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Relationship between short-term capital inflows and economic vulnerability
There are many factors that attract short-term capital flows, though it is important to see how they affect economy. According to Petroulas, “if savings are low and investment misallocation is not marginal than the additional short-term capital flows play an important role in economy’s future” (2004, pp.17). However, in China savings rate exclusively high reaching more than 50% (Ma and Yi, 2010). There is also some evidence of investment misallocation. In China, ghost cities for millions of people have been built though as their prices went through the roof they mainly become intersting for speculators, and people who needed the apartment for personal use could not afford them anymore (journeymanpictures, 2011). This proves that market forces are distorted and investments keep flowing where the supply already outgrew the consumers’ demand significantly. We can say that none of the conditions from the Petroulas’s statement above are true. He argues that in such economic situation the main effect of additional short-term capital flows is to increase the vulnerability of the economy that faces these large inflows (Petroulas, 2004).
According to another research (Gavin and Hausman, 1995), financial crises are typically preceded by lending booms. When banks are faced to the increased supply of deposits, they have more funds and can increase the supply of loans as well. However, supply might become larger than demand and it may result in decreased quality and increased risk of loans.In 2009 the lending by chinese banks exploded and every next year the number of loans kept incresing constantly (see figure 1).In addition to bank lending, a signifact part of domestic lending in China is administrated by private lend ers which are not regulated by the governmeent (Li, 2011). As borrowing from banks became more difficult and time-consuming, private cred it businesses are booming as the demand, especiaally from small and medium business sector, is vast.
The ecxessive lending creaates price booms and in China’s case country faces a huge real estate market “bubble”. Increasiing supply of real estate and speculators have driven the prices to the edge of overheating where actual consumers could not afford them anymore and it became just “a game” between the speculators. At the end of 2011 real estate prices stopped growing and even declined slighttly as China’s government impied stricter regulaations fearing for even bigger expansnion of the “bubble” (Bradsher, 2011). At this point we couuld compare this situation with the world pre-finaancial crisis of 2008 period when the real estatte price “bubble” emerged. When thye prices starrted to decline, western financial sector collappsed draging the global economic welfare with itt (Grigor’ev and Shalikov, 2009). Price decline in chinese real estate market could also marrk the beginning of economic downturn. Because China’s government owns and has strong control over the biggest country’s banks (Hu, 2003), they can manage holding the prices of reaal estate from drastic diminishing. Anyways, “o ne of the world’s few remaining real estate bubbles finally seems to be losing air” (Bradsheer, 2011). As we mentioned before, China has reserves exceeding 50% of GDP (Ma and Yi, 2010) which they could use to buffer the losses if crisis occurs. However, this might be just postponing of the more significant recession. It seems that China’s situation might also prove Gavin and Hausman’s (1995) statement that there is a strong relationship between an excessive lending and crises.
Directly, or indirectly, as we can see from the theories above, excessive short-term capital inflows increase the economic vulnerability to crises. China is faces with the excess liquidity and theoretically it decreases country’s financial stability.
China’s governmental policies that affect short-term capital flows
To understand the current economic situation in China, we need to analyse country’s monetary and fiscal policies. We focus on the governmental policies that have the biggest effect on attracting the large inflows if short-term capital.
In 1994 Yuan depreciated to 8.7 RMB/USD and officially PBC stated that they would have floating exchange rate regime. In reality the PBoC managed the exchange rate and pegged it to US dollar which can obviously be seen in the statistical data (see Figure2).
Witnessing rapid growth of the Chinese economy developed countries blamed China for “currency manipulation” by undervaluing the Yuan and insisted on letting it appreciate according to the real market situation (Soofi, 2009). In 2005 China switched to a more flexible exchange rate and the value of renminbi jumped up- during 2008 it had grown by almost 18% (see Figure2). From 2008 to 2010 PBoC tried again to slow down the appreciation of renminbi as the exchange rate had fallen to, by that time record low, around 6.8 RMB/USD (see Figure 2).However, the pressure was too high and PBoC gave the exchange rate a bit more flexibility in 2010.
