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Unlike other crisis-ridden developing
countries (e.g., Mexico, Republic of Korea,
Thailand and Brazil) known by their
utilization of foreign capital, China
weathered the storm in 1997 safe and sound.
However, some analysts argue that China
would have been involved if the Asian
financial crises had come two years later.
Many academic papers like Huang and Yang
(1998) attribute China’s survival from the crises
to the strict control of its capital account, while
disregarding the fact that China was no better
than the crisis-ridden countries in its capital and
financial account.
During the period between 1996 and 1998,
China witnessed a big drop in its capital
account, which was similar to those of
Thailand and Republic of Korea. Although
China intensified its control on the capital
account, it was not easy to identify some
flows between capital account and current
account.
Therefore, the outflow of capital remained
unchecked. Once a country is integrating
itself into the world economy, control on its
capital account will become less effective. It
is worthwhile to re-study all the economic
variables between China and those crisisridden countries comparatively in order to
identify those factors exclusive to China.
The success of China’s economic reform is
unique. China never follows the suit of
other countries, no matter what approaches
they may take, such as “sequencing” or
“big bang”. Instead, China adapts itself to
its own environment and takes full
advantage of it.
Many previous studies on capital account
liberalization have referred to financial
crises. Kaminsk and Reinhart (1999) even
measure the timing between financial
liberalization and crises with many
developing countries in their samples.
Their empirical studies imply that financial crises
(in the form of currency crisis, banking crisis, and
balance-of-payment crisis) seem inevitable after
liberalization of capital account. Will this pattern
be true of China?
This paper searches for the fundamentals
of China’s economy by reviewing how
China pulled through the Asian financial
crisis. Based on the findings, three
characteristics are identified and will be
displayed in China’s liberalization of the
capital account.
First, China has made continuous efforts to
introduce foreign capital with exportorientation. As long as the trade balance
remains in surplus, foreign investors will
place high credibility on China’s economy
and this will affect their investment
behavior.
Second, convertibility under the capital account
should first extend to “the overseas Chinese” in
close vicinity since investment from Hong Kong,
Macao and Taiwan (HKMT) dominates foreign
investment in the Mainland. If this portion of
investment remains stable, there will be a
snowball effect both by their reinvestment and by
their followers.
Finally, a more flexible exchange rate mechanism
is needed to cope with capital flight, which is
rampant in China. At present, more investment
opportunities should be provided for its domestic
residents with foreign currency holdings. Past
experience will shed light on China’s next step
towards convertibility under the capital account.
China distinguishes itself by its pragmatic
approaches towards convertibility under the
capital account. To take advantage of all the
abundant factors that China already has is one of
them. These may also include geographic location,
historical and cultural ties which cannot be found
in other economies. We just outline China’s
special features in detail.
1. Export orientation and promotion are
embodied in China’s utilization of foreign capital.
This implies that China welcomes foreign direct
investment (FDI), because most FDI bears the
obligation to export those goods processed with
imported materials. This also suggests that China
is not interested in indirect foreign capital in the
form of securities and bank loans. Therefore, all
fictitious transactions in the securities market,
real estate, and banking sector have been put
under close scrutiny.
FDI does not demand convertibility under the
capital account immediately, and it
simultaneously creates job opportunities for the
unemployed. In fact, the processing industries
(the main form of FDI) not only take advantage
of China’s abundant factor—labor, but also
generate foreign exchange receipts, which account
for nearly 40 percent of China’s total exports.
During the Asian financial crisis in 1997, while
other crisis-ridden countries were suffering “runs
on banks”, depletion of foreign exchange reserves
and trade balance deficit, China stood firm with
growth of its exports.
As indicated by the components of foreign capital
in the period of the financial crisis, short-term
capital (such as bank liability and others) took
the lead in the flight, followed by portfolio
investment (equity securities might take time to
encash), and FDI demonstrated no sign of leaving.
However, this does not imply that FDI is selffulfillment of export. Russia also introduced FDI,
but without any export obligation, thus, Russia
also got into trouble.
The trade balance serves as a
comprehensive index of a country’s
economic fundamentals. It weighs heavily
in the foreign investors’ decision-making.
Further study of China’s trade balance
discloses more information.
Only China indicates that its trade balance is
highly correlated with its GDP and FDI, whereas
the results of Thailand and Republic of Korea
demonstrate no such relationship. The strong
correlation also implies that the “export
multiplier” is high in China. Thus, export growth
contributes greatly to China’s GDP.
