HARMONIOUS DEVELOPMENT OF FX MARKET AND LIBERALIZATION OF CAPITAL CONTROLS IN CHINA

Capital control has served China reasonably well in fending off disruptive international capital movements, mobilising FX resources for national development projects, maintaining an independent exchange rate policy and ensuring FX availability for the functioning of the central planning system. However, the growing adverse effects make the reform to this regime inevitable.

The early reform led to considerable relaxation of restrictions on FX availability and introduction of market forces into China's exchange rate policy. The climax of the early reform was the establishment of convertibility on the current account in 1994, officially notified the IMF in 1996. After the Asian financial crisis, China has re-launched the reform in recent years, centred on relaxing controls over capital account transactions to achieve fundamental convertibility of the Chinese currency.

With a strategy of selective liberalisation, China is making impressive progress in reducing the intensity of capital controls, especially controls on outflow of capital. As a result, a new regime has emerged featuring free transactions in most international assets, including direct and portfolio investment, while keeping controls over a declining number of areas under the capital account.

Liberalisation of the capital account has created enormous opportunities for the development of China's FX market. But on the other hand, the advancement of the liberalisation programme has been impeded by inadequate market instruments and extremely thin market. The progress of capital account liberalisation therefore has to be administered within the scope and pace allowed for by the progress in redressing these major deficiencies of China's FX market.

The current regime framework

At present, the framework of China's capital controls consists of three pillars, i.e. controls over foreign debts, international portfolio investment and foreign direct investment.

The control over foreign debt covers Chinese government's liability, long or short-term, to foreign governments, international organisations, international banks, and companies. The control operation involves the size, structure, maturity and repayment of the debts. Planning permission and registration are also required. The types of debt subject to control extend to international loans, project financing, external collateral, and risk management.

In theory, both inward and outward investments are the remit of the control over international portfolio investment. However, as private Chinese residents are prohibited from buying foreign securities, the current regime centres on controlling overseas issuance of bonds by government bodies, listing of Chinese company's shares in overseas stock exchanges (including that in Hong Kong), and the issuance and transactions of B shares, which are a special type of Chinese shares denominated in US dollars and used to be traded only among non-Chinese residents in China.

The third pillar of China's capital controls is the management of foreign direct investment (FDI). China has been particularly successful in attracting FDIs. Controls in this field were traditionally focussed on inward FDI, including the amount of investment capital to be paid in, operational expenditures and receipts in foreign currency classified as capital account transactions, and external borrowings by FDI firms. But recently, this focus on inward FDIs is being gradually replaced by China's concern with outward FDI, especially outward FDI by Chinese companies.

Throughout the mid-1950s to the 1970s, the principle adopted by the Chinese government for capital controls was centralised management with unified operations. In the early reform years, this was modified as being centralised management of FX, uniform requirements for all units to balance FX expenditure and income, ensuring availability of FX for key projects, and allowing retention of foreign currency proceeds from trade and non-trade activities.

China's new policy stance now is that having achieved convertibility on the current account there is no rush to seek an open capital account. International experience has repeatedly shown that premature opening of the capital account is a receipt for financial crisis. At the current stage of China's economic preparedness, capital controls may have to remain in place to ensure adequate availability of external funding, maintain stability of the RMB exchange rate, promote restructuring of the domestic economy, protect the national economy especially the state sector, and safeguard financial stability.

Now that current account transactions are free and China will not go for a quick capital account liberalisation, the present principle for China's capital controls is reduced to concern the capital account only. Specifically, the new principle calls for capital account transactions to be subject to strict controls. Strict examinations, approvals, and registration procedures are required for all inward and outward investment, though FDIs are to be encouraged. Total amount of foreign debts will be restricted to an appropriate size and its structure be adjusted timely. Attention will be paid to economic efficiency in using foreign capital to ensure repayment of the principal and interest. Outward investment by Chinese enterprises is to be promoted with a view to further develop China's external sector.

Developments in the general policy regime

The official objective of China's FX liberalisation policy has been to gradually make its currency fully convertible. But despite its early progress in liberalising the FX system, China waited until 1993 to formally announce this intention, reflecting China's cautiousness in dealing with exchange controls issue from the onset.

The success of the 1994 FX reform programme boosted Chinese confidence to some extent. As a result, China's reform initiative briefly became bolder. In 1995, China confirmed again the convertibility plan adding that positive measures would be taken to create conditions for making the RMB convertible. Then in 1996, China confidently notified International Monetary Fund of RMB's partial convertibility on the current account.

