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Transcript of an Economic Forum
Foreign Direct Investment in China: What Do We Need To Know?
International Monetary Fund
IMF Auditorium
Thursday, May 2, 2002
Washington, D.C.
...........
by Markus Rodlauer, Division Chief, Asia and Pacific Department, IMF
I'll talk briefly about the outlook for convertibility of the renminbi and the further liberalization of the capital account.
As you all know, China has started in the late 1970s, early 1980s by opening up its foreign trade regime and foreign direct investment regime, and recently has then also opened a bit the portfolio inflows. Two recent milestones in external liberalization were the unification of the exchange rate system in 1994 and then the achievement of current account convertibility in 1996. That means today exporters or importers basically can do their transactions and get foreign exchange if they can prove they have an underlying current transaction.
However, there still are extensive capital controls. China basically maintains these very tight controls on the capital account for several policy reasons. First, it allows scope for an independent monetary policy and at the same time keeping a stable exchange rate. Second, it limits the vulnerability to capital flow reversals. And, third, it helps to protect certain domestic industries.
So in the current regime, as I said, FDI is fairly open, so it's a very encouraging attitude to foreign investment. But one should still remember it's very tightly regulated on an individual basis. For each deal, for each foreign investment that comes in, there are very precise conditions specified at the outset on employment, on the way of financing and how much money has to be brought in and so forth.
Then there are the portfolio and other capital flows like loans. Those, again, are very tightly, strictly controlled, and the way the control system works is that it's segregated between domestic enterprises, domestic agents, and foreign enterprises, foreign agents.
So, for example, in the equity markets, there are two divided markets. One is for domestic residents and domestic renminbi. You can buy and sell stocks if you're a Chinese citizen and have renminbi. This is one side of the market. The other side of the market is foreigners with foreign exchange who can buy another type of stocks. This has recently been opened up a bit. Some domestic residents now can buy foreign stocks, B market stocks, but still this principle pretty much applies to all the capital account transactions, loans and so forth.
So while these capital controls, as I said, are fairly comprehensive from a regulatory perspective, they have proven to be not watertight. Particularly during the Asian crisis, we have seen a very large amount of disguised outflows, and you'll recall the numbers in the first table where we had about 50 billion of outflows, which really there isn't a very good explanation for. These large outflows during the Asian crisis then prompted some tightening of these controls by the authorities, and they were somewhat effective but, still, we have fairly large unexplained outflows.
Now, where do we go from here? Should and will China further open its capital account? Clearly, there is a strong case for China to eventually open up the capital account with the ultimate goal of full convertibility. I don't think it's necessary to restate the quite well known overall benefits of convertibility. In one way, it's unavoidable. Every advanced economy today has an open capital account, and, specifically what's in there for China, clearly it would provide access to cheaper financing, new technologies, and for individual Chinese agents, access to much more diversified and risk-balanced portfolios; and in the end it would result in higher investment and higher growth. And also given the difficulties of actually keeping capital controls in place effectively, it is in the end, in the long run, inevitable, particularly since, as Nick has explained, WTO now has created concrete commitments of the authorities to integrate the financial sector much more.
Now, one could conceivably think that these financial sectors could become integrated but still keeping capital controls. But the more you integrate in the real side and have businesses coming in and out, the more pressure there will be to actually allow also a freer flow of capital. So, in the end, I think it will become inevitable, and it is, I think, a very appropriate long-term goal. And it is, therefore, not surprising, and appropriate, that China itself has stated explicitly and set itself these goals, this long-term goal.
While the benefits are very well known of capital account liberalization, so are, of course, the risks. Capital account liberalization affects financial stability through two main interrelated channels. On the one hand, there is the risk of overheating from very large capital inflows, and, on the second part, on a more micro level, opening up the capital account to free flows of capital across borders really allows excessive risk taking by individual enterprises, and especially banks. And so that from the micro level, it fosters, because of the well-known problem of asymmetric information, the risks that banks just go overboard and assume excessive risk and excessive liabilities.
These conditions raise the risk of sudden reversals of these capital flows, which could then lead to external payments crises and, therefore, large output losses and welfare losses.
A third risk which we have learned in recent years also is that initial shocks in one country to one economy, to one financial system, can be transmitted and spread much more easily to other countries through the so-called contagion effect if you have an open capital account.
Now, the Chinese authorities, of course, are very well aware of this risk and have, therefore, chosen a very deliberate and a very gradual path of capital account liberalization. And the authorities—when you ask them why is it that you keep your capital account still under control, what they mostly mention very specifically is that until their enterprises and their banks are reformed and have tight budget constraints and behave in a commercial manner, they are afraid that you would just have excessive borrowing, huge excessive borrowing, like we have had in many other transition economies, where increased latitude for enterprises and banks to make economic decisions without having the commercial orientation, the tight budget constraints, leads to huge excessive borrowing and, therefore, instability. And the second reason they mention is that their still fairly narrow capital markets could lead to very large volatility if you have uncontrolled flows across the border.
