External liberalization and the evolution of China's exchange system : an empirical approach

41856 World Bank China Office Research Paper No. 4 External Liberalization and the Evolution of China's Exchange System: an Empirical Approach1 Min Zhao The World Bank Beijing Office Abstract: China's external liberalization has been experimental and gradual, making it evolutionary rather than revolutionary. The empirical approach has allowed China to draw lessons from experiments, and subsequently establish or adapt the institution and administration system that are appropriate for the particular stage of liberalization. China's success suggests that the empirical approach is a useful and pragmatic approach to handle systemic reform in a complex and diversified economy. This paper provides a detailed description of China's external liberalization and the evolution of exchange control system in the context of the overall reform during the period between 1978 and 2005. This paper draws four conclusions from China's experience: (1) maintaining the first priority on foreign direct investment; (2) strategically timing the liberalization to smooth the capital flows; (3) carefully sequencing external liberalization; and (4) strengthening capacity in supervising and monitoring risks associated with liberalization. Looking ahead, China is likely to accelerate capital account liberalization and outward investments in near future, though in a prudent and controlled manner. This move will have far- reaching implication for the world financial market. 1Comments are appreciated. Mzhao1@worldbank.org I thank Bert Hofman for encouragement and comments and Tao Wang, Xin Wang and Chongeng Bai for comments on an earlier draft. I also would like to thank Xu Nuo for his very able research assistance and Niu Zijing for editorial assistance. The World Bank China Research Paper series disseminates the findings of research on China to encourage discussion and solicit feedback. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in these papers are those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries it represents. 1  2  Glossary of Abbreviations ABC Agricultural Bank of China BOC Bank of China CBC Construction Bank of China CFETS China Foreign Exchange Trading System EDZs Economic Development Zones EDSA external debt specified account EDPSA external debt payment specified account FDI Foreign Direct Investment FEACs Foreign Exchange Adjustment Centers (swap centers) FEDBs Foreign Exchange Designated Banks FERQs Foreign Exchange Retention Quotas FESPS foreign exchange surrender and purchase system FFEs foreign funded enterprises FTCs foreign trade corporations ICBC Industrial and Commercial Bank of China ITICs International Trade and Investment Corporations MOFERT Ministry of Foreign Economic Relations and Trade MOFTEC Ministry of Foreign Trade and Economic Cooperation MOC Ministry of Commerce MNC Multi-National Corporate NBFIs Non-bank financial institutions NFEAC National Foreign Exchange Adjustment Center NDRC National Development and Reform Commission OTC over-the-counter PBC People's Bank of China QFII qualified foreign investment institutions QDII qualified domestic investment institutions RMB Renminbi (China's currency) SAFE State Administration of Foreign Exchange SEZs Special Economic Zones SOEs State-owned enterprises TICs trust and investment corporations 3  I Introduction Prior to 1978, China was practically a close economy, with very limited trade and no financial interaction with the rest of the world. In 1978, China initiated economic reform and started opening up to the rest of the world. In December 1978, the Third Plenum of the Eleventh Central Committee of the Communist Party announced to shift the principal task of the government to reform the economic system. Over the two and half decade since the start of the opening Figure 1. Comparison of Trade Openness2 up process, China has become T hailand one of most open economies in Korea the world in many prospects. China Trade volume reached 64 Germany percent of GDP in 2005. The Chile run-up to the WTO accession M exico in December 2001 saw a major Russia reduction in trade barriers, with Indonesia average tariffs falling from France United Kingdom over 40 to 15 percent. The un- Australia weighted average tariff rate Brazil was reduced to 10 percent in Japan 2005, and key commitments United States with respect to banking services and trade and 0 0.2 0.4 0.6 0.8 1 1.2 distribution rights have also Data source: International Financial Statistics and Staff moved forward. China's calculation degree of openness is rare among economies with similar size of population or GDP (Figure1). China has also been very successful in attracting foreign direct investment (FDI): the country received about a quarter of all FDI to developing countries over the last 10 years, and a record $60.6 billion in 2004, some 9.9 percent of total