## 1. Country Examples of Capital Account Liberalization

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### I. Introduction — purpose and main inference
- Purpose:
  - Estimate an empirical model relating gross bilateral international assets and liabilities to fundamentals, including the level of capital controls, to infer potential portfolio in- and outflows that might follow liberalization of the Chinese capital account.
- Main empirical inference:
  - Gross flows both into and out of China would be substantial; the likely direction of net flows would be outflows.
  - Estimated orders of magnitude would imply significant repercussions for both Chinese and global financial markets.
- Prior related empirical findings cited in the source:
  - Forbes (2010): capital account opening could raise Chinese exposures to U.S. equity markets by almost half.
  - Sedik and Sun (2012): inflows and outflows could rise by 2–3¼ percentage points of GDP between 2012 and 2016, and outflows would increase by more than inflows.
  - He and others (2012): capital account opening could generate a stock adjustment in international portfolio assets and liabilities of 21 and 16 percent of GDP, respectively, by 2020 and in direct investment assets and liabilities of 22 and 11 percent of GDP, respectively.
- Methodological caveats:
  - Exercise assumes inferences from the sample are applicable to China.
  - Analysis is a partial equilibrium exercise; large existing and complementary distortions could generate offsetting general equilibrium effects not captured here.
  - Results for other investment are inconclusive due to difficulties in identifying determinants of other investment flows.

### II. Background: restrictions in China (selected numeric markers and features)
- Character of liberalization: gradual opening; capital flows remain subject to considerable restrictions.
- Selected quantitative policy and institutional markers:
  - QFII aggregate ceiling: US$150 billion (since July 2013).
  - R-QFII aggregate ceiling: renminbi 270 billion by end-2012.
  - QDII institution-specific ceilings: US$86 billion by end-2012.
- Main restrictions summarized by flow type:
  - FDI:
    - Inward FDI and its liquidation remain subject to approval requirements in several areas.
  - Portfolio investment:
    - Inward investment funneled through QFII; a 3-month lock-in period for most shares; aggregate ceiling noted above.
    - R-QFII introduced in 2011; aggregate ceiling noted above.
    - Outward portfolio investment channeled through QDII subject to institution-specific ceilings noted above.
    - Cross-border issuance of securities requires approval.
  - Other investment:
    - Foreign borrowing subject to a ceiling (short-term) or approval requirements (long-term).
    - Lending abroad largely unrestricted.
    - Holding of cross-border accounts requires SAFE approval.
- Observed capital flows despite restrictions:
  - “Other” investment flows are similar in absolute magnitude to those of a fully liberalized country such as Australia.
  - Capital flows have included buildup/drawdown of foreign currency deposits at domestic banks; these deposits have tended to fluctuate with exchange rate expectations.
  - Li (2008) estimated capital flows through mis-invoicing of trade flows on the order of 5.5– (value in source incomplete).

### III. Analytical approach and robust determinants (econometric framework)
- Empirical strategy:
  - Estimate a generalized multi-country version of Forbes (2010) on bilateral portfolio shares w_{ij} using IMF CPIS bilateral portfolio assets (China does not report CPIS data).
  - Dependent variable: share of country i’s total portfolio investment invested in country j (equity and debt separately).
- Key controls and data used:
  - Financial market size: stock market capitalization (equities) and outstanding domestic public and private debt securities (bonds).
  - Capital controls: updated Schindler (2009) dataset to 2011.
  - Information asymmetries: bilateral trade percent of GDP (IMF DOTS) and population-weighted geodesic distance.
  - Return differentials and correlations: annual average monthly stock market returns (59 countries) for equities; annual average 5-year sovereign bond yield (37 countries) for bonds; three-year bilateral return correlations.
  - Governance: first standardized principal component of control of corruption, rule of law, regulatory quality.
- Estimation and robustness:
  - FGLS allowing heteroskedasticity and country-pair-specific AR(1) autocorrelation.
  - Instrumental variables for market size in robustness checks (stock market value traded percent of GDP; share of private debt in total domestic outstanding debt).
- Robust empirical findings:
  - Larger source-country financial markets discourage domestic investors from investing abroad.
  - Larger destination-market size tends to attract foreign equity exposures in baseline FGLS but is not robust in IV specifications and is sensitive to outliers.
  - Higher destination-country returns (and, for bonds, lower returns at home) encourage greater foreign exposures.
  - Bond exposures are more responsive than equity exposures to returns, source-country market depth, destination-country governance, and bilateral ties.
  - Capital controls in both source and destination countries significantly reduce cross-border portfolio exposures; bond exposures are more sensitive to capital controls than equity exposures.
  - Better governance, greater trade, and proximity increase bilateral portfolio exposures.

