ceilings and approval processes retained in numerous areas.

*Source: _pdp01 - Section 4*

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