global FDI. (See Annex 1, selected economic indicators) China has successfully managed the process of the transition from a closed to an open economy. During this period, China maintained an average economic growth rate of 9.7 percent. Growth has also been relatively stable over the reform period: the standard deviation of economic growth rate is only 2.8 percentage points, or 29% of the period mean. Growth only faltered in the aftermath of the Tiananmen events in 1989, and growth slowed in 1997/98 after the Asian crisis affected the rest of the region. During the external liberalization process, China developed a comprehensive exchange control system covering all balance of payments transactions. The role of the exchange system has been evolving over time to adapt to the extent to which China economy is integrated with the global economy. Descriptions of the evolution of China's exchange 2Trade openness is calculated as the share of exports and imports in gross domestic product in 2004. 4  control system are rare. Tseng et al (1994) summarize the main elements of the trade and exchange system in 1992-93 and China's reform program in 1994. Mehran et al (1996) describe the development of China's exchange system in early stage till 1993. Since late 1990s, most economists focused their studies on the effectiveness of China's capital control (see ex. Hu, 2004; Luo, Huang & Jiang, 2005; Ma & McCauley, 2005) and few analyzes the developments of the exchange system and its evolving role in macroeconomic management. This paper reviews the process of China's external liberalization with particular focus on the role of the exchange control system, describes the achievements so far and provides prospects for the future. Section II provides an overview of the external and exchange reform process since 1978 against the background of the overall economic reform, and gives a detailed account of the reform developments of external liberalization and exchange control system. Section III draws experience from China's reform experience. Section IV discusses the outlook for further reform, and the main conclusions of this paper are presented in Section V. II External liberalization and Developments in the Foreign Exchange Management System At the outset of the reform and opening up process in 1978, China was a close and central planning economy. China traded little with the rest of the world, and total trade volume in 1978 was $20.7 billion, or 9.8 percent of GDP. External trade was carried out by a handful of foreign trade corporations (FTCs). All foreign exchange transactions were carried out by the Bank of China, a state-owned bank specializing in foreign banking transactions. All foreign exchange receipts had to be sold to the State, and all foreign exchange payments were subject to a compulsory foreign exchange plan. China did not borrow from other countries, nor received foreign direct investment. Since the 1978 Third Plenum of the Eleventh Central Committee of the Communist Party, which initiated Deng Xiao Ping's reform policies, China has gradually opened up to the rest of the world as a part of the country's reform strategy. In less than three decades, China has become a predominantly market-based economy that is highly integrated into the global economy. Trade volume increased by 70 times, the share of trade in GDP five-folded, and the country's share in world trade increased from 0.8 percent to 7.7 percent during 1978-2005. Foreign banks have spread all over the coastal China, and China has become the largest recipient of FDI in the developing world, attracting a quarter of all FDI to developing countries. This section reviews this external liberalizing process from 1978 to the present. It first summarizes the main characteristics of the process and then describes how the foreign exchange control system evolved over time in line with the liberalization in the rest of the economy. A chronology of external liberalization and the evolution of China's exchange system is presented in Annex 3. 2.1. Characteristics of external liberalization process 5  In mid-1978 the China Communist Party reviewed the lessons of the culture revolution. The review established a philosophy that "Practice is the sole criterion to test truth", which helped the authorities to overcome the obstacle of doctrinarism--communist ideology in economic management. This basic philosophy has guided the decision making in the whole reform and liberalization process. Following this philosophy, external liberalization has been experimental and gradual, making it evolutionary rather than revolutionary. The empirical approach has allowed China to draw lessons from experiments, and subsequently establish or adapt the institution and administration system that are appropriate for the particular stage of liberalization. The empirical approach has been supported by a strong political commitment to reform and