capital account liberalization -japan’s experience and its implications to china-

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Capital Account Liberalization -Japan’s Experience and its Implications to China- September 13, 2014 Kenji Aramaki Tokyo University 1

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Capital Account Liberalization -Japan’s Experience and its Implications to China-. September 13, 2014 Kenji Aramaki Tokyo University. Outline. (1) Post‐war Legal Framework (2) Overall Process-Three staged Liberalization (3) Main Features of Liberalization of Capital Account - PowerPoint PPT Presentation

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Page 1: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Capital Account Liberalization

-Japan’s Experience and its Implications to China-

September 13, 2014Kenji Aramaki

Tokyo University

1

Page 2: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Outline1. Japan’s Experience

(1) Post‐war Legal Framework(2) Overall Process-Three staged

Liberalization(3) Main Features of Liberalization of

Capital Account (4) Regulatory Response to Unstable

Capital Flow in the 1960s and 1970s

2. Implications to China (1) Characteristics of China’s Capital

Account Liberalization (2) Implications from Japan’s

Experience

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Page 3: Capital Account Liberalization -Japan’s Experience and its Implications to China-

1. Japan’s Experience(1) Post‐war Legal Framework • The Foreign Exchange Law (1949)

(and the Foreign Capital Law (1950)) wholly controlled both trade and foreign exchange after the war

• For trade, imports were placed under the approval system

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Page 4: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Four major features of foreign exchange regulations under the post‐war legal framework① General prohibition・ A principle of “general prohibition

with liberalization for exceptions” adopted

② Foreign exchange concentration system

・ All foreign exchange centrally controlled by the government 4

Page 5: Capital Account Liberalization -Japan’s Experience and its Implications to China-

③ Foreign exchange budget system・ The amounts and items to be imported

were regulated by this budget④ Authorized foreign exchange bank system・ The authorized foreign exchange banks

were used as a management mechanism of foreign exchange and capital account transactions

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Page 6: Capital Account Liberalization -Japan’s Experience and its Implications to China-

(2) Overall liberalization process-Three staged liberalization• Capital account liberalization substantively started

in the early 1960s and completed in the late 1990s, i.e., nearly 40 years later

• The whole process may be divided into three stages: 1st stage: Liberalization of trade and current

account transactions ( ~ mid‐1960s) 2nd stage: Gradual easing and a major shift to a

system of general liberalization (latter half of 1960s~ end 1970s)

3rd stage: Completion of liberalization (1980s ~latter half of 1990s)

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Page 7: Capital Account Liberalization -Japan’s Experience and its Implications to China-

The 1st stage: Liberalization of trade and current account transactions ( ~ mid‐1960s)• In 1960, “the Basic Plan for Liberalization of Trade

and Foreign Exchange” adopted by the government• It called for an increase in import liberalization, and

the general liberalization of current account transactions within two years

• In April 1964, Japan accepted IMF Article Ⅷ obligations, abolished the foreign exchange budget system, and generally liberalized current account transactions

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Page 8: Capital Account Liberalization -Japan’s Experience and its Implications to China-

The 2nd stage: Gradual easing and a major shift to a system of general liberalization (later half of 1960s ~ 70s)• “The Basic Plan” showed a cautious

stance on capital account transactions and only stated that regulations would be eased gradually

• In a testimony before the Diet in February 1962, then Minister of Finance SATO, Eisaku stated that the effects of international capital account transactions would be long and deep and therefore care needs to be paid to their treatment 8

Page 9: Capital Account Liberalization -Japan’s Experience and its Implications to China-

• Gradual easing of regulations continued over more than a decade, started with the significant inward direct investment liberalization in 1967

• The foreign exchange concentration system abolished and holdings of foreign exchange by residents liberalized in 1972

• The regulatory framework thoroughly revised and a major change from general prohibition to general liberalization implemented by the 1979 reform

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Page 10: Capital Account Liberalization -Japan’s Experience and its Implications to China-

The 3rd stage: Abolition of remaining regulations and completion of capital account liberalization (1980s ~ latter half of 1990s)• Even under the 1979 reform, certain

transactions were placed under the approval/prior notification requirements

• In 1997, the foreign exchange law was revised again, basically abolishing approval/prior notification requirements and liberalizing foreign exchange business, completing liberalization of capital accounts in Japan

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Page 11: Capital Account Liberalization -Japan’s Experience and its Implications to China-

(3) Main features of capital account liberalization ① Main feature (1): Cautious and gradual

sequencing of liberalization taking into account of the type of transactions

・ Substantive liberalization of capital account started after the liberalization of current account transactions

