Further Development of Renminbi's Exchange Rate Regime after Joining the WTO

Contents

List of Tables

List of Figures

List of Abbreviations

1. Introduction

2. Literature Review
2.1 De Jure Classification and De Facto Classification
2.2 Exchange Rate Regimes: Classification and Characteristics

3. Historical Development of the Chinese Exchange Rate Regime before Joining the WTO
3. 1 A Fixed Exchange Rate with the Unilateral RMB Peg to the U.S. Dollar
3.1.1 A Brief History of Chinese Currency Exchange Regime
3.1.2 The Pros and Cons of Chinese Currency Exchange Policy
3.2 China's Exports of Capital and Capital Account Controls before Joining the WTO
3.2.1 The Capital Exports of China before Entering WTO
3.2.2 The Capital Control Strategy of China before Entering WTO
3.3 Overvaluation and Undervaluation of RMB

4. More Developments of RMB‘s Exchange Rate Regime after Joining the WTO
4.1 The Change in Chinese Exchange Rate Regime after Entering WTO
4.2 The Status Quo of China's Capital Account Liberalization
4.2.1 Capital Management Policy of China after Entering WTO
4.2.2 The Reason behind China's Capital Restriction
4.3 China‘s high Saving Rate and Large Foreign Reserves
4.3.1 High Saving Rate: China‘s Modern Characteristic
4.3.2 China‘s Foreign Reserve
4.4 The Goal and Strategy of RMB
4.4.1 The Goal of Chinese Exchange Regime
4.4.2 Should Yuan Revaluate?
4.4.3 RMB's Strategy

5. Conclusion

Bibliography

List of Tables

1: How the Three Classification Variables Map into Exchange Rate Regimes

2: China's Current Account and Capital and Financial Account, 1994-2001

3: An Overview of Foreign Direct Investment (FDI) of China

4: Rank of China's Outward FDI Performance Index, 1991-2001

5: China's Capital Controls, 1996-2001

6: Under- and Overvaluation of the RMB, 1975-2001

7: Under- and Overvaluation of Selected Currencies in 2001

8: China‘s International Investment Position, 2004-2008

9: China‘s Capital Controls, 2002-2008

10: Status of Foreign Banks in China in 2007

11: Business Outlets and Assets of Foreign Banks in China, 2003-2007

12: Controls on Capital and Money Markets in China (By the End of December 2007) .

13: China Foreign Exchange Reserves, 1993-2009

14: High-Tech Trade as a Percentage of Merchandise Trade and Industrial Trade, 2001-2008

List of Figures

1: Capital Account Components, 1990-2001

2: Assets and Liabilities of China‘s Portfolio Investments

3: China‘s Long Term and Short Term Foreign Debt

4: Savings Rate in China, 1992-2007

5: Reserve Growth in China and Japan and East Asia, 1999-2006

6: Export Dependency Degree of China for Each Industry in 2007

7: China's Export to US Keeps Increase regardless Yuan's Revaluation

8: China's Total Exports and Imports of Processing Trade, 2000-2010

9: Expected Monthly CPI beneath the Carryover Effects in 2010

List of Abbreviations

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1. Introduction

After 20 some years of economy revolution, China in 2001 officially became a member of WTO, and since then China has entered a new era of a more rapid and deep involvement with the global economy. Entering WTO helped China to further develop, but at the same time brought uncertainty into China‘s economy. To maintain a stable economy growth, China has adjusted its economy since joined WTO, which has made China‘s currency policy a focus of global financial market. Especially during recent years, there has been a raise in global criti- cism about RMB‘s price, keeping Yuan undervalued, which resulted in an imbalance in glob- al economy. Western politic and economic consensus is that China should re-evaluate its cur- rent regime, allowing Yuan to revalue with a more flexible exchange rate. The purpose of this essay is to provide a detailed study on China‘s currency regime development, and based on the factors that shaped China‘s regime, to reach a conclusion on how China is going to adjust its exchange policy.

In the second chapter the categorization of exchange regimes is introduced. This is based on the how true the official regime to the actually exchange policy, and separate de jure classification from de facto classification. In terms of de facto classification, IFM and LYS are discussed. Additionally, various categorizations regarding RMB‘s regime such as fixed peg and crawling peg are also introduced.

The third chapter analyses China‘s exchange policy. After a brief of its recent development, an evaluation of China‘s pre-WTO regime is provided, which the article believes it basically fit into the demand of China‘s economy for the period and also helped China to avoid East Asia economy crisis. Also, although China in 1996 promised regular item exchange, but it‘s capital control has been still strict. The last section of the chapter discusses the negative impact of Yuan‘s undervaluation.