So how then to go about capital account liberalization? Well, two broad lessons from the country experience in recent years we have drawn is that those countries that have avoided crises are those that have strong macroeconomic policies and those that have a strong financial system. For China, on the macro side, I think they rank very well on one of three items, which is the external position. It's very, very strong as we know. But there are two other issues that are still to be resolved. One is you need to have sustainable public finances, which in China is still something to work on given the problems in the enterprises and in the banks. And then also the choice of the exchange rate regime, the more you open up your capital account, the more it will be necessary to have a flexible exchange rate system. And also given the very large structural changes underway in the economy, our advice has been in recent years increasingly that at some point China will have to move from its currently fixed exchange rate or very stable exchange rate system to greater flexibility gradually.
So on the macro side, there is still some work to do on the public finances and on the exchange rate and monetary policy side. In the banking and SOE side,—certainly it's key to rehabilitate the state-owned enterprises and the state-owned banks before you can think of substantially further opening up the capital account. You need a strong prudential system to contain excessive risk taking, and you need good accounting, auditing, disclosure standards to allow information to be transmitted to the markets, as well supervisors.
So, there is a large work program ahead to be able to reach this ultimate goal of convertibility, but I'd like to emphasize another point here, too. Our experience has been that opening up and liberalization is a very complex and interrelated enterprise. And while full liberalization has to come, of course, at the later stages, one cannot really wait with individual opening up until everything is perfect. Market reforms, as I said, are inter-dependent. For example, markets will not develop at all unless you open up a bit. So one has to do many of these things in tandem and gradually at the same time, which necessarily creates uncertainties and is certainly a volatile enterprise. But one has to start somewhere, and then the key is, of course, to monitor very closely, very carefully, and to be very flexible along the way and implement carefully.
China I think has got it quite right from the beginning in terms of the sequencing of what flows to open first and what last. It started with FDI. It then went over to portfolio equity flows in the stock market, and other debt-creating flows, particularly in the short end, should come last.
So, in conclusion, maybe three points. One is convertibility certainly is a valid long-term goal, and the authorities have adopted it. However, it needs to be very carefully phased in and supported by reforms and appropriate macro policies. It is, however, an inevitable process that will come, and certainly WTO accession has provided further impetus both for the actual integration of China's economy to the rest of the world, for the further opening of the capital account, and for all the necessary supporting reforms.
Thank you.
Foreign Direct Investment in China: What Do We Need To Know?
International Monetary Fund
IMF Auditorium
Thursday, May 2, 2002
Washington, D.C.
...........
by Markus Rodlauer, Division Chief, Asia and Pacific Department, IMF
I'll talk briefly about the outlook for convertibility of the renminbi and the further liberalization of the capital account.
As you all know, China has started in the late 1970s, early 1980s by opening up its foreign trade regime and foreign direct investment regime, and recently has then also opened a bit the portfolio inflows. Two recent milestones in external liberalization were the unification of the exchange rate system in 1994 and then the achievement of current account convertibility in 1996. That means today exporters or importers basically can do their transactions and get foreign exchange if they can prove they have an underlying current transaction.
However, there still are extensive capital controls. China basically maintains these very tight controls on the capital account for several policy reasons. First, it allows scope for an independent monetary policy and at the same time keeping a stable exchange rate. Second, it limits the vulnerability to capital flow reversals. And, third, it helps to protect certain domestic industries.
So in the current regime, as I said, FDI is fairly open, so it's a very encouraging attitude to foreign investment. But one should still remember it's very tightly regulated on an individual basis. For each deal, for each foreign investment that comes in, there are very precise conditions specified at the outset on employment, on the way of financing and how much money has to be brought in and so forth.
Then there are the portfolio and other capital flows like loans. Those, again, are very tightly, strictly controlled, and the way the control system works is that it's segregated between domestic enterprises, domestic agents, and foreign enterprises, foreign agents.
So, for example, in the equity markets, there are two divided markets. One is for domestic residents and domestic renminbi. You can buy and sell stocks if you're a Chinese citizen and have renminbi. This is one side of the market. The other side of the market is foreigners with foreign exchange who can buy another type of stocks. This has recently been opened up a bit. Some domestic residents now can buy foreign stocks, B market stocks, but still this principle pretty much applies to all the capital account transactions, loans and so forth.
So while these capital controls, as I said, are fairly comprehensive from a regulatory perspective, they have proven to be not watertight. Particularly during the Asian crisis, we have seen a very large amount of disguised outflows, and you'll recall the numbers in the first table where we had about 50 billion of outflows, which really there isn't a very good explanation for. These large outflows during the Asian crisis then prompted some tightening of these controls by the authorities, and they were somewhat effective but, still, we have fairly large unexplained outflows.