### IV. Predicted quantitative impacts for China from counterfactual liberalization experiments (key estimates)
- Using regression coefficients applied to 2010 data, predicted stock adjustments:
  - Predicted stock adjustment of Chinese assets abroad (gross outflows): on the order of 15–25 percent of GDP.
  - Predicted stock adjustment for foreign assets in China (gross inflows): on the order of 2–10 percent of GDP.
  - Implied net accumulation of Chinese net international assets: 11–18 percent of GDP.
- Adjustment for potential overstatement of Chinese market size (nontradable shares ~ one quarter of equity market capitalization; almost half of outstanding bond market debt held by banks):
  - Predicted net accumulation narrowed to 4–8 percent of GDP.
- India comparative note:
  - India’s stock and bond market sizes about one quarter of China’s in 2010; predicted flows would be similar orders of magnitude in percent of GDP but smaller in absolute nominal amounts.
- Phasing and macro interactions:
  - Capital account liberalization likely gradual; predicted net outflows for China could be spread over several years and partially offset other balance of payments inflows.
  - World Economic Outlook Update (July 2013) projection cited: reserve accumulation on the order of USD 580 billion per year on average over 2013–18 (projected widening current account surplus to 4.1 percent of GDP by 2018 and continued net FDI inflows).
  - If predicted stock adjustment in net portfolio assets were phased over a similar 5-year horizon, reserve accumulation could be reduced by up to one-third.
- Potential global market repercussions (order-of-magnitude examples):
  - An accumulation of 9–25 percent of GDP in international portfolio assets by Chinese residents could:
    - Account for up to 3 percent of global financial markets if allocated along MSCI portfolio shares.
    - Account for up to a quarter of financial markets in emerging market economies.
  - Benelli (2011) thought experiment: a $500 billion (some 7 percent of China’s 2011 GDP) shift out of U.S. public debt into emerging market government debt could increase U.S. bond yields by 60 bps and decrease emerging market bond yields by 240 bps. The paper notes the potential order of magnitude from China’s liberalization could be significantly larger.

### V. Domestic financial market implications (selected quantitative and qualitative points)
- Real returns on bank deposits: negative since 2003 (as reported).
- Residential investment returns:
  - Year-on-year returns since 2005 have averaged 10½ percent countrywide.
  - Year-on-year price declines have never lasted longer than four months before rebounding (as described in source).
- Wealth management products:
  - Yields substantially above regulated benchmark deposit rates—on average 2 percentage points for one-year deposits in 2012 (Barclays, 2013).
  - Estimated growth to RMB 7.1 trillion (15 percent of GDP) by end-2012 (grown sevenfold since end-2009).
- Opening access to global financial markets could reduce liquidity in domestic stock, property, and wealth management product markets.

### VI. Historical experience and risks from past liberalizations (stylized facts and country lessons)
- Historical pattern:
  - Capital account liberalization has often been followed by exchange rate or banking crises; timing of crises varies widely (e.g., U.K. and Japan about a decade later; Denmark two decades later).
- Preconditions for “safe” liberalization commonly cited (Fischer, 1998):
  - Stable macroeconomic environment, sound banking system, and developed financial markets.
- Assessment for China from cited literature:
  - Preconditions are not yet fulfilled for China.
  - Specific gaps: inability to assess financial soundness without interest rate liberalization; parts of the financial system (especially the corporate bond market) are profoundly underdeveloped; the exchange rate remains undervalued.
- Country examples and lessons (selected):
  - Poland: liberalized short-term debt flows before long-term FDI flows; intrusive bank supervision constrained risky inflows.
  - Korea: unconventional sequencing (short-term bank flows before corporate flows) led to external borrowing and foreign currency mismatches.
  - Turkey: 1980s liberalization under fiscal dominance and underdeveloped banking system followed by destabilizing inflows and crises in 1994 and 2001.
  - Israel: initial “big bang” liberalization in 1977 reversed; later gradual liberalization 1987–2005 accompanied by stabilization and careful sequencing.
  - Sweden: financial sector liberalization led to credit boom and subsequent crisis; fixed exchange rate could not be defended absent capital controls.
  - U.K. (1979–80) and Japan (1979–80) boxes document removal of exchange controls, rapid portfolio outflows, disappearance of onshore/offshore interest differentials, and sizable market adjustments.

### VII. Best-practice sequencing and policy implications (from Box 1 and lessons)
- Best-practice conditions for smoother capital account opening:
  - Implemented in an environment of macroeconomic balance, fiscal discipline and tight financial system supervision. A current account surplus helps.
  - Textbook sequencing: short-term flows liberalized before long-term flows; inflows before outflows; FDI before debt flows.
  - Interaction with financial sector and exchange rate reform:
    - Exchange rate flexibility needs two-way capital flows of a liberalized capital account.
    - Financial market liberalization helps develop a yield curve and avoid buildup of domestic foreign currency mismatches.
- Even under best practices, effects are difficult to anticipate due to nonlinearities and threshold effects (Prasad and Rajan, 2008). Example given: widely expected large net outflows in Israel and Sweden never materialized.