Chapter four offers first a detailed discussion of that how China adjust its exchange poli- cy after entering WTO, than analyses the change occurred after joining WTO to capital export and restriction, and the reason why China would not cancel the current capital restriction completely. The chapter also discusses high citizen saving rate and huge foreign reserves. Lastly the goal of Yuan‘s exchange policy is discussed; a study of global opinions and Chi- na‘s current economy situation is conducted regarding the impact of Yuan‘s revaluation on China‘s economy, export, employment, capital inflow, and deflation. After all the analysis, the article attempts to provide the possible strategy that China will adopt in the future.

Chapter five concludes that the rigid exchange policy is harmful to China‘s rapid econ omy growth, and China need to improve the flexibility of exchange regime to combat the future global economy impact.

2. Literature Review

After a lot of empirical studies, Mussa (1986, p.198) concluded: under different exchange rate regimes (fixed, floating), the performance of the real exchange rate has obvious and systematic differences. Since then, the choice of exchange rate regimes, classification and their impacts on the economy have become a focus of international economic study.

Exchange rate regime determines the extent, scope and mode of nominal exchange rate adjustment. It determines how a domestic economy relates to foreign economies, and is an important component in macro-economic policy-making. The choice of exchange rate regime is determined by one country‘s own economic development level and macro-economic objectives, and is also constrained by international background, such as the Bretton Woods System period, the regional monetary cooperation and etc.

2.1 De Jure Classification and De Facto Classification Classification of IMF

In general, there are two ways to classify exchange policy: one is the ―de jure classification„ derived from the rate announced by the central bank; another is ―de facto classification„ based on a nation‘s situation. The ―de jure classification„ policy recommended by IMF is based one source, provides a stable result, and is calculated by the rate reported to IMF by each individ- ual nation. However, there is a discrepancy between many countries‘ de facto and de jure ex- change policy. Many nations attempt to influence their exchange rates artificially; as a result they control their exchange rates just like the countries that adopt peg exchange rate policy, which is named ―fear of floating„ by Calvo and Reinhart (2002, chapter 1) after detailed analysis. Some other countries, due to their poor ability to control national currency exchange, change their rates frequently even their official exchange policy is peg exchange policy. Thus, in reality their exchange policy is similar to floating exchange rate system. Prior to 1999, IMF based on the policy reported by each country, classified exchange policy to three major types consisting eight minor policies, namely: Hard pegs (Arrangement with no separate legal tender, Currency board arrangement, Pegged exchange rates within horizontal bands); Soft pegs (Pegged exchange rate within horizontal bands, Crawling peg, Crawling band); Floating arrangements (Managed floating, Independently floating).

Since 1999, because of the discrepancy between many countries‘ de facto and de jure exchange policy, and the more in-depth researches on exchange policy, IMF has been publishing a list of de facto exchange policy of each economy entity based on IMF member‘s de jure exchange policy. According to this new classification, among 159 currencies of IMF members, there were 56.6% of them adopted intermediate regimes in September 1999. In fact, outside of America, Japan and Euro section, nearly half of IMF members adopted pegged to the dollar policy (see IMF, 1984, 1999).

Till the end of April 2008, of 185 IMF members except America, Japan and Euro section, 66 countries (or regions) were still maintaining pegged to the dollar policy (IMF, 2008b). The decrease in the number of economies adopting pegged to the dollar strategy has a lot to do with subprime lending crisis since 2007.

Levy-Yeyati Sturzenegger Classification (LYS Classification) Levy-Yeyafi and Sturzenegger‘s (2003, pp. 3-5) classification is based on K-means cluster analysis. “In K-means cluster analysis, based on nearest centroid sorting, a case is assigned to the cluster with the smallest distance between the case and the center of the cluster (cen- troid).” (Levy-Yeyafi and Sturzenegger, 2003, p. 3) LYS classification is mainly based on annual Exchange rate volatility [illustration not visible in this excerpt], Volatility of exchange rate changes [illustration not visible in this excerpt], and Volatil- ity of reserves [illustration not visible in this excerpt]. The basis for the classification is: under peg exchange policy, foreign exchange reserve should have a large fluctuation to reduce the change in nominal exchange rate; and floating exchange rate policy maintains a stable foreign exchange reserve but adjust its nominal exchange rate regularly. Therefore, the three factors should be able to define the classification of a currency.