The main reason for the appreciation of the Renminbi is large capital inflows from foreign investors to China. The bulk amount of such investments increases the demand of its currency Yuan drastically and gives pressure for the exchange rate to appreciate (Flatt, 2011). Even though the exchange rate is now given more flexibility, PBC still carefully manages it in order to keep the prices of export as low as possible and therefore to keep high global competitiveness (McKinnon, 2009). Also, the fixed exchange rate regime is used as an effective monetary tool for stabilizing China’s internal price level (ibid). The main measure for resisting the appreciation of Renminbi is usually buying US dollars and sterilizing them by purchasing US treasury bills and therefore increasing its reserves held in foreign currencies (Flatt, 2011). Efforts to manage the exchange rate give even stronger pressure on it to go down. A research by Fu and Lin (2012) reveals that unemployment rate and real exchange rate are negatively correlated. China’s communist government must keep the unemployment level to minimum which makes it another influential factor for the exchange rate of renminbi to go down and increase its value. The result of strong pressure on appreciating value and moderate governmental intervention to slow it down is, according to McKinnon, a “one-way bet that the renminbi always rises” (2009, pp. 81).
Makin (1974), as cited by Goldstein, Mathieson and Lane (1991), “was concerned with the distortions created by a system of fixed exchange rates”. However Goldstein, Mathieson and Lane (1991) argue that potential currency misalignments can also be a reason for a long-term distortion to the capital flows under a flexible exchange rate system. As a result of speculative “bubbles” and exchange rate value being driven even further from its theoretical equilibrium authors see that the outcome has to be increased exchange rate risk and rapidly changing asset prices (ibid). Because of guaranteed (at least for now) increase in the value of renminbi, there are strong intentions for the speculative “bubbles” to gain more air, if not in one sector than in other.
The goal of China’s exchange rate regime is to keep the domestic companies competitive in the global market and it serves its purpose. However, the Renminbi is obviously undervalued and this brings distortions to the markets as well as reduces the financial stability of the country.
As China’s government’s one of the main objectives is to promote economic growth (People’s Bank of China, 2012), country’s fiscal policies are generally welcoming the bulk amounts of FDI. During past several years China liberalized the FDI policies allowing more and more foreign capital companies to be established in the country (Chen, 2011). This attracted a lot of capital and, as there are some tax concessions for FDI, a lot of fictional investments came along with it (Flatt, 2011). Due to the favourable status of FDI, companies took their profits out of China and reinvested them as new FDI to gain the benefits. This process is described as capital “round tripping” (Chen, 2011). Even though now foreign companies are treated more like domestic ones, there is still a lot of unregulated short-term capital flowing through them. Because of the bulk amount of international trade and investment, Chinese government is unable to track intentional misinvoicing or how the funds that come to foreign capital companies is used.
China’s governmental policies are growth-oriented which guarantees the growth of GDP (i. e. Gross Domestic Product). However keeping the currency undervalued and attracting foreign capital leads to market distortion which is then used by speculators for short-term investment and quick profits. Thus attracting short-term capital flows and thinking only about growth increases the financial instability of the country.
Policy response to capital inflows
Even though China is growth-oriented, the government sees the potential damage that is caused by excessive short-term capital inflows. Therefore the government is already taking some measures to prevent the economy from downturn. As stated by Khan and Reinhart (1995), “policy response to capital inflows is necessary because of the fear of inflationary pressures, real exchange rate appreciation, and loss of competitiveness and deterioration of current account.
Capital inflows could also destabilize financial markets”. There are several measures, which can be used to control the capital inflows or at least to decrease the severity of the consequences. As stated by Khan and Reinhart (1995) country can regulate capital inflows by either monetary or fiscal policy. Therefore, in the next sections we will present the main monetary and fiscal tools for capital controls.
Exchange rate regime
Central bank can decide whether to keep exchange rate floating or keep it fixed, there are positive and negative aspects on either of these decisions of the monetary policy. Keeping the exchange rate floating may result in reducing the inflation, since increased demand in national currency would put pressure on nominal exchange rate, but not prices (Khan and Reinhart, 1995). Another aim of floating exchange rate is to bring the uncertainty to foreign speculators, since floating exchange rate can also result in depreciating target currency, which would mean losses for short-term investors. However, according to theory stated by Reinhart and Dunnaway (1996), because of increased demand of currency, which occurs when country is faced with capital inflows, exchange rate tends to appreciate, so this would make the country even more attractive to speculators. Also letting the nominal exchange rate to float freely would result in contracted trading sector, since the appreciating currency would not only make export goods more expensive, but it would also bring uncertainty to foreign markets in general.