Correlation Test on Thailand’s
Variables 1983-1999
Trade balance
Exports
GDP
FDI
Portfolio
Banks
Trade
balance
1.0000
0.5113
0.3473
0.7181
-0.3187
-0.7915
Exports
GDP
FDI
Portfolio
Banks
1.0000
0.9771
0.8944
0.4132
-0.2994
1.0000
0.8250
0.5085
-0.1402
1.0000
0.0573
-0.5949
1.0000
0.4972
1.0000
Correlation Test on Korea’s Variables
1983-1999
Trade balance
Exports
GDP
FDI
Portfolio
Banks
Trade
balance
1.0000
0.0972
0.1404
0.5856
-0.4884
-0.5681
Exports
GDP
FDI
Portfolio
Banks
1.0000
0.9871
0.7948
0.7344
0.1053
1.0000
0.8119
0.7149
0.0612
1.0000
0.2730
-0.2765
1.0000
0.4567
1.0000
Correlation Test on China’s Variables
1983-1999
Trade balance
Exports
GDP
FDI
Portfolio
Banks
Trade
balance
1.0000
0.9082
0.8961
0.7902
0.2062
-0.6925
Exports
GDP
FDI
Portfolio
Banks
1.0000
0.9932
0.9550
0.2668
-0.7857
1.0000
0.9641
0.2671
-0.7805
1.0000
0.4170
-0.7806
1.0000
-0.3988
1.0000
However, some scholars express concerns. Yang
Fan (2000) calculates that accumulated profits of
FDI in China will reach 2 thousand billion yuan
in 5 years time. This amount is equal to China’s
foreign exchange reserves. If these foreign
investors demanded convertibility, there would be
a crisis in China, as it happened in Thailand in
1997.
As long as the trade balance maintains favorable,
China will not be exposed to such a crisis since its
FDI correlates closely with its exports. Therefore,
Zhang Li-qing (1999) advocates full liberalization
of FDI before portfolio investment in the
sequencing of capital account convertibility.
At present, as between-country mergers become a
popular form of international capital movement,
China is reconsidering its policy towards portfolio
investment. Gradual relaxation of the securities
market is now under way. Listing of foreign
companies and share holding between domestic
and foreign companies are on the cards (see Liu
Yong, 2001).
2. Investment from Hong Kong, Macao and
Taiwan constitutes the dominant share of
“foreign capital” in China. This unique
situation was significant during the Asian
financial crisis. In 1999, nearly half of the
FDI originated from HKMT
Common culture (language) and close vicinity
(no time lag) offset the “asymmetric information”
between the Mainland and HKMT. Therefore,
“moral hazard”, “adverse selection” and
“herding behavior” become less serious. To some
extent, investment from HKMT can be regarded
as an enlarged domestic investment.
Moreover, the foreign exchange reserves in
Mainland China, Hong Kong SAR and Taiwan
province rank second, third and fourth
respectively in the world. If they joined together,
they could counteract any financial disturbances.
Since the Hong Kong dollar can be invested
directly in the Mainland, the demand for
convertibility under the capital account is not so
urgent.
This can be verified by the performance of Bshares in China’s securities market The market
share of HKMT has kept relatively stable for a
long time. Although being affected by
international interest rates (adjustment of the
interest rates in the US and Japan), the
investment of HKMT will not withdraw easily
from the Mainland after cost comparisons, which
comprise geographic location, transportation,
information dissemination and other facilities.
Statistics of FDI in Mainland China
Country and Region
Total
Asia
Hong Kong SAR, Macao SAR
and Taiwan province
ASEAN countries
Singapore
Japan
Korea
Africa
Europe
European Community
Germany
Britain
Latin America
North America
USA
Oceania
Australia
Amount
4,183,696
2,815,667
Share
1.00
0.67
2,049,868
0.49
328,634
264,252
306,358
128,025
19,606
496,693
464,886
137,363
104,494
321,835
462,284
422,255
67,611
26,676
0.08
0.06
0.07
0.03
0.00
0.12
0.11
0.03
0.02
0.08
0.11
0.10
0.02
0.01
Number of B-share Investors until Nov. 2000
Country and Region
Mainland
Hong Kong SAR, Macao
SAR, Taiwan province
United States
Japan
Great Britain
Canada
Australia
Singapore
Germany
France
Korea
Netherlands
Others
Total
Accumulated No
98,178
*4Jan.--Nov.