・ Liberalization of inward investment generally preceded to liberalization of outward investment

   e.g., While liberalization of inward direct investment started in 1967, liberalization of outward direct investment started in 1969

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Page 12: Capital Account Liberalization -Japan’s Experience and its Implications to China-

• Liberalization of direct investment generally preceded to liberalization of other types of transactions

e.g., After the major liberalization of direct investment started with the first foreign capital liberalization package in 1967, liberalization of other type of transactions such as portfolio investment followed

・ Certain transactions were treated cautiously until the very late stage

e.g., Such transactions included foreign currency denominated lending between residents and cross-border issuance of banks

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Page 13: Capital Account Liberalization -Japan’s Experience and its Implications to China-

② Main feature (2): Use of foreign exchange banks as a mechanism for foreign exchange control • Under the Foreign Exchange Law,

authorized foreign exchange banks played a major management role by tracking overseas transactions and verifying their legal appropriateness

• These functions basically maintained even after the 1979 reform

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Page 14: Capital Account Liberalization -Japan’s Experience and its Implications to China-

• Approval/prior notification requirements for some transactions exempted for business activities by authorized foreign exchange banks, thus encouraging capital flows to be channeled through foreign exchange banks

• The 1997 reform, which liberalized foreign exchange business, greatly reduced the management function of banks

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Page 15: Capital Account Liberalization -Japan’s Experience and its Implications to China-

③ Main feature (3): Neutral stance for the internationalization of the yen• The use of yen allowed for foreign payments

in 1960• At the same time, non-resident free yen

account was introduced• Non-residents were allowed to deposit with

free yen account not only those yen received for current account transactions such as import to Japan but also those yen they obtained through the sale of foreign currency to banks

• This treatment opened a channel for the inflow of short-term capital for the first time

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Page 16: Capital Account Liberalization -Japan’s Experience and its Implications to China-

• International use of the yen progressed gradually in the 1970s

e.g., While the ratios of yen-denominated export and import are respectively 17.5% and 0.9% in 1975 and 29.4% and 2.4% in 1980, these ratios for West Germany were greater than 80% and 40-50% respectively around that time.

• Policy stance at that time seems to have been a neutral one; the internationalization of the yen would proceed as a result of internationalization and liberalization of Japan’s economy and the government should not employ intentional measures to promote it 16

Page 17: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Debates on internationalization of the yen in the “Yen-Dollar Committee” in 1984• The internationalization of the yen

became a hot issue in the “Yen-Dollar Committee” that was established by the agreement between Japan’s Minister of Finance and the U.S. Treasury secretary in late 1983

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Page 18: Capital Account Liberalization -Japan’s Experience and its Implications to China-

The U.S. argued as follows:・ The yen/dollar exchange rate

issue underlying the trade imbalances between Japan and the U.S. is caused by the lack of appropriate valuation of the yen due to the closed nature of Japan’s financial and capital markets

・ Japan needs to liberalize financial and capital markets and internationalize the yen

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Page 19: Capital Account Liberalization -Japan’s Experience and its Implications to China-

• In relation to the former (i.e., liberalization of domestic markets), Japan took a position that liberalization of financial and capital markets was beneficial to Japan’s economy and therefore Japan would cope with the issue on its own initiative.

• As for the latter (internationalization of the yen), Japan took a position that may be described as a “Natural Evolution” approach as below:

The internationalization of the yen will proceed basically as a result of choice made by parties concerned in transactions

The role of policies is to remove barriers to the use of the yen when parties concerned chose to use it.

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Page 20: Capital Account Liberalization -Japan’s Experience and its Implications to China-

• While Japan implemented measures incorporated in the Committee’s report such as the abolition of yen conversion limit (a type of over-sold position limit) and the internationalization of the yen progressed to a certain extent in the latter half of the 1980s, the international role of the yen stayed relatively low or decreased subsequently partly reflecting stagnation of Japan’s economy since the 1990s

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Page 21: Capital Account Liberalization -Japan’s Experience and its Implications to China-

(3) Regulatory responses to the unstable short-term capital flows in the 1960s and 1970s

• In the liberalization process, Japan extensively used capital control measures to cope with destabilizing capital flows in the late 1960s and 1970s

• Direction of policies frequently reversed under the changing international environments

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Page 22: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Japan: Short-term Capital Controls and Developments in Balance of Payments, Exchange Rate and Foreign Reserves, 1965-1981

(Ⅰ ) (Ⅱ ) (Ⅲ ) (Ⅳ) (Ⅴ ) (Ⅵ)

▲ 6

▲ 3

0

3

6

9(bn. $)

TradeBalance

CurrentAccount

ExchangeRate(right scale)