The full RMB convertibility was only to be halted by the breakout of the Asian financial crisis in 1997. Quite unexpected, China's success in shielding the RMB exchange rate from speculative attacks generated a view within the country that capital controls were not bad or even desirable. Exchange controls consequently were tightened after 1997.

This was relieved when the Asian financial crisis was over. Especially, after 1998 when China intensified its bid for the WTO membership, calls for liberalising the FX system were rekindled. Since accession to the WTO in 2001, China has restated again that it will push for capital account convertibility.

One aspect often missing in the study of China's liberalising attempt is the definition of currency convertibility. What is really meant by convertibility could be quite different in China than conventionally understood. Chinese government economists at the central bank have talked about an intermediate plan for the "fundamental convertibility of the Chinese currency" (Jing 2000). This plan aims to achieve "total convertibility on the current account but conditional convertibility on the capital account" for RMB, meaning that some long-term capital account transactions will be allowed freedom but short-term capital movements will be prohibited, with all types of current account transactions being convertible.

Publicly, the Chinese authorities have never officially committed to a specific time for opening the capital account. Discussions on the sequence of decontrolling China's capital account are still ongoing within China. The preferred course by Chinese authorities seems to be one that first opens cross board investment in the real sector (direct investment), then frees portfolio investment in the second stage, and finally liberalises the whole financial sector to complete the reform course (Wu, 2000).

The emerging reform strategy

The recent developments of China's capital account policy suggest the reform is entering into a new stage. With a halting start, liberalisation of international capital movements across the board of China is underway and is gaining momentum. Although the pace may not be radically fast, the direction of the reform is well established, which is to go for a fundamental or basic convertibility rather than a completely free currency. With this aim, China is taking steps towards a total lifting of controls on all capital transactions but movements of short-term speculative capital.

From these recent policy move there has emerged a distinctive reform strategy, which many be characterised as a strategy of selective liberalisation. Under this strategy, China has carefully chosen one area at a time for reform while keeping other restrictions untouched rather than deregulate all controls in one go. The first chosen areas are usually those that may have more beneficial effects if reforms proceed well and will have less adverse effects if things go wrong. For example, the first area of China's capital account reform concerns the inward foreign direct investment. They in most cases can have positive contribution to the economy. However, having flowed into the country while economic conditions become worse, these investment projects usually will not suddenly exit the country hence will be less disruptive.

Once liberalisation of foreign direct investment met with success, China moved to decontrol portfolio investment. Initially, international investors were allowed only to trade among themselves foreign currency dominated shares. This is designed to attract hard currency funds into China while preventing depletion of official FX reserves should some international investors suddenly withdraw. Later on, this market is gradually opened wider to allow access by domestic residents. Next, barriers between investments by residents and non-residents are reduced and outflow of capital is allowed. This is the real significance of the emergence of the QFII scheme. Thanks to this scheme, foreign investors can fully engage the Chinese capital market as they now can have access to both the domestic and foreign currency segments. More importantly, under this scheme portfolio investment funds now are entitled to flow out of the country. Previously, foreign capital inflows are almost totally free while outflow of foreign capital is strictly regulated. Now this new established freedom for capital outflow, though has to be orderly, shows the old policy regime has started to crumble.

Although Chinese domestic residents now can fully participate in domestic capital market, their international investment opportunity however is limited. They can only trade dollar denominated B shares within China, no investment beyond the national board. However, granted that China's object is to achieve full convertibility, it is almost inevitable that permission would be given for qualified domestic institutional investors (the QDII scheme) to invest in foreign stock markets. Above all, it would be illogical that foreigners are allowed freedom to buy Chinese securities while Chinese residents are not able to invest in foreign markets.

Another distinctive aspect of China's emerging strategy is the reform's gradualist nature. The strategy to target selected areas of reform practically prescribes China to open its capital account gradually. This selective reform strategy entails the potential for the reform to expand from one area to another when conditions are ripe and the government has the courage to move forward. But the selection also means it will take some time for reforms to happen.

Such a gradualist strategy tends to enable China to avoid clustering of reform measures in a single period so that their shocking effects, if any, can be spread out. This is much in line with China's long-standing and successful strategy to general economic reforms that directs the reforms along the way of least resistance and minimum cost. It also takes in the fact that China's regulatory institutions are underdeveloped. This process is going to be slow and possibly protracted, but will not be infinite.