Now, where do we go from here? Should and will China further open its capital account? Clearly, there is a strong case for China to eventually open up the capital account with the ultimate goal of full convertibility. I don't think it's necessary to restate the quite well known overall benefits of convertibility. In one way, it's unavoidable. Every advanced economy today has an open capital account, and, specifically what's in there for China, clearly it would provide access to cheaper financing, new technologies, and for individual Chinese agents, access to much more diversified and risk-balanced portfolios; and in the end it would result in higher investment and higher growth. And also given the difficulties of actually keeping capital controls in place effectively, it is in the end, in the long run, inevitable, particularly since, as Nick has explained, WTO now has created concrete commitments of the authorities to integrate the financial sector much more.
Now, one could conceivably think that these financial sectors could become integrated but still keeping capital controls. But the more you integrate in the real side and have businesses coming in and out, the more pressure there will be to actually allow also a freer flow of capital. So, in the end, I think it will become inevitable, and it is, I think, a very appropriate long-term goal. And it is, therefore, not surprising, and appropriate, that China itself has stated explicitly and set itself these goals, this long-term goal.
While the benefits are very well known of capital account liberalization, so are, of course, the risks. Capital account liberalization affects financial stability through two main interrelated channels. On the one hand, there is the risk of overheating from very large capital inflows, and, on the second part, on a more micro level, opening up the capital account to free flows of capital across borders really allows excessive risk taking by individual enterprises, and especially banks. And so that from the micro level, it fosters, because of the well-known problem of asymmetric information, the risks that banks just go overboard and assume excessive risk and excessive liabilities.
These conditions raise the risk of sudden reversals of these capital flows, which could then lead to external payments crises and, therefore, large output losses and welfare losses.
A third risk which we have learned in recent years also is that initial shocks in one country to one economy, to one financial system, can be transmitted and spread much more easily to other countries through the so-called contagion effect if you have an open capital account.
Now, the Chinese authorities, of course, are very well aware of this risk and have, therefore, chosen a very deliberate and a very gradual path of capital account liberalization. And the authorities—when you ask them why is it that you keep your capital account still under control, what they mostly mention very specifically is that until their enterprises and their banks are reformed and have tight budget constraints and behave in a commercial manner, they are afraid that you would just have excessive borrowing, huge excessive borrowing, like we have had in many other transition economies, where increased latitude for enterprises and banks to make economic decisions without having the commercial orientation, the tight budget constraints, leads to huge excessive borrowing and, therefore, instability. And the second reason they mention is that their still fairly narrow capital markets could lead to very large volatility if you have uncontrolled flows across the border.
So how then to go about capital account liberalization? Well, two broad lessons from the country experience in recent years we have drawn is that those countries that have avoided crises are those that have strong macroeconomic policies and those that have a strong financial system. For China, on the macro side, I think they rank very well on one of three items, which is the external position. It's very, very strong as we know. But there are two other issues that are still to be resolved. One is you need to have sustainable public finances, which in China is still something to work on given the problems in the enterprises and in the banks. And then also the choice of the exchange rate regime, the more you open up your capital account, the more it will be necessary to have a flexible exchange rate system. And also given the very large structural changes underway in the economy, our advice has been in recent years increasingly that at some point China will have to move from its currently fixed exchange rate or very stable exchange rate system to greater flexibility gradually.
So on the macro side, there is still some work to do on the public finances and on the exchange rate and monetary policy side. In the banking and SOE side,—certainly it's key to rehabilitate the state-owned enterprises and the state-owned banks before you can think of substantially further opening up the capital account. You need a strong prudential system to contain excessive risk taking, and you need good accounting, auditing, disclosure standards to allow information to be transmitted to the markets, as well supervisors.
So, there is a large work program ahead to be able to reach this ultimate goal of convertibility, but I'd like to emphasize another point here, too. Our experience has been that opening up and liberalization is a very complex and interrelated enterprise. And while full liberalization has to come, of course, at the later stages, one cannot really wait with individual opening up until everything is perfect. Market reforms, as I said, are inter-dependent. For example, markets will not develop at all unless you open up a bit. So one has to do many of these things in tandem and gradually at the same time, which necessarily creates uncertainties and is certainly a volatile enterprise. But one has to start somewhere, and then the key is, of course, to monitor very closely, very carefully, and to be very flexible along the way and implement carefully.
China I think has got it quite right from the beginning in terms of the sequencing of what flows to open first and what last. It started with FDI. It then went over to portfolio equity flows in the stock market, and other debt-creating flows, particularly in the short end, should come last.
So, in conclusion, maybe three points. One is convertibility certainly is a valid long-term goal, and the authorities have adopted it. However, it needs to be very carefully phased in and supported by reforms and appropriate macro policies. It is, however, an inevitable process that will come, and certainly WTO accession has provided further impetus both for the actual integration of China's economy to the rest of the world, for the further opening of the capital account, and for all the necessary supporting reforms.
Thank you.
Until I am told the contrary, of course ...
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