Source) MOF"Bal ance of Payments", I MF"I nternat i onal Fi nanci al Stat i st i cs"

TotalReserves

0

10

20

30

40

50

60

70

80

90

100

65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81

160

200

240

280

320

360

400

440

480

520

560

600

(yen/ $)

(bn. $)

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Page 23: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Sharp rise in foreign reserves toward end 1960s

Major policy reversal from inflow promotion to inflow restriction (a switch from “heater” to “cooler”)

Three main channels of short-term capital inflow at the “Nixon Shock”

Period Ⅰ : late 1960s to mid 1971

i. non resident free yen accountsii. portfolio investment in bonds by non-

residentiii. export pre-paymentsPolicy responses

i. balance limit imposed on free yen accounts

ii. de-facto ban on the acquisition of bonds by non-resident

iii. ban on the yen conversion of export pre-payments

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Page 24: Capital Account Liberalization -Japan’s Experience and its Implications to China-

A very rough estimate: The inflow of short-term capital, at an annualized rate, was equivalent to more than 10 % of Japan’s GDP • Outstanding balance of free yen accounts; $ 0.6 bil.

at end Feb.1971 to $ 0.8 bil at end May 1971• Purchase of bonds by non-residents; $ 0.001 bil/year

in the past to $ 0.1 bil./Month in Mar. and Apr. 1971• Export prepayment; $ 0.05 bil./month to $ 2 bil. in

Aug. 1971• Annualized amount of these three inflows combined

is 26billion/year (0.2/3 + 0.1 + 2 ) ×12 ) and equivalent to 12 % of Japan’s GDP in 1971(80.7 trillion yen or $ 224.2 bil. If converted by the rate of 360 yen to the dollar)

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Page 25: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Period Ⅱ : end 1971 to around mid-1973Relaxation of restrictions

immediately after the Smithsonian Accord

Re-strengthening of controls under a massive inflow of short-term capital

Some relaxation of purchasing and holding of foreign currency by residents

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Page 26: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Period Ⅲ:end 1973 to mid 1974Return to the inflow promotion policy

under a sharp depreciation of the yen after balance of payments deteriorations under a rising inflation and the first oil crisis

e.g., Reserve rate for increases in free yen account significantly lowered

Some outflow restrictions also adopted

Period Ⅳ: 1975 to mid1977Under the relative stability of the

international financial markets, both inflow and outflow restrictions eased 26

Page 27: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Period Ⅴ: end 1977 to 1978• With resurgence of massive inflow

of short-term capital, policies switched again to inflow restrictions

e.g., Reserve rate for increases in free yen account raised (0%→ 50 %→ 100 % )

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Page 28: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Period Ⅵ: 1979 to 1980With a sharp depreciation of the yen

after the second oil crisis, policies reversed again to inflow promotion

Subsequent situationsWith the capital account liberalization

promoted by the comprehensive revisions to the Foreign Exchange Law (1979), and with Japan's continued growth and its further strengthened external position, such policy ceased to be observed after entering the 1980s

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Page 29: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Summary of Japan’s experience

(1) Substantive capital accounts liberalization started in the early 1960s and liberalization was completed in the late 1990s, taking nearly 40 years, and it proceeded through three stages; current account liberalization, a switch to a generally liberalized system, and abolition of remaining restrictions.

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Page 30: Capital Account Liberalization -Japan’s Experience and its Implications to China-

(2) With regard to the type of capital account transactions, the liberalization of inward investment generally preceded the liberalization of outward investment, liberalization of direct investment preceded to liberalization of other investment, and investments with higher risk were treated cautiously until the last stage of liberalization.

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Page 31: Capital Account Liberalization -Japan’s Experience and its Implications to China-

(3) Throughout the liberalization process, the authorized foreign exchange banks were used as an effective foreign exchange management mechanism.

(4) Non-resident free-yen accounts were introduced at an early stage, which later became one of the key channels for the inflow of short-term capital. Portfolio securities investment and trade-related payments also became key channels for the short-term capital flow.

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Page 32: Capital Account Liberalization -Japan’s Experience and its Implications to China-

(5) Foreign exchange controls and regulations on capital transactions were frequently adopted in order to manage short-term capital flows and are thought to have had effectiveness of a certain degree in preventing market instability

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Page 33: Capital Account Liberalization -Japan’s Experience and its Implications to China-

(6) Regarding the internationalization of the yen, while the yen settlement was allowed as early as in 1960, and the government made efforts to remove obstacles to internationalization of the yen partly in response to the request from the U.S., international use of the yen has not come to the level that matches the size of Japan’s economy.

