1. Why China should Still be Cautious in Capital Account Liberalization? Ming Zhang Institute of World Economics and Politics Chinese Academy of Social Science August 2015 Beijing zhangming@cass.org.cn 1

2. Outline The current capital outflow in China; Why China should still be cautious in capital account liberalization? – Domestic perspective; – International perspective; – Combining domestic and international perspectives; – New evidence and new trends arguing for capital flow management; Policy suggestions. 2

3. The evolution of China’s twin surpluses 3

4. China has been facing persistent capital outflow in the past 5 quarters 4

5. The current capital outflow has been driven by other investment outflow 5

6. Both residents and non-residents played significant roles in the current other investment outflows 6

7. The current capital outflow is closely related to the change of RMB exchange rate expectations 7

8. RMB began to face depreciation pressure against USD since 2014Q2 8

9. The reason is the effective exchange rate of RMB appreciate too fast since 2014 9

10. Why China should still be cautious in capital account liberalization? (1) Domestic perspective: – The declining of China’s economic growth and the loosening of China’s monetary policy; – The deleveraging of corporate sector, the downward adjustment of property market, and the burgeoning of local government debts; – The negative impact to commercial bank sector from RMB interest rate liberalization; – The reverse of RMB exchange rate appreciation expectation; – The slowdown of labor productivity growth due to structural adjustment; – The shallow and immature financial market under non-unified and ill- coordinated regulation regime; Case: the current boom and crash of stock market; – Unsettled uncertainties in both economic and non-economic issues. 10

11. Why China should still be cautious in capital account liberalization? (2) International perspectives: – The recovery of US economy and the relating normalization of US monetary policy; – The rise of risk aversion of international investors; – The capital outflow pressure faced by emerging markets; – The threat of persistent stagnation, international trade contraction and currency war; – The Euro zone sovereign debt crisis has not ended without a major debt-restructuring; 11

12. Why China should still be cautious in capital account liberalization? (3) Combining domestic and international perspectives: – If Chinese government accelerate capital account liberalization, there might be a persistent and large scale capital outflow; – The capital outflow and RMB depreciation expectation may reinforce each other; – The capital outflow might impair domestic financial stability, e.g. accelerating the corporate sector deleveraging and property market adjustment; – PBC might face a new dilemma: If it does not regulate capital outflow, there might be a systemic financial crisis; If it began to re-regulate capital outflow, its reputation might be impaired. – So why PBC is so hasty to liberalize the capital account? RMB internationalization? Speed up domestic reforms? 12

13. Why China should still be cautious in capital account liberalization? (4) New arguments for capital flow management: – Large short-term capital inflow has negative externality, therefore capital flow management might be desirable; – There is no significant evidence between free capital flow and economic growth; – Capital flow management should be a permanent, not a temporary macro-tool; – Under some circumstances, quantity-based measures are much more effective than price-based measures; – Re-introducing capital flow management would result in significant adjustment costs; After the global financial crisis, both IMF and some emerging market countries changed their attitudes toward capital flow management. 13

14. Policy suggestions Chinese government should put domestic structural adjustments on the top of its policy agenda. – If real economy reform lags too much behind financial reform, there might be some risks; Chinese government should speed up RMB exchange rate and interest rate reform, and try to mitigate the negative impacts of the above reform at the same time; Chinese government should strengthen the macro and micro-prudential management regimes; Chinese government should push forward capital account liberalization still in a gradual, controllable and cautious way; Chinese government should be prepared for the burst of financial crisis. 14