Having fixed exchange rate regime, central bank has to change money supply constantly to keep the exchange rate stable. If a country is facing a surge of capital inflows, their currency would appreciate because of increased demand of that currency. However, if there is a fixed exchange rate, central bank has to decrease money supply to offset the effect of capital inflows and that way make the exchange rate stable. If there is a bulk amount of capital inflows, it can be hard for a central bank to control the supply. Then increased money supply results in increased inflation and bigger prices of export goods. In one way, fixed exchange rate is beneficial, because it is less risky for foreign markets, since there is no fluctuation in exchange rate, plus import sector would especially benefit, because it would thrive when economy is faced with domestic inflation (Kenen, n.d.). On the other hand because of increased inflation and prices of products, the exporting sector would still endure a big loss. There are also two sides when dealing with capital inflows. When speculator is dealing with fixed exchange rate, he feels safer, because there is no way a currency could depreciate, but it is also less profitable, since there is no profit gained from appreciating target currency.
Neither floating nor fixed exchange rate are completely perfect, so country can also choose to manage the exchange rate, which means, that technically exchange rate can float, but the central bank makes sure, that fluctuations would not be sharp and severe to economy. A country can manage exchange rate by pegging its currency to another currency or a basket of currencies, it can also create ceiling and floor for exchange rate fluctuations. One more measure suggested by Martin and Morrison (2008) is currency depreciation. By depreciating its currency country could scare off speculators. However it is only a one time short-term measure which is also controversial in domestic and foreign markets.
Sterilized intervention
One more measure, that central banks could choose to use, is sterilized intervention. Sterilized intervention or sterilization is when central bank uses open market operations to exchange domestic securities for foreign exchanges (currency, securities, and assets) (Investopedia, 2012a). This measure is not used to stop the surge of short-term capital inflows, but rather to control the consequences of them. By sterilization central bank tries to isolate the economy from any macroeconomic effects created by increasing amount of capital inflows. Khan and Reinhart (1995) argues that encouraging the growth of the monetary aggregates may be undesirable because then the availability of credit increases and quality of loans decrease, putting banking system at risk. Also, a rapid growth could “overheat” the economy as well as increase inflation. In theory, by using sterilization, central banks can avoid these consequences of capital inflows. However, sterilization decreases money supply and according to Mundell-Fleming model- decreased money supply results in increased domestic interest rates, so in the long-run sterilized intervention actually attracts more short-term capital inflows as it becomes more profitable to speculate. Additionally, as Calvo, Leiderman and Reinhart (1996) stated, sterilization involves increasing the number of domestic bonds, which then should be bought by domestic banks to offset the currency inflow and this results in increased public debt. If public debt grows as large as to create uncertainty for investors about country’s policies it could actually stop the capital inflows, but it may also start a quick surge of capital outflows, which may increase economic vulnerability to financial crisis. Lavigne (2008) also identifies negative consequences of overusing sterilized intervention. He argues that sterilized intervention may lead to financial markets’ distortions, to be more specific – under intermediation. Since usually central banks force or stimulate other banks to buy its securities, it makes banking sector less profitable, also it interferes with free market resource allocating. Though sterilized intervention does help to reduce the inflation caused by capital inflows, it creates a lot of other problems, also every time the amount sterilized has to be bigger and bigger.
Banking regulation and supervision
Banking sector is of greatest importance when it comes to capital inflows, because if domestic interest rates are high, a lot of short-term foreign capital is being deposited into banks for quick profit. That is why central bank is using bank regulations and supervision to decrease the vulnerability and risk of banking sector. When commercial banks are faced with highly increased amount of deposits, but economic environment in a country is perceived to be developed, risk will be evaluated as low, leading to an over-expansion of credit issuance. Rapid growth of credit leads to credit and asset price bubbles which eventually makes the banking system vulnerable and risky (Roengpitya, 2010). This problem especially occurs with big banks which have a lot of customers as well as loans and deposits. These banks are being called “too big to fail”, because if they would go bankrupt, the whole banking sector as well as financial system in a country might collapse. Therefore, managers of such banks intentionally take up more risk when investing or lending money, because in case of failure central bank would be expected to save their bank from going bankrupt. This situation is called moral hazard (Khan and Reinhart, 1995). By regulating banking system central bank can decrease credit supply and therefore increase loans and investments quality. As a result, banking system would not be at higher risk and inflationary pressure would decrease. This is the only measure that does not have any drawbacks on the financial markets, but on the other hand it is the hardest measure to implement. It is nearly impossible to create a regulatory system that would flawlessly cover all aspects of banking and include all financial institutions. Also, especially in huge countries it is harder to follow if all the requirements are followed correctly.