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Page 34: Capital Account Liberalization -Japan’s Experience and its Implications to China-

2. Implications to China

(1)Characteristics of China’s capital account liberalization

・ In around mid-1980s, China had a total state control of external transactions

・ Subsequently, it liberalized the current account transactions in 1996, and gradually liberalized capital account transactions, while maintaining overall regulatory framework.

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Page 35: Capital Account Liberalization -Japan’s Experience and its Implications to China-

• In terms of three stage division of Japan’s process, China is in stage 2

• There are many commonalities with Japan, including the adoption of a firm gradualism, and sequencing of liberalization by type of transactions with inward direct investment coming first and the cautious treatment given to risky investment

• While China’s liberalization somewhat accelerated after entering the 2000s, the most distinctive feature is the fact that the pace of progress of liberalization for the internationalization of renminbi seems to be faster than the pace of liberalization in other areas.

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Page 36: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Implications from Japan’s experience(a) Control of risk• The most important thing is to control

concomitant risk when liberalizing capital account

• In Japan’s experience, the most important inflow channels included capital flows through foreign exchange banks, purchase of securities by non-residents, and trade-related capital flows

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Page 37: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Trade-related flows can be very significant and in this respect China may be already facing risk of huge capital outflows There was a huge outflow of "other investment", amounting to -$25.50 billion in 1997, and -$43.70 billion in 1998 .

▲ 60000

▲ 40000

▲ 20000

0

20000

40000

60000

80000

100000

120000

90 91 92 93 94 95 96 97 98 99 00 01 02 03▲ 80000

▲ 70000

▲ 60000

▲ 50000

▲ 40000

▲ 30000

▲ 20000

▲ 10000

0

10000

20000PORTFOLI O I NVESTMENT( r i ght scal e)

OTHER I NVESTMENT( l ef t scal e)

(Mn. USD)

(Mn. USD)

Souce) I MF"I nternat i onal Fi nanci al Stat i st i cs", SAFE

China: Trends of Portfolio Investment and Other Investment, 90-03

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Page 38: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Behind the outflow of other investment, there was a massive outflow of trade credit (increase in assets) from China under devaluation expectation of renminbi during the Asian crisis China: Trends of Trade Credits, 97-03

▲ 30

▲ 20

▲ 10

0

10

20

30

40

50

60

97 98 99 00 01 02 03▲ 45

▲ 40

▲ 35

▲ 30

▲ 25

▲ 20

▲ 15

▲ 10

▲ 5

0

5

TradeCredi t (Asset )

TradeCredi t (Li abi l i t y)(Bn. USD)

(% of Exports)

TradeCredi t (Net )

Source) State Admi ni strati on of Forei gn Exchange, "Bal ance of Payments"38

Page 39: Capital Account Liberalization -Japan’s Experience and its Implications to China-

That is just the same (while in an opposite direction) with what happened to Japan under the revaluation expectation of the yen around the Nixon shock

▲ 10

0

10

20

30

40

50

60

70

67 68 69 70 71 72 73 74

260280300320340360380400420440460480500520540

(% of Total Exports)

(Yen/ USD)

Exchange Rate

Trade Credi t(Net )

Source) Mi ni st ry of Fi nance, "Bal ance of Payments" I MF, "I nternat i onal Fi nanci al Stat i st i cs"

Japan: Trends of Trade Credits, late 60s to early 70s

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Page 40: Capital Account Liberalization -Japan’s Experience and its Implications to China-

A few points may be noted regarding the control of risk• First, the effectiveness of

management will be enhanced if capital transactions are basically conducted through financial institutions including banks.

• Second, in the case of Japan, it was direct quantitative measures that finally effectively managed short-term capital flows under major external shocks

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Page 41: Capital Account Liberalization -Japan’s Experience and its Implications to China-

In this regard, we should take not that, in the case of Thailand before and after the Asian crisis, what flew in most and what flew out most was “Other investment”, mainly composed of bank credit

Balance of payments: Thailand (in Billions of U.S. dollar)

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Page 42: Capital Account Liberalization -Japan’s Experience and its Implications to China-

More specifically, an abrupt reversal of external bank credit flows seems to have been a major cause of Thai crisis in 1997-98

▲ 20

0

20

40

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1977

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1980

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1987

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1989

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1991

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1997

1998

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2000

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2002

2003

2004

2005

Non-bank Bank Outstanding balance of net assets

(Bil.US$)

Note: Outstanding balance of net assets refers to assets minus liabilities.Source: BIS Quarterly Review, March 2007

(End of quarter)

Outstanding balance of net assets held by BIS reporting banks vis-à-vis Thailand

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Page 43: Capital Account Liberalization -Japan’s Experience and its Implications to China-

The less affected countries in the Asian currency crisis (China, Vietnam, and India) had a system of quantitatively regulating foreign borrowings by banks

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Page 44: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Regulation of foreign borrowings by banks

China Foreign borrowing over 1-year maturity by banks must be part of the

state plan for utilizing foreign capital and must be approved by the

State Administration of Foreign Exchange (SAFE). Foreign short-term

borrowing (with a maturity of 1 year or less) by banks is subject to

foreign exchange balance requirements and must be registered with

the SAFE.

