A Model of Chinese Capital Account Liberalization

Abstract

We provide a theory-based inquiry into the contours of China's international balance sheets after the renminbi becomes convertible under the capital account. We construct a two-country general equilibrium model with trading in equities and bonds and calibrate the model with U.S. and Chinese data. We interpret Chinese capital account liberalization as a removal of restrictions that prohibit agents trading Chinese bonds and U.S. equities. We explore how international risk-sharing can be achieved through portfolio diversification in each of these asset market configurations. We also look at how these holdings would change as China gradually rebalanced its production with a larger share of labor income, and as the productivity gap between China and the United States narrowed. We find that both U.S. and Chinese residents would have incentives to increase their holdings in each other's equities and to issue debt in each other's currency.

“Wait and See” or “Fear of Floating”?

“…Due to the safe haven status of the US dollar, interest rates on US dollar reserves have been much lower than interest rates on domestic asset, which imposes a financing cost on the PBOC. He and Luk (2017) provide a model of China's capital account liberalization, and Montecino (2018) discusses how capital controls can influence the exchange rate, both in the short term and long term. Kim and Pyun (2018) and Han and Wei (2018) provide empirical evidence showing that capital account openness plays an important role in the international transmission of monetary policy shocks.…”

Short-Run Effects of the Economic Reform Agenda

“…This raises the possibility that these flows could become unbalanced, favouring either inflows or outflows, due, for example, to pent-up demand for foreign assets that has been constrained by capital controls. The work of He and Luk (2013) does not foreshadow such unbalanced flows, nor does that of He et al (2012), which envisions a trend towards trade balance, offset in the current account by higher yields on foreign (newly private) holdings. Indeed, reasons pent-up demand might not be a concern include that capital controls have been leaky enough for the wealthy to acquire the foreign assets they have wanted and that China's reserves are so large that they can be repatriated if private demand for foreign assets were to rise, so balance could be maintained for some years at levels desired by the Government.…”

The determinants of international reserves in developing countries

“…According to Lane and Burke (2001), monetary policy regimes are consistent with precautionary incentives and a trend of reserve buildup. A monetary policy maker must achieve financial stability by setting up policy goals such as monetary policy independence and financial market openness (Chin et al, 2007b;Bacchetta et al, 2013;He and Luk, 2017;Jeanne, 2013). The accumulation of international reserves is also influenced by monetary policy instruments like the money supply and interest rate.…”