Volatility of reserve is more difficult to measure relative to exchange rate volatility. Levy-Yeyati and Sturzenegger (2003, p. 4) “subtracted government deposits at the central bank from the central bank‟s net foreign assets which to approximate as closely as possible the change in reserves that reflects intervention in the foreign exchange market,” they defined net reserves in dollars as:

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“Where, e indicates the price of a dollar in terms of local currency. All Central Bank items are denominated in local currency and the time period for all variables corresponds to the end of period for a specific month. Their measure of monthly intervention in the foreign market rt, is defined as:” (Levy-Yeyafi and Sturzenegger, 2003, p. 4)

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LYS classification calculated all the data reported by IMF between 1974 and 2000 of 183 countries to avoid the statistical issue of small sample.

LYS contains three major classifications of five minor types (and in fact some other inde- finable exchange policies): pegs, middle (Crawling Peg, Dirty Floating), floating (Free Float- ing, Managed Floating). (Table 1) LYS classifies the countries that have low fluctuation in their foreign exchange reserve and high fluctuation in their exchange rate as economies that adopt floating exchange policy, and high fluctuation in foreign exchange reserve and low in exchange rate as economies that adopt peg exchange policy (see Levy-Yeyafi and Sturzeneg- ger, 2003, p.5).

Table 1: How the Three Classification Variables Map into Exchange Rate Regimes

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Source: Levy-Yeyati E. and Sturzenegger F., 2003, p. 5, Table 1.

LYS is very similar to IMF‘s classification; about two third of results are the same. Additionally, it observes the following facts.

During the 20 years after Bretton Woods System collapsed, the popularity of peg ex- change policy decreased. But in 1990s, compared to IMF‘s classification, peg exchange policy is relatively stable. They refer such phenomenon as ―hidden pegs„ or ―fear pegs„. Among the economies that utilize exchange rate as Nominal Anchor, especially the small and open economies, tend to avoid promise on their currency‘s exchange rate in the fear of exchange speculation (see Levy-Yeyati and Sturzenegger, 2002, p. 1).

Intermediate regimes such as Conventional peg or Crawling peg have become less popu- lar. This proves that The ―Hollowing-out hypothesis„ (Eichengreen, 1994) or ―bipolar view„ (Fisher, 2001).

The fluctuation in exchange rate in reality is small. Among the governments that announce floating regimes often try to impact their currency exchange to stabilize them. This proves fear of floating, and in fact fear of floating has been common since 70s in 20th century (see Calvo and Reinhard, 2002, chapter 1).

Industrialized economies tend to use floating regimes, but developing economies lean towards intermediate or peg regimes (see Levy-Yeyati and Sturzenegger, 2003, pp.11-13). What LYS lacks are that it studies currency exchange based on calendar year, thus it is inaccurate when exchange policy changes or currency devaluates. Also, some observed value is questionable, many values of China reported during 1990s are not determined, for example. In summary, when it is hard to determine the de facto exchange policy, de jure classifica-tion might be more useful. Some economists like Bleaney and Francisco (2007, chapter 4) believe that de facto classification does not hold more truth than official exchange policy. Additionally, according to the data provided by Klein and Shambaugh (2008, p. 72), although the announced regimes are not always truthful, they still demonstrate the currency‘s perform-ance over a long period of time.

2.2 Exchange Rate Regimes: Classification and Characteristics

As every nation has its own currency and unique economic climate, it varies when it comes to the choice of their exchange regimes, and different choices lead to different impacts on each country and its foreign exchange market. As we already discussed in the previous chapter, IMF adjusted their exchange regime classification in 1999, with three major type and eight minor categories (see Johnston and Swinburne, 1999 pp. 36-37). The following explains some categories:

Fixed Peg

Fixed peg entails that a currency peg a fixed price to a foreign currency or a basket of currencies, and as the chosen currency fluctuates on the international exchange market, the nation‘s own currency fluctuates at the similar rate, commonly with less than 1% difference. The pegged currency is usually the currency of a major industrialized nation, or one of IMF‘s Special Drawing Rights. Under such regime, a country‘s foreign currency reserve will have to increase (or decrease) based on foreign currency exchange, in other words, to utilize the nation‘s own currency to back up net surplus or deficit.