39,769
*4Nov.
5,243
16,675
3,607
361
7,484
2,812
1,483
1,887
1,868
1,223
444
388
354
250
4,868
137,914
1,630
623
180
497
464
240
110
108
77
51
1,091
176
44
10
49
43
19
11
6
5
6
111
Furthermore, since 1993 the fixed exchange rate
between RMB and HK dollar has reduced the
exchange risks to which the returns from
investment might be exposed (no need for the
covered interest arbitrage). The gap in interest
rates between the Mainland and HKMT is also
trending down.
With the declining of global interest rates, the economic
growth in the Mainland will be attractive to “the overseas
Chinese”. This distinguishes China from other East Asian
countries, who have no such “overseas Chinese”
investment. This helps to bridge the gap between domestic
savings and investments. Recent lifting of restrictions on
access to the B-share market by domestic residents sent a
signal from the administration. Hong Kong residents
responded with great enthusiasm in their investment in Bshares. So did the residents from Taiwan, who
circumvented the “penalty threat” and remitted billions of
dollars.
China’s coastal areas, Guangdong and Fujian in
particular, are flourishing with the investment
from HKMT. On the whole, these HKMT
investors are more successful than other foreign
investors because they are well versed in the
situations of the Mainland.
Small as they are, the enterprises, 73
percent of them originating from Hong
Kong have accumulated a large amount of
capital for reinvestment in the Mainland.
As Hong Kong is an international financial
center as well as an entrepot, the other
foreign investors will be influenced
accordingly.
They will follow their predecessors in their
investment pattern. In order to facilitate the
HKMT investment, convertibility under the
capital account should be first extended to Hong
Kong dollar and then to the other currencies.
Only after full utilization of HKMT investment,
will China put on the agenda to liberalize the
capital account (i.e., realization of convertibility
towards all currencies).
3. It is imperative to establish a more flexible exchange
rate mechanism to control capital flight. The scale of such
flight in China is so large as to be ranked the fourth in the
world (after Venezuela, Mexico and Argentina). The
volume of such flight could be seen before and after
unification of the official exchange rate and swap market
rate in 1994. In order to take advantage of RMB
devaluation (1994), a huge amount of foreign exchange
receipts (mainly via export under-invoicing) suddenly
altered direction and started to flow in just before the
devaluation and then the flight resumed its previous
tendency again.
This movement (fluctuation of foreign
exchange receipts) had an adverse impact
on China’s exchange reserve management
and monetary policy. Much literature has
been written on the measurement of capital
flight. It is universally acknowledged that
“error and omission” in China’s balance of
payment contains a lot of information
about the flight.
A sampling inquiry was made in four cities
(Harbin, Lanzhou, Wuhan and Beijing) by
the Research Institution of International
Finance, Bank of China. The report
indicates that expectation of RMB
devaluation is the main motive for foreign
exchange holding among urban residents.
As long as such expectation exists, capital
flight will continue. A question thus arises:
Is the RMB over-valued at present? Debate
concerning the pro’s and con’s of RMB
devaluation, as well as the floating
mechanism (a wider trading band or target
zone) has reached no conclusion so far.
However, some adjustments in the exchange
mechanism cannot be avoided especially after
liberalization of the capital account. In addition,
the so-called “triangle problem” will trouble the
policy-makers in their selection of exchange rate
system. The “triangle problem” makes it clear
that an economy cannot reach three objects
simultaneously, i.e., autonomy in domestic
monetary policy, fixed exchange rate system, and
liberalization of capital account.
Definitely China will not surrender its
autonomy in monetary policy, this leaves
only two options after liberalization of
capital account: either to float
independently against US dollar or float
jointly with Hong Kong dollar against US
dollar. The following diagram illustrates
this vision.
Capital Account
Control
Liberalization
Three Options for China
RMB
HK$
US$
US$
RMB
HK$
HK$
US$
RMB
Notes
Continue to peg US$
Float jointly against US$
Float independently against US$
After all, economic stability in Hong Kong
will be a preponderant consideration. The
currency board system in Hong Kong has
survived many contagious financial crises.
With the exchange rate of Hong Kong
dollar under consideration, any
adjustments to the RMB exchange rate
mechanism will not be done unilaterally.
It will be “a hard nut to crack” to sustain
the stability of Hong Kong while removing
the expectation of RMB devaluation.