SUPPLIER AND TECHNOFIN®

Do China’s capital controls still bind? Implications for monetary autonomy and capital liberalisation

Divergent interpretations of the interaction of monetary and foreign exchange policies in China often arise from different assumptions about the efficacy of capital controls.

At one extreme is the view that capital controls merely change the form of capital flows without altering their magnitude.

On this interpretation, pegging the exchange rate or closely managing its path implies that China imports its monetary policy and lacks control over domestic short-term interest rates.

At the other extreme is the view that capital controls are still effective or binding enough to allow short-term interest rates to be set domestically, even though the exchange rate is managed.

The contrasts between these views sharpen in the context of growing cross-border flows under both the current and capital accounts over the past 10 years.

Different views on the status quo also inform the interpretation of the likely results of further liberalisation of capital flows.

Again, at one extreme, this would just unevenly lower transactions costs and thereby alter the mix of cross-border capital flows, but without necessarily affecting their total volume.

On this interpretation, capital account liberalisation might be of interest to specialists in international finance, but not to those who follow the Chinese macro economy.

And at the other extreme, capital account liberalisation would influence both the scale and composition of capital flows and ultimately force a choice between exchange rate management and an independent monetary policy.

Argument on the sustained interest rate differentials is that Chinese capital controls have continued to bind, despite the responsiveness of cross-border flows to price signals in an increasingly open economy.

These observed differentials cannot be plausibly accounted for by liquidity or credit factors. Even the narrowing of these differentials since the unpegging of the renminbi in July 2005 leaves them at substantial levels.

If capital controls still bite, future liberalisation is likely to proceed incrementally in order to accommodate a shifting balance of exchange-rate, and financial- and monetary-stability objectives.

The monetary autonomy narrowly defined in terms of the government’s ability to set short-term domestic interest rates.

Such a definition may be appropriate to many industrial countries where monetary policy has confined itself to setting a short-term interest rate.

In fact, China’s monetary policy employs a wide variety of other instruments, including setting administered deposit and minimum lending rates as well as quantitative measures like reserve requirements, lending quotas, window guidance and administrative restrictions on investment.

Such measures could give China’s monetary policy room for manoeuvre even if its short term interest rates were tightly constrained by the exchange rate policy.

Thus, a finding that short-term interest rates are not tightly constrained implies a fortiori monetary independence in the broader sense that is more relevant in the case of China.

In particular the test is whether onshore and offshore renminbi interest rates are substantially the same.

Recognising the practical difficulty of drawing appropriate comparisons given the low level of development of money markets in China, a comparison was introduced based on a newly introduced liquid instrument, the People’s Bank of China (PBC) bill.

The gap between renminbi and US dollar short-term interest rates during the period of de facto dollar pegging of the renminbi between the mid-1990s and July 2005, arguing that these rates converged as China’s inflation fell from double-digit levels in the early 1990s and not evidently since.

The responsiveness of various measures of capital flows to interest-rate differentials and exchange-rate expectations. Section 6 discusses challenges to China’s capital account liberalisation.

The China’s capital controls remain substantially binding.

They prevent the equalisation of onshore renminbi yields and those implied by offshore NDFs. We also find that the observed convergence of short-term interest rates between China and the United.

States was more characteristic of the mid- to late 1990s than of the years since.

With its remaining capital controls, China’s short-term interest rate setting seems less imported from the United States than either that of Hong Kong as a small open economy with a hard dollar peg or that of the euro area as a large economy with a flexible exchange rate.

That said, capital flows between China and the rest of the world do respond to interest rate differentials and to expected exchange rate changes.

The partial convergence of onshore and offshore renminbi yields since July 2005 as reflecting the authorities’ choice to act as if they were bound by interest rate parity.

That is, in the transition from the pegged regime, the Chinese authorities found it convenient to take the burden off the capital controls by signalling a rate of appreciation against the dollar that is broadly consistent with the dollar-renminbi interest rate differential.

It is recognised an element of unintended and temporary relaxation of capital controls resulting from financial market development getting ahead of the controls.

Over time, financial market development and further decontrols should pave the way for phased integration of China into the global market and diminish the importance of remaining controls.

However, the latest onshore/offshore gaps remain large and it would be premature to assume that the authorities would not test the effectiveness of capital controls in a major way as monetary and exchange rate policies evolve.

Finally, analysis suggests that the choices regarding liberalisation will affect more than the form of inflows.

Guonan Ma and Robert N. McCauley
Bank for International Settlements

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