### VIII. Conclusions — main takeaways (as summarized in the source)
- Capital account opening in China will likely be followed by substantial gross portfolio flows as global and domestic portfolios adjust.
- During the adjustment period there may be net outflows from both equity and bond markets as domestic investors seek to diversify large domestic savings—contrasting with expectations for countries like India.
- These net outflows of portfolio investment could offset pressures for reserve accumulation from net FDI or other investment inflows or current account surpluses for several years to come.
- Historical experience counsels careful sequencing, gradual phasing, strengthened financial sector supervision, and attention to macroeconomic stability to limit crisis risk.

*Source: _wp13189 - 1. Country Examples of Capital Account Liberalization; excerpts and quantitative points from the provided PDF content unit.*

### 1. Country Examples of Capital Account Liberalization .........................................................18

### 1. Country Examples of Capital Account Liberalization .........................................................18

### I. INTRODUCTION
- China’s 12th Five-Year Plan pledges to accelerate capital account liberalization.
- The paper estimates an empirical model relating gross bilateral international assets and liabilities to fundamentals, including the level of capital controls, to infer potential portfolio in- and outflows that might follow liberalization of the Chinese capital account.
- Main empirical inference: gross flows both into and out of China would be substantial; the likely direction of net flows would be outflows.
- Estimated orders of magnitude would imply significant repercussions for both Chinese and global financial markets.
- Prior related findings cited:
  - Forbes (2010): capital account opening could raise Chinese exposures to U.S. equity markets by almost half.
  - Sedik and Sun (2012): based on experience of 37 developing and emerging markets that liberalized since the mid-1990s, inflows and outflows could rise by 2–3¼ percentage points of GDP between 2012 and 2016, and outflows would increase by more than inflows.
  - He and others (2012): capital account opening could generate a stock adjustment in international portfolio assets and liabilities of 21 and 16 percent of GDP, respectively, by 2020 and in direct investment assets and liabilities of 22 and 11 percent of GDP, respectively.
- Methodological and scope caveats noted:
  - The exercise implicitly assumes that inferences from the sample are applicable to China.
  - Analysis is a partial equilibrium exercise; large existing and complementary distortions could generate offsetting general equilibrium effects not captured here.
  - Difficulties in identifying determinants of other investment flows are noted; results for other investment are inconclusive based on panel regressions.

### II. BACKGROUND: RESTRICTIONS IN CHINA
- China has gradually been opening its capital account, but capital flows remain subject to considerable restrictions.
- Existing classification schemes referenced: Quinn (2003), Chinn and Ito (2008), Schindler (2009).
- Schindler (2009) classification: main categories of capital flows in the balance of payments — FDI, equity and bond flows; flows through collective investment vehicles (e.g., ETFs or mutual funds); and foreign borrowing.
- Caveat: indices measure existence of restrictions, not their intensity; they may not capture relaxations (e.g., increases in quotas versus elimination).
- Summary of restrictions by category (as described in the source):
  - FDI:
    - Inward FDI and its liquidation remain subject to approval requirements in several areas.
  - Portfolio investment:
    - Inward investment is channeled through Qualified Foreign Institutional Investors (QFII), subject to a 3-month lock-in period for most shares, and an aggregate ceiling of US$150 billion (since July 2013).
    - In 2011, an R-QFII scheme was introduced that allows qualified firms to invest offshore renminbi back into China, subject to an overall ceiling that was raised to renminbi 270 billion by end-2012.
    - Outward portfolio investment—for foreign securities purchased by residents—is channeled through Qualified Domestic Institutional Investors (QDII), subject to institution-specific ceilings that amounted to US$86 billion by end-2012.
    - Cross-border issuance of securities requires approval.
  - Other investment:
    - Foreign borrowing is subject to a ceiling (for short-term borrowing) or approval requirements (for long-term borrowing).
    - Lending abroad is largely unrestricted.
    - The holding of cross-border accounts requires SAFE approval.
- Despite restrictions, substantial non-FDI capital flows into and out of China are observed:
  - “Other” investment flows are similar in absolute magnitude to those of a fully liberalized country such as Australia; these include buildup or drawdown of foreign currency deposits at domestic banks.
  - These deposits have tended to fluctuate with exchange rate expectations (Ma and McCauley, 2003) as state-owned enterprises have adjusted profit repatriation.
  - Many capital flows also pass through the current account; Li (2008) estimated capital flows through mis-invoicing of trade flows on the order of 5.5– (text cuts off at this point).

### III. ANALYTICAL APPROACH AND STRUCTURE OF THE PAPER
- Empirical strategy:
  - Estimate a model of gross bilateral international assets and liabilities across a wide range of countries incorporating fundamentals including capital controls.
  - Use regression results to infer potential portfolio in- and outflows that might follow Chinese capital account liberalization.
- Structure:
  - Section II (this section) describes main Chinese capital controls.
  - Section III (in the paper) recaps experiences of other advanced and emerging market countries that opened capital accounts since the 1970s.
  - Section IV presents econometric results.
  - Section V concludes with implications of the econometric results.

