China's Capital Controls: Through the Prism of Covered Interest Differentials

• Date: 01 February 2014
• Author: Risto Herrala,Yin‐Wong Cheung
• DOI: http://doi.org/10.1111/1468-0106.12054
• Published date: 01 February 2014

CHINA’S CAPITAL CONTROLS: THROUGH THE PRISM

OF COVERED INTEREST DIFFERENTIALS

YIN-WONG CHEUNG*City University of Hong Kong

RISTO HERRALA Institute for Economies in Transition

Abstract. We study the renminbi covered interest differential, an indicator of the effectiveness of

capital controls. It is found that the differential is not shrinking over time and, in fact, appears larger

after the global f‌inancial crisis than before. That is, capital controls in China are still substantial and

effective. In addition to exchange rate changes and volatilities, the renminbi covered interest differ-

ential is affected by credit market tightness indicators. The marginal explanatory power of these

macroeconomic factors, however, is small relative to the autoregressive component and the dummy

variables that capture changes in China’s policy.

1. INTRODUCTION

Following its rapid ascendance in the global economy, China’s economic poli-

cies and activities have been in the limelight. Capital controls, for instance, have

been a staple component of China’s economic policy since 1949, but only

recently have they been scrutinized by the international community. As usual,

debates on China bring up different perspectives and that on China’s capital

controls is no exception.

One viewpoint is that capital controls allow China to maintain an underval-

ued currency and have provided cheap capital to fuel its phenomenal economic

growth. Jeanne (2012), for example, shows that capital account policies could be

designed to implement trade protectionism. Indeed, complaints have been

lodged about China’s (seriously) undervalued currency, which is made possible

by its capital control policy, and is seen as a crucial device that gives China an

unfair edge in global trade.1These restrictions not only create distortions in

domestic capital markets but also induce imbalances in the global economy.

An alternative view is that, in the case of China, capital controls are a

necessary evil. For China to pursue an independent monetary policy to maintain

a stable exchange rate and stabilize its economy, capital controls are perceived

to be an indispensable policy tool. Indeed, with its underdeveloped f‌inancial

sector and extensive reform agenda, the restriction on capital movement is

*Address for Correspondence: Department of Economics and Finance, City University of Hong

Kong, Hong Kong. E-mail: yicheung@cityu.edu.hk. We thank David Cook, Charles Engel, Bob

McCauley, XingWang Qian, Chang Shu, and participants of the 2013 Bank of Finland Institute for

Economies in Transition and City University of Hong Kong Conference on ‘Renminbi and the

Global Economy’ for their comments and suggestions, and XingWang for providing us with some

of the data.

1This is the majority view on capital controls and undervaluation. For alternative points of view,

see, for example, Cheung et al. (2007) and Schnatz (2011) on the RMB undervaluation and He et al.

(2012) on capital account liberalization and the RMB real exchange rate.

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Pacif‌ic Economic Review, 19: 1 (2014) pp. 112–134

doi: 10.1111/1468-0106.12054

© 2014 Wiley Publishing Asia Pty Ltd

believed to be an important attribute that has helped insulate China from the

unduly large external f‌inancial volatility in the recent global f‌inance crisis

(Fernald and Babson, 1999; Yu, 2009).

Capital controls are blamed for ineff‌iciency and misallocation in capital

markets, which can have severe long-term growth and welfare costs. In practice,

when a country adopts a capital control policy, it has to bear the associated

political stigma. Despite this, capital controls are quite commonly used in devel-

oping countries.2The apparent change in the IMF’s policy stance in the early

2010s may have lessened the political stigma that comes with the practice of

capital controls. In developing a new policy framework for advising countries, a

series of IMF studies acknowledge that, under certain circumstances, developing

countries could install capital control measures to protect themselves against

macroeconomic and f‌inancial instability (Ostry et al., 2010, 2011; The Strategy,

Policy, and Review Department, IMF, 2011).3However, capital controls should

not replace structural reforms that, for example, enhance the eff‌iciency and

capacity of the domestic f‌inancial sector.

Since the 1980s, China has undergone a sequence of reforms to transform its

centrally-planned economy into a market-driven economy. While making sub-

stantial strides in modernizing its economic structure and integrating with the

global economy, China has reiterated its policy of maintaining a stable environ-

ment for trade, investment and growth. A stable exchange rate of the renmimbi

(RMB) is one of the policy instruments used to achieve the policy objective.

According to the monetary policy trilemma, China, with a preference for a

stable exchange rate, has to choose between capital mobility and policy inde-

pendence. In reality, we observe that China imposes capital controls and exer-

cises monetary policy independence (Aizenman and Sengupta, 2013). The

effectiveness of restrictions on capital f‌lows, therefore, has substantial implica-

tions for China’s ability to manage and stabilize its domestic economy.

Indeed, in the 2000s, China was quite conscientious about capital f‌light and

hot money, and introduced a few policy measures to curb illicit capital f‌lows

(Hung, 2008). Apparently, this episode of tightening of controls was a response

to an abrupt surge in illicit capital f‌lows and not a shift away from the pro-

claimed policy of continuing f‌inancial market reform. The recent off‌icial

efforts to promote the international use of the RMB are widely interpreted as a

concerted effort to liberalize the f‌inancial market (Chen and Cheung, 2011). In

February 2012, for instance, a report from the People’s Bank of China outlines

a three-stage reform proposal to promote the international use of the RMB and

to open up China’s capital account in 10 years.4Even though the proposed

2In fact, capital control policies were not uncommon even among developed countries as recent as

in, say, the 1980s.

3Some economists, including Joseph Stiglitz, have suggested that emerging economies need capital

controls to curb and manage capital f‌lows.

4The report in Chinese ‘我国加快资本账户开放的条件基本成熟’ published by the China Securities

Journal online (http://www.cs.com.cn/xwzx/07/201202/t20120223_3253890.html) was from the

Financial Survey and Statistics Department headed by SongCheng Sheng at the People’s Bank of

China.

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