Nonlinear Capital Flow Tax: Capital Flow Management and Financial Crisis Prevention in China

• Author: Kang Shi,Jiandong Ju,Shang‐Jin Wei,Li Li,Guangyu Nie
• DOI: http://doi.org/10.1111/cwe.12284
• Published date: 01 July 2019
• Date: 01 July 2019

©2019 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 1–28, Vol. 27, No. 4, 2019

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Nonlinear Capital Flow Tax: Capital Flow Management

and Financial Crisis Prevention in China

Jiandong Ju, Li Li, Guangyu Nie, Kang Shi, Shang-Jin Wei*

Abstract

How to promote capital account liberalization while preventing financial crises is

a challenging task for policymakers. This study proposes a nonlinear (progressive)

capital flow tax as a solution. We first demonstrate that the collateral requirement of

international borrowing can give rise to multiple equilibria and self-fullling nancial

crises. We then show that the crisis equilibrium characterized by large exchange rate

depreciation, capital ight and welfare loss can be eliminated by imposing a nonlinear

(progressive) tax scheme on capital outows with the marginal tax rate increasing with

the size of individual capital outows. The implementation of such a tax scheme in China

is also discussed.

Key words: capital account openness, nancial crisis, nonlinear capital ow tax

JEL codes: F34, F41, H21

I. Introduction

To what extent developing countries should open up their capital accounts is a

central yet controversial issue for both academic researchers and policymakers.1 This

question is particularly important for China. Since its accession to the World Trade

Organization (WTO), China has adopted a “prudent and steady” strategy for capital

account openness, but its openness has now reached a critical stage. On the one hand,

with a growing economic size and expanding degrees of openness in trade and foreign

*Jiandong Ju, Professor, PBC School of Finance, Tsinghua University, China. Email: jujd@pbcsf.tsinghua.

edu.cn; Li Li, Assistant Professor, Jinan University−University of Birmingham Joint Institute, China. Email:

lily2007.li@gmail.com; Guangyu Nie (corresponding author), Associate Professor, College of Business,

Shanghai University of Finance and Economics, China. Email: nie.guangyu@shufe.edu.cn; Kang Shi,

Associate Professor, Department of Economics, The Chinese University of Hong Kong, China. Email:

kangshi@cuhk.edu.hk; Shang-Jin Wei, Professor, Business School, Columbia University, USA. Email:

sw2446@gsb.columbia.edu. This work was supported by the National Natural Science Foundation of China

(No. 71803124) and the Shanghai Pujiang Program (No. 17PJC043). Author names are listed alphabetically,

and all authors contributed equally to this manuscript.

1See the literature review section for details, and Eichengreen (2001) and Kose et al. (2006).

Jiandong Ju et al. / 1–28, Vol. 27, No. 4, 2019

©2019 Institute of World Economics and Politics, Chinese Academy of Social Sciences

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direct investment (FDI), the potential efciency gain from capital account openness

has increased dramatically. On the other hand, China’s economic growth in recent

years has been slowing down and facing uncertainties and external shocks. Other

complementary nancial reforms are also still in progress. Thus, maintaining nancial

stability and avoiding crises become policy objectives of rst order importance.

The contributions of this study are twofold. First, we empirically examine the

link between capital account openness and financial crisis. Unlike previous studies

that focused on the average effects of capital openness, our focus is on exploring the

economic conditions under which capital account openness is particularly crisis prone.

These empirical findings provide important guidance for policymakers regarding the

preconditions and timing of openness. Second, we build a theoretical model and show

that international borrowing may lead to multiple equilibrium and self-fullling nancial

crisis. Based on our model, we develop a nonlinear capital outow tax framework and

discuss the implementation of such a policy tool at the micro level.

Using a cross-country panel dataset that covers 79 countries during 1973–2010,

we nd strong evidence that the effect of capital account openness on the likelihood of

financial crises varies substantially under different economic conditions. Specifically,

when a country faces a slowdown in its growth or overvaluation of its exchange rate,

opening up its capital account significantly increases the risk of a financial crisis

occurring. Moreover, exchange rate flexibility is also critical, and a fixed exchange

rate regime is associated with a much higher risk of financial crisis when a country

opens up its capital account. This finding has important implications for the pecking

order of nancial reforms as it indicates that a country should rst remove restrictions

on uctuations of the exchange rate before opening their capital account. Apart from

domestic factors, external shocks also have a significant impact. We find that if the

opening up of the capital account is accompanied by a reversal/tightening up of the

monetary policy in the core country, such as the US, then the risk of nancial crisis rises

signicantly. Our results suggest that the effect of opening up a capital account depends

crucially upon underlying economic conditions.

Since the late 1990s, there has been a general trend among emerging market

economies to open up their capital accounts. However, quite a few have subsequently

suffered nancial crises of varying degrees. A recently emerging strand of literature pays

particular attention to the underlying reasons why the opening up of capital accounts

in emerging market economies often leads to nancial crises (Bianchi, 2011; Korinek,

2011; Korinek and Mendoza, 2014). Studies in the optimal capital flow management

literature show that with free capital mobility, private nancing decisions can lead to

a negative pecuniary externality to the country as a whole. Such negative externality