“It's potential drawbacks are: provides a target for speculative attacks, avoids real exchange rate volatility but not necessarily persistent misalignments, does not by itself place hard constrains on monetary and fiscal policy, the credibility effect depends on accompanying institutional measures and record of accomplishment.” (Sozovska, 2004, p. 5)

Crawling Peg

Crawling peg combines the flexibility of floating regime and the stability of fixed peg. What it means is that a currency pegs to currency parity, and with a set of carefully selected factors, adjust frequently to the parity in a small amount, while trying to maintain the continuity of the exchange adjustment. The main factors may include: the change in national price in relation to its main international trade partners, the level of foreign reserves, the country‘s foreign trade performance, and the situation of the national International Balance of payments current account. One of the reasons to adopt crawling peg is the existence of high inflation rate, hence many Latin America economies choose such a regime. Another reason is political: countries such as Brazil and Argentina choose crawling peg regime to gain advantage in export.

Floating

Floating policy refers to the exchange rate of a currency is determined by the demand and supply of free market. Depending on whether a government influences the market, Floating regime includes Free Floating regime (i.e. Clean Floating) and Managed Floating (i.e. Dirty Floating). Currently it is common for most developed economies to influence the market on a varying degree. There are many different styles to Managed Floating, Single Floating, Joint Floating, and Peg Floating, for example.

The advantage of a Floating regime is to avoid the impact of International hot money and the risk of financial crisis. Additionally, it promotes a healthy flow of capital and improves the development of international trade. On the other hand, it leads to foreign currency market instability due to recurrent fluctuation. Also, the management of exchange rate sometimes does not work property, due to the unstable global trade performance, and it is a especially unfavorable policy for developing economies.

Basket of Currencies

Basket of currencies is an exchange regime that a government selects a set of major currencies with varying priority based on its main trade partners‘ investment level to determine its currency‘s floating rate. As the basket of currencies float, the currency of the country floats. The hidden risks of this regime are the large capital influx caused by value raise expectation and speculative impact in short term operation.

Basket, Band, Crawling

In 1965 and 1985, Williamson published Crawling Peg and Exchange Rate Target Zone the- ory¹. After which, Krugman, Rudiger Dornbusch and Park developed these two theories fur- ther. Since South East Asia Financial Crisis, Rudiger Dornbusch and Park (1999) combined Crawling Peg, Exchange Rate Target Zone, and Crawling band as ―BBC policy„ (i.e. Basket, Band, Crawling). BBC is the combination of ―Basket of currencies„, Crawling Peg and Band regime. Basket of currencies is used to find the central exchange rate so a stable currency ex- change can be achieved and to avoid negative impact of major currency price fluctuation. Further, Crawling Peg adjusts the impact on Real Effective Exchange Rate from price change. Together Basket of currencies and Crawling peg can secure the stability of Real Effective Exchange Rate. Then, Band regime provides space for exchange rate to rise and fall, which affords some room for a government‘s financial policies.

3. Historical Development of the Chinese Exchange Rate Regime before Joining the WTO

Prior to 1979, the RMB exchange rate was planned by the government according to certain principles and became the regulatory tool in the planned economy. But a high degree of plan- ning meant that market forces played very little role in the Yuan‘s exchange rate, and actual exchange rate was seriously out of touch to the economic reality. To rationally determine RMB exchange rate, and let the exchange rate to play the role of leverage in the national economy, China actively rebuilt its own financial system and reformed the economy to open to the outside world. Indeed, foreign exchange reform has been a vital component of China's overall economic reforms. Since the late 1970s, China's foreign exchange regime has also begun a long transformation.

3.1 A Fixed Exchange Rate with the Unilateral RMB Peg to the U.S. Dollar

3.1.1 A Brief History of Chinese Currency Exchange Regime

Since 1979 when China opened its door, as a vital part of economy re-construction and for- eign trade, the development of its currency exchange policy has always been Beijing‘s main task. It is commonly held opinion among Chinese economists that, before China enters WTO, there should be three stages of its currency regime (see Zhang, 2005, chapter 1; He and Yang, 2004, chapter 2):

1. Between 1979 and 1985, China‘s official regime was ―Currency Basket,„ in fact it was De facto crawling peg„ although. (see Zhang, 2005, chapter 1) Because of the politi- cal consideration, Chinese currency was artificially strong. In fact, one US dollar used to exchange for 1.45 RMB in July, 1980.² At that point RMB was obviously overval- ued and was extremely damaging to Chinese export. Hence, keeping the official trade rate, ―trade internal settlement price„³ has been established, which was much lower than the official rate. “For internal settlements under the foreign exchange allotment quota, the rate is 2.80 RMB per U.S. Dollar.” (Cowitt, 1985, p.171) The official rate was started to align with the settlement price, RMB had started a devaluation period.