opening up. Over time, China has developed a comprehensive exchange control and monitoring system, which allows for a deep integration in the world economy in terms of trade and investment, but which has shielded China from external crisis in the process. Empirical Approach Many economists and observers describe China's reform and opening up process as gradualism. Merriam-Webster's Collegiate Dictionary (tenth edition) defines gradualism as "the policy of approaching a desired end by gradual stages". By this definition, the term gradualism does not capture the characteristic of China's reform and liberalization process very well. The reasons are twofold. The first is that China's reform and liberalization never followed any blueprint. At the on-set of the reform, no one knew where the reform would end. The second is that almost all liberalization measures were first tested, either in a location or in one industry, before the experiment, if successful, was expanded nationwide. When the empirical evidence from experiments helped build strong political will, the liberalization process has sometimes been radical, rather than gradual. The current account convertibility introduced in 1996 and service sector liberalization under WTO commitment in 2001 are examples of radical reform. Likewise, disappointing results from an experimental reform slowed down the liberalization process. Two periods (1987-1991 and 1997-2000) are such cases of slowdown. An "empirical approach" therefore is a better alternative to describe China's liberalization process-- truth from facts. As Deng Xiaoping said in 1985, the reform and opening up is a very big experiment and one can not learn from books.3 Examples of the empirical approach in external liberalization are numerous, including liberalizing FDI in four SEZs in 1980, the opening of foreign exchange swap centers in selected cities in1986, the opening of the banking sector to foreign banks in Special Economic Zones (SEZs) first and the opening of the domestic capital market for selected foreign institutional investors in 2002, as well as the opening of investment abroad for selected domestic financial institutions in 2005. In all cases, restrictions were relaxed after the authorities had confidence that these experiments were successful. 3P. 130, The 3rd volume, Selected Works of Deng XiaoPing, 1993, People Publishing House 6  Figure 2 policy cycle of empirical approach Pre-appraisal Issue Decision making identification Evaluation Experiment Figure 2 depicts the policy cycle of the empirical approach. The cycle often starts when an issue or problem emerges. The authorities collect proposals and carry out a pre- appraisal of these proposals. A preliminary policy is formed based on the result of pre- appraisal. Then the policy will be tried in a selected location or in a specific industry. Subsequently, the findings of the experiment are evaluated, and problems with the experimental approach identified. An appraisal will be carried out to judge whether the modification is needed. Then the authorities decide whether to discontinue the policy, or further experiment in more locations, or extend the policy nationwide. The evolution of FDI policies is the most striking example of this approach. In 1980, the first SEZs were established in four coastal cities (Shenzhen, Zhuhai, Shantou in Guangdong and Xiamen in Fujian) in the provinces Guangdong and Fujian, hometowns of many oversea Chinese investors, with the aim to promote exports and economic growth. These zones were given the freedom to offer special advantages to attract foreign investors. Within four years between 1981 and 1984, the trade volume of Shenzhen SEZ has increased by 60 times. To scale up the success of these zones to the entire coastal region, the open-door policy extended to 14 coastal cities in 1984 and to the deltas of the Yangtze, Pearl and Minnan Rivers in 1985. In 1988, the policies were expanded to Hainan Island and another 140 coastal cities and counties including Nanjin, Hangzhou and Shenyang in 1988. After the coastal regions took-off in the 1980s, the open-door policy was gradually extended to the inland region in the 1990s. A big leap was made in 1999 when the whole western region was opened for FDI (Catin, Luo and Huffel, 2005). 7  Figure 3 Spatial Gradualism of the open-door policies in China Credibility with strong political commitment China's success suggests that the empirical approach is a useful and pragmatic approach to handle systemic reform in a complex and diversified economy. However, as the empirical approach is subject to policy reversals, foreign investors were concerned about the continuity of reform and opening up policy. In view of this concern, the China Communist Party (CCP) and the authorities made strong commitment to protect foreign investors' interest in China and to reform and opening up policy. Evidence of this commitment includes: