Pain or Gain? Chinese Experience of Capital Account Liberalization

• DOI: http://doi.org/10.1111/cwe.12290
• Author: Hongfeng Peng,Jingwen Yu
• Date: 01 September 2019
• Published date: 01 September 2019

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

China & World Economy / 79–107, Vol. 27, No. 5, 2019

79

*Hongfeng Peng, Professor, School of Finance, Shandong University of Finance and Economics, China.

Email: fhpeng@whu.edu.cn; Jingwen Yu (corresponding author), Associate Professor, Center for Economic

Development Research, School of Economics and Management, Wuhan University, China. Email: jwyu@

whu.edu.cn. The authors are grateful for support from the Natural Science Fund of China (No. 71661137003),

the National Social Science Fund of China (No. 16ZDA032) and the Science Foundation of Ministry of

Education of China (No. 17JZD015).

Pain or Gain? Chinese Experience of Capital

Account Liberalization

Hongfeng Peng, Jingwen Yu*

Abstract

The neoclassical growth model predicts that capital account liberalization could

potentially enhance economic performance; however, there is no consistent empirical

evidence to support this positive association. Using a novel dataset of Chinese capital

account openness, this paper demonstrates a positive relationship between capital

account liberalization and aggregate economic performance. The difference-in-

differences method is used to capture the causal effect of capital account liberalization

on economic performance by taking advantage of variations in both external nancial

dependence and the progress of capital account openness. We investigate three channels

that could strengthen this positive relationship using a rm-level dataset. We nd that

capital account liberalization could: (i) alleviate the degree of resource misallocation,

and this effect is more signicant in industries relying heavily on external nance and

in regions with more favorable business environments; (ii) enhance rms’ total factor

productivity; and (iii) promote innovation. Our findings suggest that a strategy of

gradual openness will leave some leeway not only for improvement in domestic markets

but also to mitigate exposure to unfavorable global shocks.

Key words: capital account liberalization, difference-in-differences, innovation,

productivity

JEL codes: F20, F21, F36, F41

I. Introduction

Since the implementation of the reform and opening-up policy in 1978, China has

made great progress in economic development and has moved toward integration with

Hongfeng Peng, Jingwen Yu / 79–107, Vol. 27, No. 5, 2019

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

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the global economy. However, the pace of integration is unbalanced across trade and

nancial sectors. For example, although the renminbi (RMB) has been freely convertible

on current accounts since 1996, the Asian nancial crisis in 1997 and the US subprime

crisis in 2008 interrupted the progress of RMB capital account liberalization. Although

China has made progress on capital account liberalization, some restrictions on the

capital account convertibility of the RMB remain. Considering this background, we are

interested in the gradual opening process of the capital account in China and particularly

its effect on the Chinese economy.

The neoclassical growth model predicts that capital will flow into countries with

a lower capital/labor ratio because the marginal return on capital is larger. Therefore,

capital mobility could promote resource allocation efficiency because financially

constrained firms could borrow from abroad at lower cost, which would lead to

additional investment and temporary economic growth. In addition, nancial openness

could provide more portfolio choices to diversify potential risk and facilitate nancial

development (Chinn and Ito, 2006; Klein and Olivei, 2008; Trabelsi and Cherif, 2017;

Wei, 2018). These factors provide a theoretical basis for developing countries to open up

their capital accounts to promote economic performance.

A growing literature has focused on the effect of capital account liberalization

on economic performance and the channels through which it could spur economic

performance (Bonglioli, 2008; Quinn and Toyoda, 2008; Larrain and Stumpner, 2017).

However, controversy remains over the positive effect of capital account liberalization.

One theory is that large and frequent capital ows will lead to huge uctuation in the

macroeconomy and thus negatively affect long-run economic performance. Unfettered

capital ows may also lead to nancial instability. Some studies even found a strong

correlation between financial crises and capital account liberalization (Demirgüç-

kunt and Detragiache, 1998; Fratzscher, 2012; Devereux and Yu, 2014). For example,

analyzing cross-country data, Demirgüc-Kunt and Detragiache (1998) found that

nancial liberalization and banking crises occurred in chronological order. Therefore,

the contribution of capital account liberalization on economic growth depends on many

factors, such as financial depth, good contract enforcement and effective prudential

regulation. Based on the data of 80 developing countries from 1980 to 2004, Lin and

Ye (2014) found that the deregulation of controls on equity capital ow generated a

positive effect on economic growth in the short term but a negative effect in the long

run. Stock market openness leads to a boost in consumption rather than a boom in

investment.

The capital account openness indices used in the published literature, however,

are primarily coded from the International Monetary Fund (IMF) Annual Report on