2. Since IMF formally categorized China as one of the economies that adopted ―Man aged floating exchange rate regime„ in October 1986 (see Cowitt, 1995, p. 416), China entered into its 2nd phase of currency trade transformation, while Chinese gov- ernment had not declared managed floating regime until April 9, 1991. Between 1986 and 1993, although Beijing stated it was simple managed floating, it was in operation ―Dual Exchange Rates Regime„: there were two effective rates, namely, official nominal rate (adjustable peg system) and market rate (unofficial managed floating rate). Regardless if the official rate changes, the combination of official and market rate was the effective rate in Chinese foreign trade operation, and was a floating rate. Chinese central bank had partial control on the official rate, and to less extent, some control on the market rate too. Therefore, RMB has gradually entered managed floating regime. At the same time, as the market rate was higher than the official rate, some Chinese exporters who enjoyed the lower official rate sold the dollar in a newly found black market. In this background, RMB has continuously devaluated from 2.8 for a dollar in 1985 to 5.7 in 1993,⁴ and the difference in official and market rate has become smaller, paving the way for a single trade rate.

3. The third stage is between 1994 and 2001. Since January 1994, a monumental devel opment took place, Beijing declared managed floating exchange rate regime. The offi- cial rate and market rate had become one, and ―foreign exchange retained„ system was abolished, instead, ―exchange surrender system„ was established. Although RMB was still under the ―de facto peg under managed floating„ of pegged exchange rate cate- gory in IMF categorization. In the next few years, RMB went through a steady ap- preciation period: from the history high of 8.7 for a dollar in 1994 to 8.3 in 1997⁵ - in a short four years, the currency appreciated in total 4.6%, averaging 1.15% each year. Before 1997, Chinese policy was always ―Real Targets Approach„: the goal is to en- courage export and gain foreign currency. However, during and after the Asia Finan- cial Crisis, the policy turned to ―Nominal Anchor Approach„: RMB maintains a fixed rate to US dollar (i.e. pegged to the dollar). This change is fundamental.

Evidently, there are disagreements. Reinhart, C. and Rogoff (2003a, p. 51) separated RMB‘s global trade policy change to four stages: 1974 January to 1981 February, the first stage in which the Chinese government adopted de facto crawling band around US dollar re- gime at 2% of fluctuation; the second stage is to July 1992, while the currency was managed floating; then, to January 1, 1994, back to de facto crawling band around US dollar; lastly, from January 1, 1994 to 2001 December, RMB is under de facto peg to US dollar regime.

In summary, although China has a different view on RMB exchange regime, from 1979 to 2001 China has brought life into the rigid exchange regime. The government has progres sively gave up control on the currency trade to market, and allow meanwhile RMB to devalu ate which boosted China‘s reserve and enhanced global trade.

It should be noted that although the arrangements for the Yuan's fixed regime was in ac- cordance with the requirements of China's economic development stage at that time and has played an important role to promote economic development. But after the Yuan has gone through a series of long, slow, frequent, small, and irregular changes, it still remains at a fixed exchange rate system.

But fixed system has many shortcomings, such as the lack of exchange rate flexibility to withstand external impacts, the lack of theoretical basis for the adjustment of the exchange rate and so on. The analysis of the RMB's advantages and disadvantages can provide references when the government needs to adopt another regime.

3.1.2 The Pros and Cons of Chinese Currency Exchange Policy

China has adopted the de facto peg to the dollar exchange policy for its currency, Renminbi, since 1994. The policy reflects the unique situation of Chinese financial climate and has its merits as follows:

1. US dollar is one of the leading currencies in international trade and investment, and this is particularly true for China. Maintaining a fixed exchange rate to the dollar facilitates exporting and importing between Chinese and foreign economy entities by reducing the innate risk from foreign currency exchange.
2. Since the majority of properties held by Chinese finance departments and its citizens are measured in USD, a more flexible exchange policy will inevitably mean increased risk to Chinese assets. If a ―Currency Basket„ policy were in place, for instance, RMB‘s rate to USD would have to change when a fluctuation occurs between US dollar and Euro or Japanese Yen rates. This carries exchange risks to the Chinese US dollar assets even though the value of the asset in US dollar did not change, while its value in RMB after the exchange was altered.
3. All of countries in East Asia except Japan implement a similar dollar peg exchange policy. It is true that some of the countries gave up this policy after the Southeast Asia Financial Crisis, but they have gradually resumed the fixed rate policy while their na- tional economies recover from the crisis (see McKinnon and Schnabl, 2004b p.2). It is arguable that, by adopting this same policy, the US dollar serves as a stabilizing force between Chinese and the East Asia economies in this case, not to mention the effect on preventing competitive currency depreciation.
4. Generally speaking, the reason for a developing country to adopt Nominal Anchor Approach is to stabilize their national price, progressively catch up on international price, reduce internal inflation and stabilize economy (see Zhang, 2004, p. 9).
5. The dollar is one of the most trusted currencies. By peg to it the Chinese currency gains its way to the international exchange market.