### IV. Key Quantitative Points Extracted from the Source
- Policy and institutional numerical markers:
  - China’s 12th Five-Year Plan (no date specified in excerpt).
  - QFII aggregate ceiling: US$150 billion (since July 2013).
  - R-QFII aggregate ceiling: renminbi 270 billion by end-2012.
  - QDII institution-specific ceilings: US$86 billion by end-2012.
- Comparative and empirical estimates cited:
  - Sedik and Sun (2012): inflows and outflows could rise by 2–3¼ percentage points of GDP between 2012 and 2016.
  - He and others (2012): portfolio assets and liabilities adjustments of 21 and 16 percent of GDP, respectively, by 2020; direct investment assets and liabilities adjustments of 22 and 11 percent of GDP, respectively.
  - Forbes (2010): potential increase in Chinese exposures to U.S. equity markets by almost half.
  - Li (2008): mis-invoicing estimate on the order of 5.5– (incomplete value in source).

*Source: _wp13189 - 1. Country Examples of Capital Account Liberalization .........................................................18*

### 5.9 percent of GDP in 2007.

### _wp13189 - 5.9 percent of GDP in 2007.

### Capital account opening: caution from historical experience
- Capital account liberalization has historically often been followed by exchange rate or banking crises.
- Crisis timing after liberalization has varied widely (examples): U.K. and Japan about a decade later; Denmark two decades later.
- Preconditions for “safe” capital account liberalization commonly accepted since Fischer (1998): a stable macroeconomic environment, a sound banking system, and developed financial markets.
- Assessment for China (as summarized by past literature cited):
  - Preconditions are not yet fulfilled for China.
  - Specific gaps: inability to assess financial soundness without interest rate liberalization; parts of the Chinese financial system, especially the corporate bond market, are profoundly underdeveloped; the exchange rate remains undervalued.

### Stylized facts from capital account liberalization episodes since the 1970s
- Gross capital flows generally increased substantially after liberalization (examples):
  - United Kingdom (1979): buildup of gross international assets over five years of some 60 percent of GDP.
  - Chile (1992): about 30 percent of GDP.
  - Italy (1992): about 30 percent of GDP.
- Net capital flow direction post-liberalization varied by country (nonlinearities, threshold effects).
- Four factors highlighted as determinants of net flows:
  - Domestic business cycle: more advanced domestic upswing typically associated with greater net outflows (residents diversify abroad in upswing; borrow in downswings).
  - Growth prospects: higher trend growth associated with larger increases in net other investment inflows.
  - World business cycle: more advanced global upswing typically associated with increased net portfolio inflows.
  - Sequencing of financial sector liberalization: more recent financial repression (shorter time since financial sector liberalization to capital account liberalization) tends to be associated with greater portfolio investment net outflows.

### Econometric framework and robust determinants of bilateral portfolio exposures
- Baseline regression: generalized multi-country version of Forbes (2010) on bilateral portfolio shares w_{ij}.
- Dependent variable: share of country i’s total portfolio investment invested in country j (equity and debt separately) using IMF CPIS bilateral portfolio assets; China does not report CPIS data.
- Key cost-of-investing controls included:
  - Financial market size: stock market capitalization (equities) and outstanding domestic public and private debt securities (bonds) from the World Bank’s Global Financial Development Database.
  - Capital controls: updated Schindler (2009) dataset to 2011.
  - Information asymmetries: bilateral trade in percent of GDP (IMF DOTS) and population-weighted geodesic distance (Mayer and Zignano, 2011).
  - Return differentials: annual average monthly stock market returns (59 countries) for equities; annual average 5-year sovereign bond yield (37 countries) for bonds (Bloomberg).
  - Return correlations: bilateral correlation coefficient in monthly stock market returns or sovereign bond yields over past three years.
  - Governance: first standardized principal component of control of corruption, rule of law, regulatory quality (World Governance Indicators).
- Estimation approach: FGLS to allow heteroskedasticity and country-pair-specific AR(1) autocorrelation; instrumental variables used for financial market size in robustness checks (stock market value traded percent of GDP; share of private debt in total domestic outstanding debt).
- Robust empirical findings:
  - Larger source-country financial markets discourage domestic investors from investing abroad.
  - Larger destination-market size tends to attract foreign equity exposures in baseline FGLS, but this effect is not robust in instrumental variables and is sensitive to outliers (notably Japan and the U.K.).
  - Higher returns in the destination country (and, for bonds, lower returns at home) encourage greater foreign exposures.
  - Bond exposures are generally more responsive than equity exposures to returns, source-country market depth, destination-country governance, and bilateral ties.
  - Capital controls in both source and destination countries significantly reduce cross-border portfolio exposures; bond exposures are more sensitive to capital controls than equity exposures.
  - Other expected signs: better governance, greater trade, and proximity increase bilateral portfolio exposures.

