The Sustainability of China's Exchange Rate Policy and Capital Account Liberalisation

64 Pages Posted: 26 Jun 2008

See all articles by Lorenzo Cappiello

Lorenzo Cappiello

European Central Bank (ECB)

Gianluigi Ferrucci

European Central Bank (ECB)

Date Written: March 2008

Abstract

This paper deals with two related issues: the sustainability of China's exchange rate regime and the opening up of its capital account. The exchange rate discussion deliberately passes over the issue of the "equilibrium" value of the renminbi and its alleged undervaluation - typically at the heart of the current policy debate - and focuses instead on the domestic costs of the current regime and the potential risks to domestic financial stability in the long run. The paper argues that the renminbi exchange rate should be increasingly determined by market forces and that administrative controls should be progressively relinquished. The exchange rate is obviously linked to well-functioning and efficient capital markets, which require no barriers to capital flows. Thus, exchange rate reform has to be correctly sequenced with reform of the capital account to avoid disruptive capital flows. The paper discusses China's twin surpluses of the current and capital accounts and attempts to identify the drivers of this "anomalous" external position. The pragmatic strategy pursued by the Chinese authorities in the aftermath of the Asian crisis encouraged FDI inflows and favoured the accumulation of a large stock of foreign exchange reserves. Combined with a relatively weak institutional setting, these factors have been important determinants of the pattern and composition of the country's capital flows and international investment position. Finally, the paper speculates on the outlook for Chinese capital flows should barriers to capital movements be lifted. It argues that whether China continues to supply capital to the rest of the world or eventually becomes a net borrower in international capital markets - as was the case for most of its recent history - will depend on the evolution of its institutions.

Keywords: China, exchange rate policy, international investment position, capital account liberalisation, institutions

JEL Classification: F10, F21, F31, F32, P48

Suggested Citation

Cappiello, Lorenzo and Ferrucci, Gianluigi, The Sustainability of China's Exchange Rate Policy and Capital Account Liberalisation (March 2008). ECB Occasional Paper No. 82, Available at SSRN: https://ssrn.com/abstract=1084909

Lorenzo Cappiello (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
+49 69 1344 8765 (Phone)

Gianluigi Ferrucci

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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