Regardless of the advantages of the regime, Chinese government‘s policy still has the following limitations:

1. ―Equilibrium Exchange Rate-Theory„ concludes that the exchange regime of an economy needs to adapt to its national economy structure and international economy climate (see Montiel, 1999, p. 290). If the de facto rate does not follow the change in fundamental economical factors but stay stale or only small adjustment, on a macro economy level, imbalances will occur internally and externally.

External imbalance leads to trade surplus and the influx of Foreign Direct In- vestment (see Zhang, 2004, p. 7). In China, surpluses in both of the current account and capital and financial account have occurred every year from 1994 to 2000 (except 1998) (see Table 2), and foreign currencies were always over-supplied. Under the then regime, central bank had no option but to absorb the over-supplied foreign cur- rencies with its reserves.

Table 2: China's Current Account and Capital and Financial Account, 1994-2001

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Source: SAFE, Balance of Payments, online data and statistics

This approach caused some adverse effects. China's foreign currency re- serves were mainly used to purchase the short-term bonds of the US government and the interbank deposit of offshore financial institutions. The investment profits of such products are much lower than the interest payable for the overseas loans and the costs paid for the foreign direct investment. Accordingly, China held a large number of low-profit foreign currency assets and meanwhile borrowed foreign currencies at a high price from state financial market. This must burden China with enormous costs. Furthermore, the foreign reserves are mainly controlled by the central bank, the risks derived from exchange rate fluctuation cannot dispersed to other micro economy ent- ities, leading to an enormous risk for the US dollar reserves in the central bank.

Internal imbalance refers to the discrimination on the non-export department. Because of the regime export economies are encouraged, in a long term, it leads to an unhealthy disparity in a nation‘s resource allocation (see Guo, 2004).

2. It is difficult to sustain a stable Nominal Effective Exchange Rate, handicapping the development of trade and investment. Pegging to the dollar only promises a fixed rate between two nominal exchange rates. When USD revaluates, RMB revaluates; when USD devaluates, RMB devaluates - RMB only follows RMB passively. When there is an adjustment between the dollar and other major international currencies, RMB maintaining a rate to USD, but there will be large change in the nominal rates between RMB and other major international currencies. Consequently, the fluctuation of other international currencies will have an immense impact on RMB‘s exchange rate. This external impact on RMB‘s effective rate has a damaging effect to trade and investments between China and Japan, and European countries.

3. The long-term absolute but artificial stable exchange rate between USD and RMB leads to difficulties for China to export. To encourage export, China increased tax re- bate and gave interest allowance for export product. As a result, although the export has been increasing, the government has increased cost, and this gives exporters the opportunity to fake export for tax benefits (see Wang, 2005, p. 19).

4. The forceful foreign exchange payment methods raises more risks for the exporters, leads to higher payment costs, and thus damages the ability for exporter to compete. Besides, it is very expensive to audit the exporters, not to mention the hindered efficiency from the auditing process (see Wang, 2005, p. 17).

5. Pegging to a single currency leads to increased speculation against RMB. In a closed economy, the pegged regime is a second best option. It has made important contributions for the steady growth of China's economy in the late 90's. But in an open economy, there is a substantial increase in foreign trade and the inflows of foreign capitals, foreign exchange market becomes more active, the pressure for RMB to fully enter the market increases, and it is increasingly difficultly to stabilize exchange rate through government intervention. These changes require the RMB exchange rate to speed up market-oriented reforms, improve the RMB exchange rate formation mechanism.

3.2 China's Exports of Capital and Capital Account Controls before Joining the WTO

The United States and other developed economies have been advocating the financial liberalization since the late 90's. The majority of developing countries have also gradually opened their financial market. International flows of capital and China's economic development has become increasingly linked. However, China's capital account liberalization started late and subjected to the RMB exchange rate policy. As a consequence, the actual export of capital has always remained low. Capital controls were also extremely strict.