### Predicted quantitative impacts for China from counterfactual liberalization experiments
- Using coefficient estimates from regressions (Tables 3 and 6) applied to 2010 data yields:
  - Predicted stock adjustment of Chinese assets abroad (gross outflows) on the order of 15–25 percent of GDP.
  - Predicted stock adjustment for foreign assets in China (gross inflows) on the order of 2–10 percent of GDP.
  - Implied net accumulation of Chinese net international assets of 11–18 percent of GDP.
- Adjustment for potential overstatement of Chinese market size (nontradable shares ~ one quarter of equity market capitalization; almost half of outstanding bond market debt held by banks) narrows predicted net accumulation to 4–8 percent of GDP.
- Comparable thought experiment for India:
  - India’s stock and bond market sizes about one quarter of China’s in 2010; predicted flows would be similar orders of magnitude in percent of GDP but smaller in absolute nominal amounts.
- Phasing and macro interactions:
  - Capital account liberalization is likely to proceed gradually; predicted net outflows for China could be spread over several years and partially offset other balance of payments inflows.
  - World Economic Outlook Update (July 2013) projection cited: reserve accumulation on the order of USD 580 billion per year on average over 2013–18 (projected widening current account surplus to 4.1 percent of GDP by 2018 and continued net FDI inflows).
  - If predicted stock adjustment in net portfolio assets were phased over a similar 5-year horizon, reserve accumulation could be reduced by up to one-third.
- Potential global market repercussions:
  - An accumulation of 9–25 percent of GDP in international portfolio assets by Chinese residents could:
    - Account for up to 3 percent of global financial markets if allocated along MSCI portfolio shares.
    - Account for up to a quarter of financial markets in emerging market economies.
  - Benelli (2011) thought experiment: a $500 billion (some 7 percent of China’s 2011 GDP) shift out of U.S. public debt into emerging market government debt could increase U.S. bond yields by 60 bps and decrease emerging market bond yields by 240 bps. The paper notes the potential order of magnitude from China’s liberalization could be significantly larger.
- Domestic financial market implications:
  - Real returns on bank deposits: negative since 2003.
  - Residential investment returns: year-on-year returns since 2005 have averaged 10½ percent countrywide; year-on-year price declines have never lasted longer than four months before rebounding.
  - Wealth management products: yields substantially above regulated benchmark deposit rates—on average 2 percentage points for one-year deposits in 2012 (Barclays, 2013); estimated growth to RMB 7.1 trillion (15 percent of GDP) by end-2012 (grown sevenfold since end-2009).
  - Opening access to global financial markets could reduce liquidity in domestic stock, property, and wealth management product markets.

### Conclusions (summary of main takeaways)
- Capital account opening in China will likely be followed by substantial gross portfolio flows as global and domestic portfolios adjust.
- During the adjustment period there may be net outflows from both equity and bond markets as domestic investors seek to diversify large domestic savings—contrasting with expectations for countries like India.
- These net outflows of portfolio investment could offset pressures for reserve accumulation from net FDI or other investment inflows or current account surpluses for several years to come.

*Source: _wp13189 - 5.9 percent of GDP in 2007.*

### Box 1. Country Examples of Capital Account Liberalization

### Box 1. Country Examples of Capital Account Liberalization

### Best practice: conditions for smooth capital account opening
- Implemented in an environment of macroeconomic balance, fiscal discipline and tight financial system supervision. A current account surplus helps.
- Following the textbook sequencing: short-term flows liberalized before long-term flows, inflows before outflows, and FDI before debt flows.
- Interaction with financial sector and exchange rate reform: to succeed in establishing a market based exchange rate, exchange rate flexibility needs the two-way capital flows of a liberalized capital account; financial market liberalization helps develop a yield curve for a functioning exchange rate market and avoid the buildup of domestic foreign currency mismatches.
- Even in the best of circumstances, the effect of capital account liberalization remains difficult to anticipate. Many relationships are highly nonlinear (Prasad and Rajan, 2008). Example: widely expected large and persistent net capital outflows in Israel and Sweden never materialized.