Closely related with the selective reform is the sequencing issue. China is noted internationally for its approach to phase in reforms. Although reforms may not be blueprinted ex ante, the phase-in approach to reforms has allowed China to achieve ex post consistency of economic transformation (Naughton, 1994). The reform to China's regime of capital controls comes as no exception. It has been revealed that the Chinese authorities will phase in the capital account liberalisation via three stages, which also spells out the sequencing of the reform. In the first stage, foreign direct investment is to be liberalised. The second stage focuses on liberalising international portfolio investment. The third, and final, stage sees the overall liberalisation of China's financial sector (Wu, 2000). China today has almost passed the test of the first stage and is well in the middle of the second. Currently, there are virtually no restrictions on inward foreign direct investment and restrictions on outward FDIs are being relaxed. For the main task of the second stage reform, i.e. the liberalisation of portfolio investment, recent developments as revealed in the previous section indicate that only outward portfolio investment by Chinese citizens is still subject to restrictions. However, if the QDII schemes are to be instituted, which is widely tipped to be so in the near future, liberalisation in this area will essentially be accomplished.

China has also made progress in the third stage tasks of opening up the whole banking system. There is a growing presence of international banks in China. As a result of China's commitment to the WTO membership, foreign banks will soon be allowed to do all types of banking business, including deposit and loan transactions in Chinese currency. Foreign securities firms will be fully functioning on the Chinese capital markets as well. Indeed, according to Bank of International Settlement' research (McCauley, 2000, and Icard, 2002), China's banking market is relatively open. In terms of foreign currency deposits as a percentage of broad money, China is actually more open than has generally been recognised (McCauley, 2000).

The final distinctive aspect of China's reform strategy is the promotion of a two-way flow of capital, i.e. not only foreign capital is free to flow across the Chinese board, the Chinese currency is also to be allowed free flow to international market. Radically different than conventional opening up of the capital account that essentially gives foreign capital free entry into and exit from the home country, this is about increased use of the Chinese currency internationally. Heated debate has been going on within China about the possibility of the RMB becoming a currency that is internationally acceptable in trade and investment. It is argued that, while foreign capital is allowed to flow freely into and exit China, more efforts should be made to promote the outflow of capital by Chinese investors seeking overseas investment opportunity. Preferably, the Chinese currency and capital can dominate this two-way traffic (Chen, 2002). The Chinese government has already taken steps in this direction. Notable examples include encouragement of outward Chinese FDIs, increased allowance for the Chinese currency being brought out of the country by Chinese residents (for a trip to Hong Kong, an individual now can take 30,000 RMB yuan out of the country while previously this was only 6,000 yuan), provision of government sponsored facilities for using the RMB in board trade transactions with China's neighbours. The newest development in this regard is the announcement by the Chinese government on 3 March 2003, which formally gave permission to allow China's foreign trade to be denominated in RMB. This carries the eventuality that the Chinese currency will become a vehicle currency for international trade and a currency for international settlement. As a result, there will soon emerge the overseas RMB balance in the accounts held by international business and perhaps also be used for investment purposes. These are all essential elements of an international currency.

Implications for the development of FX market in China

Recent developments suggest that as a major trading nation, China has accepted the inevitability of free capital movements in the process of integrating into the world economy. Now in China, to open or not to open the capital account is no longer a question under serious debate, but how and when are. In re-launching the programme of currency convertibility, China has so far made critical progress and more to come.

In this environment of sweeping capital account liberalisation, new windows of opportunity have appeared for the development of Chinese FX market. Relaxation of the capital policy has given China's FX market the best possibility in its modern history to grow in volume, market participation and exchange rte management, thus transforms the structure and functioning of the market in a profound way. Basically, the following are the most important areas of change that will drive dynamic transition in the market.

First, exchange rate management. As a result of recent controversies about the level of the RMB and its institutional arrangements, a regime shift is possible in the near future. The precise form of the future RMB exchange rate regime is not known now, but one thing is pretty certain that there will have a higher degree of flexibility in that regime than now. This implies the way the Chinese monetary authority manages the RMB exchange rate will have to change. Currently, the opening, closing and weighted average prices of the RMB against foreign currencies are formed after every session of trading in the CFETS. The weighted average price of USD/RMB is published by the People's Bank of China as the benchmark price for the next day's FX transactions by authorised banks. If China decides to adopt a basket peg, this system will become invalid. More attention will be paid to the composition of the basket, the overall band, if any, allowed for the rate fluctuations and monitoring of the daily rate movements. This calls for the switch of the focus of the operation room of the central bank, which plays a pivotal role in the functioning of the whole FX system.

If, on the other hand, China takes on a market-oriented managed float, even the nature of the central bank's operation room will be transformed. For such a managed floating regime, introduction of market forces is essential. This will involve direct or indirect participation of market players other than the central bank. Institutional arrangements then are needed for the participation of these institutions in the operation room to which the access was previously monopolized by the monetary authority. This may take the form of a pre-sessional meeting of major players to set the rate for the day under the supervision of the central bank. With the central bank standing in the background, this will give more room for the interactions between market supply and demand, which in the long run is beneficial to the health of China's financial system. More significant it will be when foreign banks are invited or entitled into this process, which will considerably enhance credibility of China's exchange rate policy.