3.2.1 The Capital Exports of China before Entering WTO

Capital Export refers to that a government and its departments export capitals, including grant, loan, government export credit and etc. It can be categorized into loan capital and production capital export. The former refers to provide loans to foreign governments or private organiza- tions, or purchase securities, stock from a foreign country. The latter refers to establish com- panies in a foreign country directly; in other words, to conduct foreign direct investment.

China’s Foreign Direct Investment

FDI helps national companies to avoid trade barrier, realizing products global trade; it also enhance a corporation‘s ability to compete on an international level with the benefit of scale economy. At the time when domestic demand is low, FDI is also a very effective tool to counter domestic production overcapacity.

Table 3: An Overview of Foreign Direct Investment (FDI) of China

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Source: UNCTAD, World Investment Report 2003, FDI Policies for Development: National and International Perspectives, Country fact sheet: China The table above reflects China FDI Outward and Inward during 1985 to 2001. It is evi- dent that in the period, China‘s FDI outwards far surpass the inwards. This situation is mostly due to the background and policy of China. At the early stage when China opened its door, the purpose of attracting foreign investments is to aid the capital deficit in China‘s own de- velopment. In the 90s, the purpose of attracting foreign investments is to ―exchange technolo- gies with market„. Entering 21th century, with the increase in the savings of Chinese citizen, the deficit in domestic capital is largely relieved. Meanwhile, ―exchange technologies with market„ proved to be less effective than planned. As a result, China has adjusted its strategy to FDI, however China‘s FDI is still severely lacking. A common ratio of inward and outward FDI for a developed economy is between 1:1.2 and 1:1.5, and for a developing economy is 1:0.2 and 1:0.43.⁶ Based on the table 3, the lowest ratio between inward and outward FDI is 1:0.022 (in 2000), which is far from the common ratio of a developing country. Consequently, China‘s lack of FDI leads to Chinese business‘ low demand for foreign currency, which di- rectly hindered the effectiveness of China‘s large foreign currency reserves.

China’s Indirect Foreign Investment

Indirect foreign investment is China‘s main investment method. It includes securities investment and other investments. Securities investment consists of stock investment and bond investment. Other investments consists of loans (mainly short term), trade credits (mainly short term), and currency savings. The priority of China‘s indirect investment is short term trade credits, bond investment and then stock investment.

Since the risk for stock investment is high, China has always focused on bond investment, combined with a quite controlled stock investment portfolio.⁷ Contrary to stock investment, from 1997 with a few exceptions, bond investment profit has always been positive income and maintained an overall increasing trend.

American bond in USD is the main investment option among China‘s bond investment. Additionally, short term trade credits have been relatively emphasised by China too. The pol- icy since 1979 has always been ―export-oriented„, and export credit on deferred payment or payment in advance to pay for imports facilitates China to encourage export and acquire ne- cessary materials and technologies. Thus trade credits especially short term is an important investment method. (Figure 1)

Figure 1: Capital Account Components, 1990-2001

(Unit: Billions of US Dollars)

Source: All the data are from International Financial Statistics (IFS), SAFE Online Data Statistics, as cited in Ouyang, et al. 2007, Figure 3, p. 26

United Nations conference on trade and development (UNCTAD) developed Outward FDI Performance Index (OND). “The Outward FDI Performance Index is calculated as the share of a country´s outward FDI in world FDI as a ratio of its share in world GDP.” (UN- CTAD, 2002)

The formula is:

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OND can reflect the two determining factors of an economy‘s FDI: ownership advantages and location factors. “Ownership advantages, or firm-specific competitive strengths of TNCs (such as innovation, brand names, managerial and organizational skills, access to information, financial or natural resources, and size and network advantages) that they are exploiting abroad or wish to augment through foreign expansion. Location factors, which reflect primarily economic factors conducive to the production of different goods and services in home and host economies, such as relative market size, production or transport costs, skills, supply chains, infrastructure and technology support.” (UNCTAD, 2002)

The various ONDs of each economy reveal the difference in each country‘s foreign in- vestments fueled by "ownership advantages" and "location factors". The result from UN- CTAD shows, during 1999 to 2001, developed economies had higher OND, and China was listed on 60th at 0.092 OND, far behind world average. From Outward FDI Performance In- dex, the performance of China foreign investment has been decreasing from 1995 to 2001. (Table 4)