### Five country examples: sequencing, outcomes, and lessons
- Poland
  - Pressures to finance the budget deficit forced the authorities to liberalize short-term debt flows before long-term FDI flows.
  - Intrusive bank supervision constrained flows entering through the liberalized capital account into the banking system to offset financial stability risks.
- Korea
  - Liberalization sequenced in an unconventional manner: liberalizing short-term bank flows before corporate flows, portfolio flow liberalization before exchange rate liberalization and FDI liberalization.
  - This sequencing supported large external borrowing and a buildup of foreign currency mismatches in balance sheets.
- Turkey
  - Capital account liberalization during the 1980s (completed by 1989) under fiscal dominance and an underdeveloped banking systems was followed by destabilizing capital inflows and two crises, in 1994 and 2001.
- Israel
  - Implemented two capital account liberalizations:
    - A “big bang” in 1977 that was reversed within 1½ years.
      - The “big bang” liberalization was a 50 percent devaluation and full exchange rate and capital account liberalization in the context of underdeveloped capital markets, a lack of hedging markets, and severe macroeconomic imbalances.
      - It was followed by large inflows that subsequently reversed. Restrictions were re-imposed in 1979.
    - A gradual liberalization in 1987–2005.
      - Accompanied by macroeconomic stabilization, followed conventional sequencing and careful phasing by sector (beginning with foreign residents, then new immigrants, asset managers, corporates, and finally households).
      - Approval requirements were converted into reporting requirements resulting in an important database for monitoring vulnerabilities.
- Sweden
  - Liberalized bond markets first, followed by financial sector liberalization in 1985, and partial capital account deregulation beginning in 1989.
  - Pre-1985, the financial sector was centrally planned. When bank lending was liberalized, a credit boom to satisfy pent-up demand followed, coinciding with large fiscal deficits and rising inflation.
  - A tax change in 1991 raised the real interest rate from -1% to 4% overnight and ended the credit boom.
  - The fixed exchange rate could not be defended absent capital controls and was allowed to float.

### Box 2. U.K. Removal of Exchange Controls in 1979–80 — Previous regime
- While the amount of FDI flows was unrestricted, their domestic financing was restricted. Portfolio investments were confined to the offshore market.
- Sterling-financed outward FDI (at official exchange rates) had to improve the balance of payments.
- Foreign borrowing-financed outward FDI was freely allowed and subsequent profits from such FDI could be freely used to repay the foreign borrowing.
- Foreign currency transactions related to outward FDI not financed by foreign borrowing, to portfolio flows, and to other investment had to be channeled through the “investment currency market”.
  - All purchases of foreign exchange in the investment currency market were financed only by the sale of existing securities and by foreign borrowing.
  - This created a parallel exchange rate in the investment currency market that persistently demanded a 30–50 percent premium over the official exchange rate.
  - To prevent leakages, at least two thirds of after-tax profits from outward FDI had to be repatriated and, until end-1977, at least 25 percent of the proceeds of the sale of foreign portfolio securities had to be exchanged at the official exchange rate (“surrender penalty”).
- Foreign currency deposits of residents were restricted to working balances and domestic currency lending by resident banks to nonresidents was restricted to trade-related purposes.

### Box 2. U.K. Removal of Exchange Controls in 1979–80 — Reforms
- From June 1979, interest payments on foreign borrowing and repayment of foreign borrowing with maturities above one year could be financed at the official exchange rate and all restrictions related to financing FDI and on European Economic Community securities were lifted.
- All remaining restrictions on portfolio investments were lifted in October 1979.
- In June 1980, additional reserve requirements on domestic banks for credit growth in excess of 1 percent per month were lifted, thus reducing incentives for banks to move trade credit off balance sheet into the commercial bill market.

### Box 2. U.K. Removal of Exchange Controls in 1979–80 — Impact
- Estimates of the impact of the abolition of the controls do not take into account that, simultaneously, the new Thatcher government launched a series of macroeconomic stabilization and labor market reforms and the North Sea oil came on stream. The pound appreciated strongly and domestic interest rates rose.
- Change in financing of FDI
  - Levels of FDI were unaffected but about GBP 638 million (0.27 percent of GDP) of FDI-related foreign borrowing were refinanced.
  - The share of repatriated foreign earnings initially dropped from 47 percent to 37 percent but subsequently increased again.
- Increased portfolio outflows
  - Portfolio investment outflows increased from negligible amounts to GBP 45 billion (20 percent of GDP) although this was partly offset by increased portfolio inflows, such that the overall impact was to increased net portfolio outflows by some GBP 30 billion (13 percent of GDP).
  - The foreign share of net investment flows increased from 7 to 20 percent for pension funds, from 4 to 17 percent for insurance companies, and to 100 percent for unit trust funds.
- Foreign currency deposits of residents
  - Residents’ foreign currency deposits in U.K. banks doubled while their foreign currency borrowing increased by one third.
  - Residents’ foreign currency deposits and borrowing from foreign banks both increased by about half as much again.
  - Sterling lending by U.K. banks to nonresidents—mostly foreign banks—increased from about GBP 6 million per month in September 1979 to GBP 300 million (0.13 percent of GDP) in June 1981.
  - Some of this was offset by rising Sterling deposits of nonresident banks with U.K. banks.
- Onshore/offshore interest rate differential disappeared
  - The onshore/offshore interest rate differential dropped from about 4 percent in late 1978 to close to zero by end-1979 and remained around zero thereafter.
  - The deviation from covered interest parity also virtually closed.

*Box 1. Country Examples of Capital Account Liberalization*

### Box 3. Japan. Removal of Exchange Controls in 1979–80

### Box 3. Japan. Removal of Exchange Controls in 1979–80

### Previous regime
- Japan oscillated between imposing capital inflow and outflow controls depending on exchange rate pressures.
- OECD (1984) identify several waves of capital controls:
  - (i) 1970–72, tightening of already strict capital inflow controls and easing of outflow controls in response to current account surpluses;
  - (ii) 1973–74, easing of restrictions on inflows and tightening of restrictions on outflows in response to current account deficits and capital outflows;
  - (iii) 1975–77, easing of all restrictions as exchange pressures eased; and
  - (iv) 1977–78, tightening of inflow controls to contain short-term capital inflows.
- By 1978:
  - nonresident yen deposits (a key channel for short-term capital inflows) were subjected to a 100 percent reserve requirement;
  - foreign debt was subject to a reserve requirement of 0.25 percent;
  - banks were subject to a daily conversion limit of foreign currency into yen;
  - nonresident purchases of yen-denominated securities were strictly controlled and nonresident purchases of government bonds prohibited;
  - residents were prohibited from issuing foreign currency bonds or yen-denominated foreign bonds and nonresident issuance of yen-denominated bonds was restricted;
  - foreign currency borrowing by residents was tightly controlled.
- Offshore interest rates (euroyen rates) were about 5 percent below onshore money market rates (Fukao, 1995).
- The domestic financial system remained subject to regulation of deposit rates and a strict separation of banks between those engaged in short-term lending, those engaged in long-term lending, those engaged in foreign exchange deposit-taking, trust funds, and securities firms.

### Reforms
- All remaining capital account restrictions on both outflows and inflows were removed in 1979/1980.
- Domestic interest rates remained heavily regulated and the main push for financial sector liberalization occurred only around 1985.

- Capital account liberalization 1979–80:
  - In January and February 1979, reserve requirements on nonresident yen deposits and restrictions on nonresident purchases of yen-denominated securities were eliminated.
  - In May 1979, the government bond (Gensaki) market was opened to nonresidents.
  - In November 1979, the quota for foreign currency conversion by banks was increased.
  - Restrictions on medium and long-term foreign currency borrowing by corporates were successively relaxed between February 1979 and March 1980.
  - In March 1980, limits on interbank transfers to domestic banks were raised, interest rates on foreign deposit in domestic banks were liberalized, and Japanese banks were allowed to issue yen-denominated foreign bonds.
  - In 1981 and 1983, foreign asset holdings were permitted for pension funds and postal life insurance funds up to ceilings of 10 percent of assets.

- Financial liberalization 1979–92:
  - A market with liberalized interest rates was introduced for commercial deposits in May 1979, for money market certificates in March 1985, for yen-denominated bankers’ acceptances in September 1985, and for commercial paper in November 1987.
  - Interest rates for large time deposits were liberalized in October 1985, for all times deposits in June 1993, and for all sight deposits in October 1994 (Aramaki, 2006).
  - The Tokyo offshore market, established in December 1986, allowed resident banks to take deposits and lend to nonresidents without the restrictions applying to domestic banking.
  - Competition between banks, trust funds, and securities firms was allowed in June 1992.

### Impact
- Net capital outflows:
  - In the five years following capital account liberalization, net foreign assets increased by some 10 percent of GDP.
  - Permission for institutional investors to acquire foreign assets generated strong capital outflow pressures (Fukua, 1995).
  - Between 1985 and 1990, foreign assets and liabilities increased by some 30 percent of GDP each, whereas net foreign assets remained broadly around 10 percent of GDP.
- Onshore/offshore interest rate differential disappeared:
  - The differential between the London euroyen market rate and the domestic money market rate dropped from about 5 percent in early 1979 to close to zero by end-1979 and remained around zero thereafter (Fukao, 1995, Maloney, 1992).

*Source: Box text from the provided IMF content unit.*

### REFERENCES

### _wp13189 - REFERENCES

### Sources on Reserves and Reserve Management
- Bayoumi, Tamim, and Christian Saborowski, 2012, “Accounting for Reserves,” IMF Working Paper 12/302 (Washington: International Monetary Fund).  
- Benelli, Roberto, 2011, “Potential Impact on Global Bond Markets of Reallocating Reserves,’’ China: Spillover Report for the 2011 Article IV Consultation and Selected Issues, (Washington: International Monetary Fund).  