The second area of possible change is market participants. Recent liberalisation has considerably relaxed restrictions on the access of enterprises and individuals to FX. We are witnessing a steady increase in corporate FX turnover as they are allowed to retain a growing share of their FX income through export. Although it is a worldwide trend that trading between banks and non-financial customers is declining, Chinese corporate customers have just started to enter the market with their newly found freedom, which makes it a rising market. Furthermore, given their limited exposure to international financial transaction, this also provides new niche business for banks to take over the administration of the FX activities and back offices of these companies. This type of outsourcing of activities will prove to be of huge potential.

Another exciting development is the increasing involvements of Chinese individual residents in the FX market. Chinese individuals are already entitled to trade foreign currency to foreign currency transactions. On the other hand, they now have more freedom to buy FX for overseas study, holiday abroad and even international shopping.

The increased presence of Chinese corporate customers and individuals in the FX market will bring about changes to the structure of the market.

In the meantime, new opportunities created by China's decisive move to currency convertibility come with fresh challenges and risks. The gradual transition to an open capital account has exposed serious deficiencies of the state of the development of China's FX market. Chief of them is the very limited supply of market instruments. A proper FX market can be expected to provide at lease three FX instruments- spot, outright forwards, and FX swaps. In addition to these traditional products, many markets also trade in Non-Deliverable Forwards (NDF), currency swaps, currency swaps, OTC currency options, currency futures, and exchange-traded currency options. These instruments are very flexible, can be tailored and customized to meet the particular needs of a customer with respect to currency, amount, and maturity date. But most important of all, these instruments are mainly used to hedge against currency risks. However, the Chinese inter-bank FX trading system only offers spot trading of the RMB against the US dollar, the Euro, Japanese Yen, and Hong Kong dollar. Outside this system, Bank of China was the first bank that was granted a licence to undertake forward business of the RMB against foreign currencies. But that was not until 1997. So far, forward business in these banks is insignificant. So, in a sense, the forward market in China is non-existent, not to mention other non-spot market instruments. This state of market development has virtually deprived Chinese firms and banks of hedging opportunities against exchange rate risk in major international currencies. This has serious detrimental effect on China's attempt to liberalise the capital account. Under the old regime, Chinese exporters had to surround all their FX receipts from export to the exchange authority. As a result, the government became the owner of these FX funds but also the owner of the risks associated with them. Furthermore, as the Chinese currency is pegged to the dollar so there are no exchange rate risks in any case. Chinese firms therefore did not need to worry about currency risks. However, as the liberalisation of China's capital controls deepens, recently Chinese firms are able to retain a growing proportion of their export proceeds, which means growing currency risks. Precisely on this regard, the inadequate development of China's foreign market has prevented the liberalisation forging ahead.

In addition to the failure of providing minimal hedging facilities for transition to an open capital account, another major problem exhibits in the current sate of China's FX market is the inadequate liquidity in the market. A liquid market is one in which participants can rapidly execute large volume transactions with a minimal impact on prices. Market liquidity may be measured in terms of tightness, depth and resiliency (European Central Bank, 2003). An illiquid market tends to be dominated by a few major players, especial large foreign banks, and is vulnerable to various shocks. Min and McDonald (2000) find that the thinness of FX market in Asian countries was an important factor contributed to the Asian financial crisis and also a factor constrained adjustment of crisis countries to the financial turmoil in the subsequent period. China's FX market at present is no doubt a very thin market. Given the eventuality that at the early stages of China's capital account liberalisation, capital flows across China's border will be volatile, such a thin market is crisis prone and so may derail the liberalisation process.

These two major deficiencies of China's FX market are the pulling forces of China's reform to capital account policy as far as foreign currency transactions are concerned. Given the fact that liberalisation of capital controls will ultimately lead to free transactions of foreign currency, the inadequate development of China's FX market constitute a major obstacle to China's currency convertibility.

It is therefore, on one hand, the development of China's FX market relies on the opportunities created by its move to an open capital account. But on the other hand, the advancement of the liberalisation programme has to be sequenced and managed in such a way that its speed and scope are compatible with the state of the development of China's FX market. The progress of capital account liberalisation has to be administered within the scope and pace allowed for by the progress in redressing these major FX market deficiencies. It is in this regard, the harmonious development between the progress of China's financial liberalisation and the improvement of FX market is critically important for the future of a convertible Chinese currency.