Table 4: Rank of China's Outward FDI Performance Index, 1991-2001

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Source: UNCTAD: Outward FDI Performance Index, online data and statistics

Overall, China's economy has begun a rapid growth since 1994, and has become one of the main attractions for foreign investments. The FDI has played also an important role in China's international trade. But the development of China's overseas investment lags behind its economy. This is due to various factors. Although the rapid economy development of China created a large domestic consumer market, while drawing tremendous amount of foreign investments, it also reduces the pressure and incentives for its domestic corporations to investment in foreign economies. The most crucial reason is that, however, Chinese businesses lack of ownership advantages, and are not very efficient to utilize host country advantage of the location factors. And because of China did not begin the process of capital account liberalization until joining the WTO, large cross-border flows of capital will inevitably lead to government restrictions. In the next section main contents, characteristics and validity of China's capital restrictions will be discussed.

3.2.2 The Capital Control Strategy of China before Entering WTO

Before 1996, the cross border financial flow review published by IMF in their Annual Reports on Exchange Arrangements and Exchange Restrictions (AREAER) used a method called bi- nary (0/1) evaluation in six categories.⁸ Since 1997, IMF extended the framework of the AREAER⁹ and give capital account transactions 13 different subcategories (see Xiao and Kimball, 2005, p. 59).

The method refers to that in each subcategory, a 0 or 1 will be given to base on if there is a regulation in place, and finally the Simple average of those 13 factors is used to evaluate each country's capital control indices. When capital control index is at its max of 1, it means the country has regulation in each of the 13 areas. On the other hand, when the index is 0, it means the country has no regulation in all areas. The table 5 below shows China's capital con- trols from 1996 to 2001, and it is evident that the regulation is at its strongest in 2001. (Table 5)

Table 5: China's Capital Controls, 1996-2001

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Source: IMF, Annual Report of Exchange Arrangements and Exchange Restrictions (AREAER), 1996-2001.

In the Table above, ―1„ indicates that there exists specific restriction; ―0„ indicates no restriction; ―Na„ indicates that there was no subcategory of ―personal capital movements„ in 1996 AREAER edition.

In December 1996, China promised WTO that it will follow WTO No. 8, ―Current Account Convertibility„, and started to adjust its policies. In reality, however, China did not entirely give up capital control and RMB is not freely exchangeable. A comprehensive foreign currency control system is still in place for China.

China adopts trade control and exchange control in its financial control system. Trade control entails controlling cross-border capital transactions. Exchange control refers to control the currency exchange in global trade; in other words to control the inward trade, outward trade and mutual trade related to capital and finance items. Capital and finance items include industry class capital transactions, business capital transactions, stock transactions and other financial transactions (see SAFE, 2009, chapter 3).

Industry class capital transaction mainly refers to foreign direct investment. The control of China on its industry class capital inflow was relatively loose, compared to capital outflows. For those approved foreign direct investments, a FDI corporation foreign currency registry was enforced for currency exchange, which audits FDI at the time of liquidation, divestment or share transfer.

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¹ See Williamson, 1965, 1985.

² See Reinhart and Rogoff, 2003b.

³ “This rate was formed by adding to the Effective Rate an „equalization price‟ for balancing export and import profits and losses, and applied to all national enterprises and corporations engaged in trade, as well as to receipts and expenditures in foreign exchange for trade-related transactions in invisibles, such as shipping and insurance. ”(IMF 1981, p.107, cit. in CUHK, 2000)

⁴ See Reinhart and Rogoff, 2003b.

⁵ See Reinhart and Rogoff, 2003b.

⁶ This ratio is calculated based on the FDI in- and outflows given by World Investment Report 2003 (see UNCTAD, 2003a, pp. 249-256).

⁷ Actually, in China`s balance of payments between 1997 and 2005, capital stock information is even not recorded. The first capital stock investment profit is recorded in 2006 (see SAFE, online data and statistics).

⁸ The six categories include: bilateral payments arrangements with members and non-members, restrictions on payments for current account transactions, restriction on payments for capital account transaction, import surcharges, advance import deposits, and surrender or repatriation requirements for export proceeds.

⁹ “AREAER editions before and including 1996 had a reporting framework called, „Summary Features of Exchange and Trade Systems in Member Countries‟. Editions since 1997 have a reporting system called, „Summary Features of Exchange Arrangements and Regulatory Frameworks for Current and Capital Transactions in Member Countries‟.” (Xiao and Kimball, 2006, p.2)