Bank foreign exchange liquid assets (1year or less) should not be less

than 60% of liquid liabilities (1year or less) and 30% of total foreign

exchange assets.

For financial institutions trading foreign exchange on their behalf, the

daily total amount traded (total open foreign exchange position)

should not exceed 20% of the foreign exchange working capital.

Vietnam

Foreign borrowing by banks is subject to approval from the State

Bank of Vietnam (SBV) to borrow abroad.

India Foreign borrowing by banks is subject to approval by the government

of India, the Ministry of Finance (MOF), and the Department of

Economic Affairs.

Banks are required to maintain on an ongoing basis tier I capital of 5%

the open position limit approved by the Reserve Bank of India (RBI).

Major regulation of foreign borrowings by banks in less affected countries (as of 1996)

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Page 45: Capital Account Liberalization -Japan’s Experience and its Implications to China-

However, such a situation may have already changed even for China. In 2012, China experienced a huge outflow of other investment amounting to $260 billion. i.e., six times as large as in 1998

-3,000

-2,000

-1,000

0

1,000

2,000

3,000

4,000

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

Capital & Financial AccountDirect Investment (net)Portfolio Investment (net)Other Investment (net)

China's Capital & Financial Account: 1982-2012

(source) SAFE, Chinese Government

($100 mil )

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Page 46: Capital Account Liberalization -Japan’s Experience and its Implications to China-

What flew out most from China in 2012 are ① Currency & Deposits, ② Loans, and ③ Trade Credit

-3,000

-2,500

-2,000

-1,500

-1,000

-500

0

500

1,000

1982

19

84

1986

19

88

1990

19

92

1994

19

96

1998

20

00

2002

20

04

2006

20

08

2010

20

12

Other Investment (net)Trade Credit (net)

Loans (net)

Currency & Deposits (net)

Other

Breakdown of other investment: 1982-2012

(source) SAFE, Chinese Government

($100 mil )

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Page 47: Capital Account Liberalization -Japan’s Experience and its Implications to China-

• Third, one more important thing to be examined is whether to maintain a regulatory system for the unlikely adverse events, as was instituted in the 1979 revision in Japan

• In other words, will China jump to and complete stage 3 or proceed step by step?

• In this connection, it is noteworthy how China will handle negotiations of a bilateral investment treaty with the U.S. The U.S. insisted to the very final stage on total abandonment of capital transaction regulations in the negotiations with Singapore and Chile, and this became a major issue.

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(b) Internationalization of renminbi

• In order to promote internationalization of the renminbi, it is necessary to allow holding and free disposal of renminbi by non-residents

• In Japan’s experience, free holding of local currency by non-residents would lead to abrupt rise and fall of capital flows, significantly affect liquidity position of financial institutions and stability of foreign exchange rate and can influence effectiveness of monetary policy.

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Page 49: Capital Account Liberalization -Japan’s Experience and its Implications to China-

• It is also difficult to promote internationalization of a currency, separately from the liberalization of domestic financial and capital markets.

• It should be asked whether the policy of promoting internationalization of renminbi aims at economic goals based on assessment of benefits/costs and risk or aims at political goals such as strengthening autonomy of the nation

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Page 50: Capital Account Liberalization -Japan’s Experience and its Implications to China-

(c) Foreign exchange rate determination system

• Under what is called “Impossible Trinity” argument in international finance, it is not possible to achieve three goals at the same time, stability of exchange rate, free flow of capital and independent monetary policy.

• China as a big economy with its own economic cycle cannot give up independent monetary policy, then it has to choose either free capital flows or stable exchange rate

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Page 51: Capital Account Liberalization -Japan’s Experience and its Implications to China-

• While it may not be a choice between all or nothing, in other word there may be some middle ground in between, it has to be asked whether China is ready to modify its current very stable exchange rate regime (classified as crawling peg like system by the IMF) in accordance with the schedule of capital account liberalization.

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Page 52: Capital Account Liberalization -Japan’s Experience and its Implications to China-

Thank you謝々

ご清聴、有難うございました

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