Research On The Effectiveness Of Capital Control In China

In the previous thirty years, although China has been implementing relatively severe capital controls, both gross capital inflows and gross capital outflows have seen rapid increase. Accordingly, doubts on the effectiveness of China’s capital controls emerge among a number of researchers, and they therefore advocate that China should liberalize the capital account with all speed. Based on this backdrop, this thesis tries to estimate the effectiveness of China’s capital controls. We first review both English and Chinese major literature, and the findings in most studies show that China’s capital controls were noticeably effective. However, there are two main gaps in the existing literature, one of which is the lack of international comparisons and the other is the absence of quantitative analysis using the up-to-date data. Following that, this thesis illustrates the purpose, types and effectiveness of capital controls. Furthermore, this study systematically reviews the evolution and current situation of China’s foreign exchange policies on capital account management, including RMB exchange rate regime reform, foreign exchange policy reform on direct investment, foreign exchange policy reform on portfolio investment, and other foreign exchange policy reforms. After that, we use both qualitative analysis and quantitative analysis to estimate the effectiveness of China’s capital controls. Qualitative analysis is carried out using three descriptive indices, including long-term investment and short-term investment, cross-border capital inflows and outflows, as well as net errors and omissions. The qualitative analysis roughly reveals the evolvement of China’s capital account openness and capital flows. We then choose 23 other emerging market economies for international comparisons. The differential between gross foreign liabilities proportion and the corresponding GDP proportion in China is not only significantly lower than that in these economies with an open capital account and these economies with mild capital controls, but also noticeably smaller than that in other economies with severe capital controls. Quantitative analysis includes three methods of Investment-Savings Correlation, Edward-Khan Model, and Covered Interest Rate Parity. Investment-Savings Correlation Method examines the correlation between domestic investment and savings, and the result shows that investment and savings are significantly correlated at the 10% confidence level. It means that China’s investment mainly relies on domestic savings, which indicates the great efficacy of China’s capital controls. We then use Edward-Khan Model to directly estimate the effectiveness strength of capital controls. At the 1% confidence level, the effectiveness strength value is 0.86, which further shows that China’s capital controls are effective. Finally, based on Covered Interest Rate Parity, we calculate onshore-offshore RMB yield gaps, where the offshore RMB yield is measured by Non-Deliverable Forward(NDF)-implied RMB yield. The average gap in the latest 20 months was about 220 basis points, which is still considerably large compared to the findings in other studies conducted several years ago, and this result again shows that China’s capital controls are effective. Based on the aforementioned results, this thesis suggests that China should liberalize the RMB capital account in a timely and orderly manner.