Abstract
China has three major imbalances: a trade surplus, a capital account surplus and a large annual build up, and a very high level of international reserves. Capital flows, especially flows of US government securities, are also important in assessing the bilateral and overall imbalances in transactions. China has a capital account surplus reinforcing its current account surplus and the accumulation of foreign exchange reserves, mainly US dollar denominated assets. This is unusual because a sustainable fixed or floating requires that countries with large current account surpluses run capital account deficits.
The worst consequences of imbalances have been the build-up of large, low-return foreign exchange. These reserves have led to rapid growth in money and credit and, in turn, to a sharp acceleration in inflation, something that China had assiduously avoided since 1994 and that has raised serious doubts about the credibility of the monetary authorities and damaged its inflation-fighting reputation. Moreover, efforts to offset money growth and inflation have deepened existing inefficiencies in the financial system, which China had hoped to begin remedying by its efforts to recapitalize and list its banks’ equities on stock exchanges. China could eliminate these imbalances by policies that would reduce growth. An alternative solution is to lift restrictions on capital outflows, allowing households and business to diversify their wealth holdings and realize higher returns and/or less volatility in their own income and wealth. This would transform future asset growth from massive central bank holdings of US securities to holdings of higher return and lower risk assets abroad. Such a step also would eliminate pressures on the People’s Bank of China (PBOC), allowing for more rapid deregulation of banks, slower money, and credit growth and lower inflation.
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- 1.
The current account refers to Balance of Payments accounting where the current account measures the exports (credit, +) and imports (debit, –) of goods, services, income payments for resource services, and unilateral international transfers.
- 2.
See Tatom (2007) for a discussion of some of the arguments over the US–China trade imbalance and the likely lack of justification and the ineffectiveness of bilateral exchange rate or trade policy actions in eliminating a multilateral imbalance. Cheung et al. (2008) provide supporting evidence that the Renminbi is not misaligned so that efforts to force a currency appreciation are doomed to failure, as they did earlier (2007). See also Bailey and Lawrence (2006).
- 3.
In 2007, the US current account deficit with China was US $289.7 billion, 39.2% of the overall US current account deficit. China’s leading trade partner, the United States, accounts for 32.5% of China’s trade in goods and services, while the United States’ top trade partner, Canada, accounts for 16.8% of US trade; China, accounts for 10.3%.
- 4.
Phillips (2008) suggests that the overall US capital inflow is at risk because of concerns over future policy or simply the large indebtedness of the United States to the rest of the world. The diversification, liquidity, return, and safety benefits to foreign investors in the United States are not written in stone, and policy discussions and decisions over the past year raise doubts about the extent of those benefits in the future. The concentration of foreign exchange holding in a single increasingly risky name is more likely to be the tripwire for adverse global capital market developments.
- 5.
Goldstein and Lardy (2008) argue that the Chinese have not appreciated their currency enough since the amount allowed so far has been accompanied by a growing current account surplus and an acceleration on foreign exchange growth.
- 6.
Capital controls typically apply to inflows, but putting restrictions on inflows or outflows reduce incentives for foreigners to invest in a country. Chilean restrictions on capital inflows outflows from 1991-98 were expected to insulate the country from the sudden stops of capital inflows associated with the financial crises in Asia. Instead, the restrictions acted as a disincentive to invest in the country and the undesired fall in the capital account balance was accomplished by a surge in outflows instead of a decline in inflows. See Forbes (2007) for evidence of how these restrictions also raised the cost of capital for smaller traded domestic firms and Gallego et al. (2000) and Cowan and De Gregorio (2005) for overviews and lessons from the Chilean experience.
- 7.
Cappiello and Ferrucci (2008) focus on the importance of opening the capital account and moving toward a flexible exchange rate as sequenced steps to reduce the opportunity cost of a fixed exchange rate system. They do not single out the benefits of lifting capital outflow restrictions, however, which are emphasized here. People’s Bank of China Deputy Governor Xiang (2006) provides an excellent review of China’s financial sector and economic development and outlines the next steps to be taken. He notes the importance of a harmonious relation between economic development and development of the financial sector. He also points to the importance of developing internal financial markets and opening the sector to global competition.
- 8.
Chinese authorities have made recent changes in tax incentives for capital inflows that will reduce such investments, but these changes are strongly in the interest of promoting economic efficiency and equality and may actually boost the attractiveness of investing in China. Earlier, in order to promote direct investment, tax incentives were given that lowered the income tax rate paid by foreign firms. These may have been successful in priming the pump for foreign investment, but they misallocated capital and other resources within the economy. Ending those subsides will improve the integrity of the tax system and of economic policy, even if they have a slight negative effect on capital inflows. Unfortunately, regulators have offset the benefits of these steps by tightening restrictions on majority or even minority ownership of foreign acquisitions in the financial services industry and by regulatory delays in approving such acquisitions. Regulators have also cracked down on capital inflows that have come from inflated invoicing of exports, forcing more rapid and exact documentation to convert dollar receipts into Renminbi. Making foreign investment subject to changing and arbitrary rules, as well as limiting the potential for control of domestic financial firms severely diminishes the attraction of investing in China.
- 9.
See Beim and Calomiris (2001) for an extended discussion of the conditions and effects of repressed financial markets.
- 10.
Demirguc-Kunt and Levine (2008b) provide a detailed review of the literature on the finance-growth linkage and they provide new evidence that government policies have significant effects on the operations of the financial system and on access to financial services by large segments of the population. Their review shows that “The services provided by the financial system exert a first-order impact on long-run economic growth.” (p. 2).
- 11.
Some analysts argue that Asia, or at least China, is the exception to the rule that the quality of financial institutions is a critical determinant of economic growth and development. Maksimovic et al. (2008) find evidence that formal financial institution finance is associated with faster firm growth, but funds raised from alternative channels is not. Moreover, they find that this result is not due to the selection process for firms that have access to formal financial institutions.
- 12.
Porter (1998) emphasized the role of competition in open goods markets for upgrading the competitiveness of domestic enterprise and boosting economic growth. In the case of financial services firms, such improved competitiveness will arise through the import of capital from abroad.
- 13.
Demirguc-Kunt and Levine (2008a) provide evidence that the more developed the financial system is the lower is income inequality and poverty and the greater is access by low income households to financial services.
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Tatom, J.A. (2009). The Chinese Imbalance in Capital Flows. In: Barth, J., Tatom, J., Yago, G. (eds) China’s Emerging Financial Markets. The Milken Institute Series on Financial Innovation and Economic Growth, vol 8. Springer, Boston, MA. https://doi.org/10.1007/978-0-387-93769-4_9
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