### Capital Account Liberalization and Financial Openness
- Chinn, Menzie D., and Hiro Ito, 2008, “A New Measure of Financial Openness,” Journal of Comparative Policy Analysis, Volume 10, Issue 3, pp. 309–22 (September).  
- Eichengreen, Barry, 2001, “Capital Account Liberalization: What Do Cross-Country Studies Tell Us?” World Bank Economic Review, Vol. 15, No. 3, pp. 341–65, (Washington).  
- Fischer, S., 1998, “Capital-Account Liberalization and the Role of the IMF,” in “Should the IMF Pursue Capital-Account Convertibility?” ed. by P. Kenen, Princeton Essay in International Finance, No. 207.  
- Kaminsky, Graciela, and Sergio Schmukler, 2003, “Short-Run Pain, Long-Run Gain: The Effects of Financial Liberalization,” NBER Working Papers No. 9787.  
- Lardy, Nicholas, and Patrick Douglas, 2011, “Capital Account Liberalization and the Role of the Renminbi,” Peterson Institute for International Economics Working Paper No. 11-6 (February 23).  
- Prasad, Eswar, and Raghuram Rajan, 2008, “A Pragmatic Approach to Capital Account Liberalization,” Journal of Economic Perspectives, Vol. 22, No. 3, pp. 149–72.  
- Quinn, Dennis P., 2003, “Capital Account Liberalization and Financial Globalization, 1890–1999,” International Journal of Finance and Economics, 8 (July) pp. 189–204.  
- Rodlauer, Markus, and Papa N’Diaye, 2013, eds., “IMF and PBC Joint Conference on Capital Flows Management: Lessons from International Experience,” International Monetary Fund and People’s Bank of China.  
- Sedik, Saadi Tahsin, and Sun, Tao, 2012, “Effects of Capital Flow Liberalization—What is the Evidence from Recent Experiences of Emerging Market Economies? (November) IMF Working Paper 12/275 (Washington).  

### China-Focused Studies and Capital Flows to Emerging Markets
- Benelli, Roberto, 2011, “Potential Impact on Global Bond Markets of Reallocating Reserves,’’ China: Spillover Report for the 2011 Article IV Consultation and Selected Issues, (Washington: International Monetary Fund).  
- Guo, Kai, 2011, “China’s Closed Capital Account and Capital Flows to Emerging Markets,” China: Spillover Report for the 2011 Article IV Consultation and Selected Issues (Washington: International Monetary Fund).  
- Guonan, Ma, and Robert McCauley, 2003, “Opening China’s Capital Account Amid Ample Dollar Liquidity,” BIS Papers chapters, in: Bank for International Settlements, China’s Capital Account Liberalization: International Perspective, Vol. 15, pp. 25–34, (Bank for International Settlements. ed.).  
- He, Dong, Cheung, Lillian, Zhang, Wenlang, and Wu, Tommy T., 2012, “How Would Capital Account Liberalization Affect China’s Capital Flows and the Renminbi Real Exchange Rates?” China and the World Economy, Vol. 20, No. 6, pp. 29–54.  
- Groombridge, Mark, 2001, “Capital Account Liberalization in China: Prospects, Prerequisites, and Pitfalls,” Cato Journal, Vol. 21, No. 1, pp. 119–31.  
- Li, Dongping, 2008, “Mis-invoicing in Trade Transaction of China and its Effects on Monetary Policy in Recent Years,” International Economic Review, Vol.3, pp. 1–15.  
- Mei, Jianping, Jose A. Scheinkman, and Wei Xiong, 2009, “Speculative Trading and Stock Prices: Evidence from Chinese A-B Share Premia,” Annals of Economics and Finance, Vol. 10, No. 2, pp. 225–55.  
- Yan, May; Mimi Kong; and Sean Hung, 2013, “Containing China’s Wealth Management Market and Impacts on the Financial System—Revisiting the Key Issues,” Barclays Equity Research.  

### Financial Integration, Capital Flows, and International Investment Patterns
- Bertaut, Carol, and Linda Kole, 2004, “What Makes Investors Over or Underweight? Explaining International Appetites for Foreign Equities,” International Financial Discussion Papers No. 819. Board of Governors of the Federal Reserve System.  
- Forbes, Kristin, 2010, “Why Do Foreigners Invest in the Unites States?” Journal of International Economics, Vol. 80, No. 1, pp. 3–21.  
- Lane, Philip, and Gian Maria Milesi-Ferretti, 2008, “International Investment Patterns,” Review of Economics and Statistics No. 90 (3), pp. 538–49.  
- Schindler, Martin, 2009, “Measuring Financial Integration: A New Data Set,” IMF Staff Paper, Vol. 56, No. 1, pp. 222–38 (Washington).  

### Methodological and Empirical Techniques
- Harding, D., and A. Pagan, 2002, “Dissecting the Cycle: A Methodological Investigation,” Journal of Monetary Economics, Vol. 49, pp. 365–81.  
- Taylor, Mark, and M. J Artis, 1989, “U.K. Exchange Controls: Effects of Abolition,” CEPR Discussion Paper No. 294.  

*Source: _wp13189 - REFERENCES*

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