It is important to emphasize the importance one measure from bank regulation- it is reserve requirements for domestic banks. This is because this tool is thought to be effective for controlling the effects of excessive capital flows (Reinhart and Dunnaway, 1996). Raising the reserve requirements for banks would decrease the credit supply and that would decrease the risk of having a lending boom and an asset price bubble. Reinhart and Dunnaway (1996) noted that reserve requirements are a tax on banking system, but banks tend to pass this tax on their clients. If the tax is passed on to depositors it could actually decrease capital inflows, because decreased interest rate on deposits would make it less profitable for speculators to invest in such deposits. However, if it is passed on to borrowers it would actually increase capital inflows, since firms would then rather borrow from foreign investors, than borrow from domestic banks. Another problem is that this is a onetime measure, so it could only help for a short time period. In the long-term new institutions would be established bypassing the regulations (Khan and Reinhart, 1995). Such institutions would grow until they become “too big to fail” and country would be faced with the similar problems as global economy had during the financial crisis of 2008. To sum up, raising reserve requirements just hold of the negative capital inflows’ effects for a short period of time, but eventually the effectiveness of this measure diminishes.
Fiscal tightening
One more measure practiced by governments is fiscal tightening. Keynesian theory states, that government has to step in and increase government spending when economy is in a downturn, but it has to contract its expenditure when economy is booming. Decreasing government spending should result in lower aggregate demand (Khan and Reinhart, 1995). This happens, because cut expenditure to institutions would lower their spending for products and services or wages to their workers. Lower aggregate demand would result in contracted domestic market and eventually in decreased inflationary pressures, since it would be unprofitable to raise prices in low demand market. Fiscal tightening would benefit the country not only by decreasing inflation, but it would also be less attractive to capital inflows, because contracted market and slower economy offers lower returns. Schadler (2008), however, argues that fiscal restraint may actually attract more capital inflows. This would happen, because investors would feel safer with stable fiscal policy, making their investments less risky. Schadler (2008) also explains that capital inflows attracted by fiscal tightening would be preferable to country, since it would not attract speculators (because of decreased return), but mostly FDI. However, usually governments do not choose this measure because it decreases country’s GDP, it takes a long time to discuss such sensitive matter and most importantly it is unpopular for politicians to take such decisions. To make matters worse if this measure is delayed or not taken to its full extent, rapid growth could outrun it and after the economy had grown significantly, the country could lack basic infrastructure due to flaw of governmental expenditure.
Table of contents :
1. INTRODUCTION
2. LITERTATURE REVIEW
2.1 Capital flows and their movement
2.2 Relationship between short-term capital inflows and economic vulnerability
2.3 China’s governmental policies that affect short-term capital flows
2.4 Policy response to capital inflows
2.4.1 Exchange rate regime
2.4.2 Sterilized intervention
2.4.3 Banking regulation and supervision
2.4.4 Fiscal tightening
2.4.5 Trade barriers for capital inflows
2.5 The People’s Bank of China measures against the short-term capital flows
3. THEORETICAL FRAMEWORK
4. DESCRIPTION OF THE METHOD
5. PAST EXPERIENCE
5.1 Exchange rate regime
5.2 Sterilized intervention
5.3 Banking regulation and supervision
5.4 Fiscal Tightening
5.5 Trade barriers for capital inflows
6. IMPLEMENTATION OF THE MEASURES IN CHINA
6.1 Exchange rate regime
6.2 Sterilized intervention
6.3 Banking regulation and supervision
6.4 Fiscal Tightening
6.5 Trade barriers for capital inflows
7. CONCLUSIONS
8. REFERENCES
