66926 POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise FEBRUARY 2012 • Number 74 JUN 010 • Numbe 18 Capital Account Liberalization: Does Advanced Economy Experience Provide Lessons for China? Jeff Chelsky The initial post–World War II pursuit of capital account liberalization (CAL) by advanced economies was Europe-centric, with roots in a broader political—rather than economic—agenda of greater European integration. In continental Europe, CAL was addressed mostly through the adoption of multilateral instruments and codes. In contrast, CAL by the United States and United Kingdom was pursued unilaterally, motivated by their status as global reserve currency issuers and global financial centers. China’s situation is fundamentally different. China today has no equivalent to the European political motivation for CAL or the domestically driven financial motivation of the United States or the United Kingdom. And while China may have long-term aspirations to be a global reserve currency issuer, the extent to which it international- izes its currency is constrained by powerful domestic economic and political interests that continue to benefit from an export-led growth model underpinned by a pegged and undervalued exchange rate, both of which are difficult to maintain with an open capital account. Alongside China’s overarching concern with the maintenance of financial and economic stability, these factors imply a different path for China than paths taken by advanced economies, with significant accelera- tion in the gradual pace of liberalization unlikely without accelerated development of domestic constituencies that tradition- ally support CAL. Postwar Motivations for Capital Account transfers associated with current account transactions), man- Liberalization in Advanced Countries dates given to the International Monetary Fund (IMF). Full cur- As in China today, advanced economy views on the degree of rent account convertibility had been achieved in most advanced CAL in the immediate post–World War II period grew out of economies by 1958; full capital account convertibility took an the widespread desire to maintain fixed exchange rates. Reflect- additional 30 years. ing the economic disruption caused by competitive devalua- Institutional Underpinnings of Postwar tion in the interwar years, the postwar Bretton Woods architec- Capital Account Liberalization in Advanced ture prioritized the liberalization of trade (that is, current Economies account transactions), a mandate given to the General Agree- ment on Tariffs and Trade (GATT), and the maintenance of Exclusion of capital account convertibility from the original fixed exchange rates and commitment to current account con- Bretton Woods architecture, (and the IMF’s Articles of Agree- vertibility (that is, access to foreign exchange for payments and ment (1945), specifically) reflected several factors: (i) the rela- 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise tive importance of current account transactions in overall glob- France), which pursued a more managed, codified, and institu- al financial flows between countries; (ii) the desire for fixed tional approach. The momentum for CAL that picked up in exchange rates to avoid competitive devaluations; and (iii) Brit- the second half of the 1980s can largely be attributed to a sig- ish fear of large-scale repatriation of overseas sterling balances, nificant shift in, if not outright reversal of, French policy to- (particularly from India and Argentina). These factors help ex- ward CAL, derived from its experience with controls in the plain why the right to impose capital controls was explicitly early part of the decade. In contrast, (largely) Anglo Saxon embedded in the original IMF Articles. Keynes, in particular, countries tended to pursue CAL unilaterally. For the United considered the right to control capital movements as a perma- Kingdom and the United States, this partly reflected their sta- nent rather than transitional arrangement (James 1996, 38). tus as global financial centers and, in the case of the United The right to regulate capital, particularly short-term capital, States, as the predominant reserve currency issuer, with power- was subsequently included in the European Economic Com- ful domestic financial interests supporting CAL.5 munity’s Treaty of Rome (1957). The establishment of codified CAL frameworks was at least Liberalization of Short-Term Flows initially driven largely by the pursuit for European integration As noted, momentum for CAL (particularly of short-term and the desire to establish a single market. The objective was flows) picked up in the late 1980s following the reversal of formally set out in 1950 by the Organization for European Eco- French opposition to full CAL, which came in response to nomic Cooperation (OEEC)—precursor to the Organisation France’s unsuccessful experience with capital controls in the for Economic Co-operation and Development (OECD). But early part of the decade. In 1986, reflecting changed French the Treaty of Rome, which established the European Economic views, the EC proposed adopting as liberal as possible a capital Community, provided for freedom of capital movement with- account regime. In 1988, it adopted a directive6 enshrining the in Europe “only to the extent necessary to ensure the proper principle of full CAL between member states while retaining a functioning of the Common Market.� This was in contrast to time-bound safeguard clause. In 1991, the Maastricht Treaty free movement of goods, services, and people. The CAL objec- solidified commitment to CAL.7 In 1989, the OECD code was tive was partial, restricted to longer-term “productive� capital amended to include virtually all capital flows, explicitly ac- (for example, foreign direct investment [FDI]), and was main- knowledging that full CAL was a valid goal and the hallmark of tained by the OECD following its creation in 1961. The carry a fully developed economy. This change validated earlier CAL over to the OECD is not surprising given that the OECD’s ini- by states such as the United Kingdom, the United States, Ger- tial membership was heavily dominated by Europe: members many, and Canada; it also served as an impetus to CAL for other of the OEEC plus Canada and the United States.1 For the next members, and as an inducement to more ambitious CAL, in- quarter century, the predominant orthodoxy among European cluding in countries seeking OECD membership in the 1990s. policy makers was supportive of liberalizing longer-term capital By 2005, the more liberal regime governed 70 to 80 percent of (that is, FDI), but not all capital flows. world capital flows (Abdelal 2007, 12). The OECD’s Code of Liberalization of Capital Movements, ad- Liberalization and Financial Sector opted in 1961 and heavily based on the OEEC’s 1959 code of Development the same name, initially maintained a country’s right to impose controls on capital movements, particularly short-term flows. It Experiences of advanced economies with CAL have shown that focused on liberalization of “productive� capital, excluding financial innovation reacts swiftly to opportunities presented short-term flows, until 1989. Adhering members could enter by deregulation, creating new and more complex instruments reservations against any item in the code.2 Despite its initially and markets, and making the maintenance of controls increas- narrow scope and framework of reservations, it did encourage ingly difficult. This is consistent with the OECD finding that CAL in countries seeking OECD membership. Japan, for exam- once a critical level of financial development is achieved, evad- ple, was requested to ease FDI controls before attaining member- ing remaining controls in periods of stress becomes easier ship in 1964. Reflecting the objective of partial CAL, capital (OECD 2002, 9). Innovations in communications technology controls were still common in Europe into the 1980s, with a have also made efforts to control capital flows more difficult. more rapid move to full CAL only beginning later in the decade.3 Reflecting this development, the move away from using con- The apparent contradiction between the establishment of trols gained momentum throughout the 1990s, particularly in multilateral frameworks for CAL and the prevalence of capital OECD countries. controls in advanced economies for much of the 30 years fol- China and the Political Economy of Capital lowing the end of the war reflects, to some extent, differences Account Liberalization in approach to CAL between the (largely) Anglo Saxon coun- tries, which tended to pursue more rapid unilateral liberaliza- The experiences of advanced economies have limited paral- tion,4 and continental Europe (most clearly embodied by lels to China’s situation. China does not seem to possess the 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise same political agenda and objectives that provided the initial interests in Hong Kong SAR that may not be supportive of motivation for CAL in continental Europe, nor are there sim- more ambitious CAL on the mainland. ilarly powerful domestic financial interests pushing for CAL More generally, there are many financial institutions and (including of short-term flows) such as those in place in both economic agents in China—both in the private and public sec- the United States and the United Kingdom. However, over tors—that benefit from the closed system and that are unlikely time, these may emerge as China allows greater international- to welcome the increased competition that greater openness ization of its currency and develops its private domestic fi- would bring. This is an inevitable consequence of any heavily nancial sector. This suggests that the pace of China’s CAL regulated system. The current Five Year Plan asserts that public might most effectively be accelerated through reforms that ownership will continue to play a “dominant� role in the econ- contribute to the development and empowerment of sup- omy, including in the financial sector, which constrains the portive domestic constituencies, including among savers, scope for an emerging domestic private financial sector to be- consumers, and the domestic (that is, mainland) private fi- come a sufficiently powerful constituency in support of more nancial sector. rapid CAL. It is therefore unclear the extent to which financial Elements of China’s 12th Five Year Plan are consistent with sector development alone in China will build a constituency building domestic constituencies for greater CAL. Indeed, in for greater openness unless it is accompanied by a broader liber- his address to the National People’s Congress, Premier Wen Jia- alization of the financial sector. Perhaps as domestic and inter- bao vowed to continue “to energetically develop financial mar- national pressures on the RMB to appreciate continue and the kets and encourage financial innovation,� and the Five Year Plan exchange rate becomes more volatile, the hedging needs of Chi- explicitly commits to push forward RMB capital account con- nese institutions—both public and private—may foster demand vertibility and expand the scope of cross-border yuan trade.8 for greater financial sector and capital account liberalization. However, at the same time, Wen expressed the government’s At the same time, the Chinese authorities have expressed intention to “closely monitor and control cross-border capital the desire to see the RMB become a major global reserve cur- flows and prevent the influx of hot money.�9 rency over the longer term. But CAL is widely accepted as a pre- In support of gradual CAL, the Chinese government ex- condition for currency internationalization, which itself is a panded the size of its Qualified Foreign Institutional Investor necessary step toward reserve currency status. Recent debates (QFII) system, allowing more than 100 international institu- within the IMF and under the French presidency of the G-20 tions to invest in China’s securities market. At end 2010, total on the composition of the special drawing right (SDR) curren- quota approved for QFIIs had reached US$19.7 billion, with a cy basket and prospects for RMB inclusion in the basket have, if government commitment to expand to US$30 billion. How- anything, reinforced the importance of full capital account con- ever, in relative terms, the size of this program is quite small, vertibility as a precondition for a global reserve currency.11 Chi- amounting to less than 2 percent of total stock market hold- nese officials have not disputed the criticality of this require- ings. The Qualified Domestic Institutional Investor (QDII) pro- ment; however, when there is a perceived tension between the gram, which sanctions approved banks, trust companies, fund speed of CAL and broader considerations of stability (financial houses, securities firms, and insurance companies to invest and social), stability has typically taken precedence. Moreover, abroad in approved overseas markets, is also expanding, but at if global economic growth slows and remains sluggish, Chinese end 2010, only 95 Chinese institutions had been granted QDII policy makers are likely to move with additional caution in pur- suing greater openness and the move away from an export-led status, with a total quota of US$68.4 billion. The bond market growth model. This does not bode well for an accelerated pace remains heavily regulated, with issuers of domestic bonds lim- of CAL, despite professed longer-term ambitions for the RMB ited to domestic institutions (KPMG 2011a). as an international reserve currency. To a significant extent, the commitment to CAL is being pursued through efforts to internationalize the RMB by mak- About the Author ing Hong Kong SAR, China, an RMB offshore clearing center.10 The pool of offshore RMB deposits held in Hong Kong SAR has Jeff Chelsky is Lead Economist and Coordinator of the Interna- grown nearly tenfold since 2009 (KMPG 2011b). Hong Kong tional Policy and Partnerships Group, part of the Poverty Reduc- SAR is also the channel through which RMB-denominated tion and Economic Management (PREM) Network at the World bonds (so called dim sum bonds) are issued: issuance of dim Bank. sum bonds has expanded rapidly. Bringing RMB onshore from Notes Hong Kong SAR involves a number of administrative hurdles; however, while many of these hurdles may not be excessively 1. Canada already had a relatively open capital account (and a onerous, their existence and the quantity of business the cur- floating exchange rate) and the United States, as predominant rent liberalization approach brings to banks and other financial issuer of global reserve currency, also pursued a liberal regime institutions operating in Hong Kong SAR risk creating vested (Abdelal 2007, 7–8). 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise 2. The code is nonbinding and relies on a combination of trans- Camdessus, M. 1998. “Bolstering Market Access of Developing parency regarding restrictions and peer pressure to achieve lib- Countries in a Globalized World.� Statement by the Managing Director of the IMF at the High-Level Meeting of the United eralization. Nations Economic and Social Council, July. Washington, DC 3. http://europa.eu/legislation_summaries/internal_market/ G-20 Leaders Summit. 2011. “Final Communiqué.� Cannes, single_market_capital/l24405_en.htm. France, November 3–4, http://www.g20-g8.com. 4. This may have reflected a lesser affinity for managed, techno- IMF (International Monetary Fund). 1945. Articles of Agreement. cratic mechanisms. Washington, DC. 5. While sterling had been a major reserve currency, this in part ———. 2004. “The IMF’s Approach to Capital Account Liberaliza- reflected a colonial legacy where colonies had been required to tion.� Independent Evaluation Office, http://www.imf.org/ External/NP/ieo/2004/cal/091504.pdf. accept sterling as payment. With independence, former colo- ———. 2010. “The Fund’s Role Regarding Cross-Border Capital nies increasingly chose the U.S. dollar. Flows.� Strategy, Policy, and Review Department and the Legal 6. Council Directive 88/361/EEC, in effect in July 1990. Department, Washington, DC, http://www.imf.org/external/ 7. The treaty stated that “all restrictions on the movement of np/pp/eng/2010/111510.pdf. capital between Member States and between Members States James, H. 1996. International Monetary Cooperation Since Bretton and third countries shall be prohibited.� Woods. IMF and Oxford University Press. 8. The 12th Five Year Plan for National Economic and Social Kenen, P. 2011. “Currency Internationalisation: Lessons from the Development (2011–15), chapter 48, section 3, adopted by Global Financial Crisis and Prospects for the Future in Asia and the Pacific.� BIS Papers No. 61, proceedings of a joint confer- the National People’s Congress in March 2011. ence organized by the BIS and the Bank of Korea in Seoul on 9. Wen Jiabao, “Report of the Work of the Government,� deliv- March 19–20, 2009. ered at the Fourth Session of the Eleventh National People’s ———. 2012. “Currency Internationalization: An Overview.� BIS Congress, March 5, 2011. paper, January 11, http://www.bis.org/repofficepubl/arpre- 10. Kenen (2011, 11) notes that a precondition for successful search200903.01.pdf. currency internationalization is that “the government must KPMG. 2011a. China’s Capital Markets: The Changing Landscape. www.kpmg.com. first remove all restrictions on the freedom of any entity, do- ———. 2011b. “Mainland China Banking Survey.� www.kpmg.com. mestic or foreign, to buy or sell its currency, whether in the spot National Institute of Economic and Social Research (European or forward market.� Commission). 1996. “Capital Market Liberalization, Subseries 11. The communiqué of the G-20 Leaders Summit (2011) in III, Dismantling Barriers.� August, http://ec.europa.eu/inter- Cannes states: “We agree that the SDR basket composition nal_market/economic-reports/docs/studies/stud9_en.pdf. should continue to reflect the role of currencies in the global National People’s Congress (China). 2011. “Twelfth Five Year Plan trading and financial system. The SDR composition assessment for National Economic and Social Development (2011–15).� should be based on existing criteria, and we ask the IMF to fur- Adopted in March. ther clarify them. To adjust to currencies’ changing role and OECD (Organization for Economic Cooperation and Develop- ment). 1961. Code of Liberalization of Capital Movements. www. characteristics over time, the composition of the SDR basket oecd.org/daf/investment/codes. will be reviewed in 2015, or earlier, as currencies meet the ex- ———. 2002. “Forty Years’ Experience with the OECD Code of Lib- isting criteria to enter the basket.� eralization of Capital Movements.� October, http://www.oecd. org/dataoecd/7/16/44784048.pdf. References ———. 2011. “Promoting Orderly Capital Flows: The Approach of Abdelal, Rawi. 2007. Capital Rules: The Construction of Global the Code.� OECD Code of Liberalisation of Capital Movements. Finance. Harvard University Press April, http://www.oecd.org/dataoecd/35/50/47281851.pdf. Bakker, A., and Bryan Chapple. 2002. “Advanced Country Experi- Ostry, J., A. Ghosh, K. Habermeier, M. Chamon, M. Qureshi, and ences with Capital Account Liberalization.� IMF Occasional D. Reinhardt. 2010. “Capital Inflows: The Role of Controls.� Paper 214, Washington, DC. IMF Staff Position Note, SPN/10/04, February. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise