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- Index number:
- 000014453-2017-00285
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- Dispatch date:
- 2017-05-08
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- Publish organization:
- Modern Bankers
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- Exchange Reference number：
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- Name：
- Pan Gongsheng: Policy Framework and Management Orientation of China's Foreign Exchange Market
It is our mission to boost the reform and opening up of China's financial market, and enhance facilitation of cross-border trade and investment to serve the real economy, while guarding against the excessive impact from cross-border capital flows and safeguarding the stability of China's financial market in a complex and changing world.
Dynamic Evolution of Cross-border Capital Flows across the World
Cross-border capital flows, the natural products of economic globalization, help boost the effective allocation of capital around the world and drive the spread and flows of advanced technologies and management experience to promote global economic growth. At the same time, since cross-border capital flows are profit-seeking, pro-cyclical and easy to overshoot, the large-scale disorderly fluctuations of capital in the short term may impact the economy and finance. Historically, emerging economies had witnessed tremendous inflows and outflows of cross-border capital many times, which triggered systematic financial risks. When a huge amount of capital flows in, the operation room of the monetary policy in an emerging economy will be squeezed, and asset prices will be pushed up, thereby dampening the momentum of emerging economies for driving economic reforms and structural adjustment. In comparison, the massive capital outflows may lead to currency depreciation, violent volatilities in the financial market and heightened fragility of the financial system, and consequently trigger systematic financial risks.
Since the advent of this century, global cross-border capital flows have weathered through two stages. In the first stage, which began in 2000 and ended in 2013, a tremendous amount of global capital flew into emerging economies. Before the 2008 global financial crisis, the inflows were attributable to the rapid economic developments and high returns on invested capital in emerging economies. After the global financial crisis, the inflows were a result of rampant liquidity in global markets due to the adoption of QE policies in major developed economies. In the second stage that began in 2014, global capital began to flow out of emerging economies. This change of course is chiefly because along with the economic slowdowns of emerging economies, developed countries adopted divergent monetary policies, especially the Fed's exit of QE policy and kick-starting of interest rate hikes. The global economy is still faced with heavy uncertainties at the moment. Major countries are struggling with many risk factors. The global financial markets are in volatility, cross-border capital flows are uncertain, and the volume, speed, direction and structure of cross-border capital flows are changing dynamically.
After the financial crisis, the international community has reached a consensus that the global macroeconomic and macro prudential policy cooperation are of great significance. When adjusting policies, major economies should take into full consideration the spillovers to the global economy so as to jointly safeguard financial stability. Christine Lagarde, IMF Managing Director, noted rightly in her speech at the China Development Forum 2016 that "increased global integration brings with it greater potential for spillovers — through trade, finance or confidence effects. As integration continues, effective co-operation is critical to the functioning of the international monetary system. This requires collective action from all countries." In recent years, the international community has also begun to promote coordination and cooperation under the frameworks of the G20, IMF and FSB. Under such circumstances, fragile economies should be committed to boosting structural reform, optimizing the economic and foreign trade structures, and promoting the equilibrium of the balance of payments to achieve sustainable economic growth. The policy authorities of every country should implement proper macro-prudential policies to make macro and countercyclical adjustments to the pro-cyclical fluctuations and cross-market risk communication and to guard against systematic risks.
Features and changes in China's cross-border capital flows
Impacted by the changes in the landscape of global capital flows, China's cross-border capital flows have been divided into two phases since the beginning of this century. The first phase was between 2000 and the first half of 2014 when China posted the twin surpluses under the current and capital accounts, foreign exchange reserves rose rapidly and global capital flooded into China. Before the global financial crisis, massive direct investments flowed into China, and in the wake of the crisis, the share of other investment funds such as portfolio investments and external debt began to rise. The second phase began with the second half of 2014. China's current account has registered surplus but capital account, deficit, and the deficit has begun to overtake the surplus, cross-border capital has also begun to flow out, leaving foreign exchange reserves to turn from increase to decrease. In terms of time and direction, China is consistent with the global landscape of cross-border capital flows.
Two changes should be noted: first, external assets of market participants have risen rapidly. Previously almost all of China's external assets were official foreign exchange reserves. When the official foreign exchange reserves reached its peak, China's external assets accounted for more than 70%. In recent years, China's external assets have been restructured, with official foreign exchange reserves dropping and external assets held by market participants rising. As at the end of 2016, foreign exchange assets held by the government and by market participants accounted for 50% respectively. Second, the external debt of market participants has declined. A few years ago as the Fed adopted the QE monetary policy, the interest costs of the US dollars were low and Chinese enterprises borrowed heavy external debt. In the past two years, as the Fed gradually exited from the QE policy and raised interest rates, the interest rates of the US dollars have climbed and the USD exchange rate, strengthened. At the same time, the RMB interest rate has declined. Under this circumstance, it becomes easier for Chinese enterprises to raise funds in China and they have begun to quicken its step to service external debt in the US dollars, so as to reduce the risks arising from high-lever operation and currency mismatch. In the first quarter of 2016, Chinese enterprises' full-scale external debt in domestic and foreign currencies fell to USD 1.4 trillion from USD 1.8 trillion at the end of 2014. In particular, the external debt in foreign currencies declined from USD 900 billion to USD 750 billion. Since the second quarter of 2016, China's external debt has rebounded as the deleveraging of Chinese companies' external debt came to a halt.
China's cross-border capital inflows and outflows are currently developing towards an equilibrium. The trends of the foreign exchange market can be reflected from foreign exchange reserves, banks' sales and settlement of foreign exchange, balance of cross-border receipts and payments, and US dollar index. In December 2015, the Fed raised interest rates for the first time and in the fourth quarter of the year, the US dollar index went up by 2.4%, and from December 2015 to January 2016, China's foreign exchange market went through significantly heightened volatilities. In the fourth quarter of 2016, as expectations of Fed's interest rate hikes were strengthened, coupled with the presidential election in the US, the US dollar index climbed by 7.1%, but China's foreign exchange market experienced remarkably less fluctuation compared with the fourth quarter of 2015. Since January 2017, China's foreign exchange market has stayed stable. With foreign exchange reserves going up in February and March, the balance of cross-border receipts and payments became positive after a 17-month-long deficit, suggesting that China's cross-border capital inflows and outflows are moving towards an equilibrium.
Going forward, the balance of cross-border receipts and payments will boast a sound and robust foundation: first, China's economy is in a high-speed growth range, and as the supply-side structural reform is deepened, China will witness better and more efficient economic growth. Second, the surplus under the current account remains in the reasonable range, with the balance for 2016 accounting for 1.8% of GDP. Third, China will continue to be one of the most attractive and competitive investment destinations for overseas long-term capital. Fourth, China has adequate foreign exchange reserves.
China's ODI and FDI
China's outbound direct investments (ODI)
China has witnessed rapid growth in ODI in recent years, with that of 2016 exceeding 40%. Such fast growth is a testimony to the enhanced overall national strength, the higher level of opening up, and the stable advancement of the Belt and Road Initiative, the international production capacity cooperation, and administration streamlining and power delegation, which are favorable for boosting China's economic transformation, and the economic growth worldwide and in host countries to achieve mutual benefit and common development.
However, there are also unreasonable and unusual investing behaviors in China's ODI, such as large-scale investments in industries beyond the main business, "small parent company and large subsidiaries", and "quick investment and quick exit". Heavily indebted though, some enterprises still borrow a large amount of money for overseas M&As, and some even are involved in illegal asset transfers in the guise of ODI.
The Chinese government has always encouraged enterprises to participate in international economic competition and cooperation, the Belt and Road Initiative and international production capacity cooperation, so as to promote domestic economic transformation and upgrading and deepen the mutually beneficial cooperation between China and the rest of the world, by following the outbound investment management principle that "under the guidance of the government, enterprises will play a dominant role based on the market orientation and international practices". Foreign exchange administration also encourages capable domestic enterprises that meet the conditions to engage in real outbound investing activities in compliance with regulations. Given the lessons and experience of Japan in fast growth in outbound investments in the 1980's, making outbound investments quickly doesn't justify smooth investments by Chinese enterprises going global, but stable investments may ensure smoothness. Outbound investments and M&As are just like a bunch of thorny roses, which are beautiful and fragrant but may pierce your hands. Sometimes they are like sand on the beach, which it seems that you may hold a handful of them but finally they slip from your hands. Over the past few months, alongside the adjustments and implementation of the macro-prudential policies, China's outbound investments have slowed down, indicating market participants are becoming more reasonable.
China's foreign direct investments (FDI)
In 2016, China was ranked No. 3 worldwide and No. 1 among emerging economies by the size of foreign capital attracted. Its foreign investment structure was improved and upgraded, with the foreign capital continuing to go into high value-added service industry and the high-tech manufacturing industry. Given China's economic growth, advancement of the structural reform and immense market potential, China will remain one of the investment destinations that are attractive to long-term capital.
Using foreign capital is a basic national policy for opening up and a key component of the open economic system. In his keynote speech to the World Economic Forum in Davos in 2017, President Xi Jinping pointed out that "China will actively build a loose and orderly investment environment". As for foreign exchange administration policy, FDI will be basically convertible, and foreign exchange capital will be settled discretionarily, and the authentic capital exchanges and payments in compliance with regulations such as capital increase and decrease, share transfer and investment withdrawal will be subject to no restrictions.
The outward remittances of the profits of foreign-invested enterprises, an item under the current account, are convertible. A foreign-invested enterprise can either use its profits to make further investments or remit them out freely. An outward remittance of profits should be authentic and comply with relevant regulations including the Company Law in China. Where the losses of the previous years should be offset, the profit distribution resolution of the Board of Directors, the audited financial report and the tax clearance certificate in China should be presented. The four conditions are not newly introduced, but have been in existence for a long time and are reasonable.
Policy framework and orientation of foreign exchange administration in China
In formulating and implementing the foreign exchange administration policies, China has observed the following two principles: first, reform and opening up should be adhered to by supporting and boosting the two-way liberalization of the financial market, to further enhance the cross-border trade and investment facilitation and the real economy. Second, efforts should be made to guard against the risks arising from cross-border capital flows and the impact from disorderly flows of cross-border capital on the macro economy and financial stability, so as to maintain the stability of the foreign exchange market and create a sound market environment for reform and opening up. Based on the above principles, China's foreign exchange administration policies show the following connotations:
First, an "open window" will not be closed again. Foreign exchange administration will not turn back onto the old path of capital controls. At the end of last century, we achieved full convertibility under the current account. Since the beginning of this century, we have also enhanced the convertibility under the capital account and achieved basic convertibility under the direct investment. What's more, we have smoothly pressed ahead with convertibility under portfolio investment by opening channels such as QFII, RQFII, QDII, RQDII, Shanghai-Hong Kong Connect and Shenzhen-Hong Kong Connect. These open-up policies will not be eliminated.
Second, China's capital account shall be opened up in a prudential and orderly manner. In 2016, China' efforts to liberalize the capital account had many highlights, such as macro-prudential management of full-scale cross-border financing, further liberalizing and facilitating investment in the inter-bank bond and foreign exchange markets by foreign institutions, optimizing the policies for Shanghai-Hong Kong Connect and kicking-start the pilot program for Shenzhen-Hong Kong Connect, and deepening the QFII reform and reducing quota restrictions and lock-up constraints. However, reform needs both objectives and the strategies to achieve the objectives. The progress of liberalizing the capital account shall be aligned with the stage of economic development, the situation of financial markets and financial stability. At different stages, the internal and external factors shall be taken into full consideration to identify the priorities, cadences and steps in liberalizing the capital account.
Third, a macro-prudential management and micro market regulation system for cross-border capital flows shall be established. Efforts shall be made to build the macro-prudential management system of cross-border capital flows, refine the early warning and response mechanism for cross-border capital flows, and further diversify the macro-prudential management toolkit for cross-border capital flows. Foreign exchange authorities shall intensify regulation of the foreign exchange market, conduct market regulation and market law enforcement in accordance with the existing laws and regulations and foreign exchange administration policies, and crack down on irregularities in the foreign exchange market to safeguard the solemnness of China's laws and regulations and its foreign exchange administration policies, and the healthy, stable and benign order in the foreign exchange market.
Fourth, the exchange rate formation mechanism shall be improved to enhance the elasticity of the RMB exchange rate. Recently the RMB exchange rate has found a basic equilibrium amid the two-way fluctuations, fluctuated slightly against a basket of currencies and gone through ups and downs against the US dollar. Next, foreign exchange authorities shall stably advance the reform of the RMB exchange rate formation mechanism, make exchange rate policies more standardized and transparent, and guide market expectations to make sure that the RMB exchange rate finds an equilibrium at a reasonable and balanced level. Moreover, the exchange rate elasticity will be enhanced based on the changes in the supply-demand relation in the foreign exchange market to maintain the role of exchange rate in adjusting the equilibrium of the balance of payments.
Operation and management of foreign exchange reserves in China
Over the past two years, impacted by multiple factors both at home and abroad, China's foreign exchange market and cross-border capital flows have weathered through strong impacts and severe test. Since the beginning of this year, China's foreign exchange market has stayed stable, and cross-border capital flows have developed towards an equilibrium. As at the end of March, China registered foreign exchange reserves of RMB 3.01 trillion, accounting for nearly 30% of the world's total, which made it No. 1 among major economies and left the No. 2 far behind.
How many foreign exchange reserves a country should hold to hit a reasonable level? There are no common standard for that both at home and abroad. It is actually dependent on a country's macroeconomic conditions, level of economic openness, capabilities of using foreign capital and financing abroad, as well as sophistication of its economic and financial systems. China boasts adequate foreign exchange reserves, measured either by traditional indicators or by aggregative indicators proposed by the IMF economists.
China's foreign exchange reserves are impacted by three factors: first, exchange rate conversion and changes in asset prices. China's foreign exchange reserves are denominated and reported in the US dollars. When non-USD foreign exchange reserves are converted into the USD, the exchange rate will influence the changes of reserves, and the prices of bonds and stocks invested with foreign exchange reserves are changing every month and therefore become the key influencers to the changes in foreign exchange reserves. Second, diversified use of foreign exchange reserves. For example, when used to invest in the Silk Road Fund, the China-Latin America Production Capacity Cooperation Fund, and China-Africa Industrial Capacity Cooperation Fund, this part of foreign exchange reserves needs to be deducted from the foreign exchange reserves data. Third, the operation by the People's Bank of China in the foreign exchange market.
Under the principle of security, flows, value preservation and growth, China's foreign exchange reserves are used to make prudential, standardized and professional investments, optimize and dynamically adjust investment portfolios and strategies to safeguard and promote the stability and development of the international financial markets, with respects for the international market rules and practices.
China has no intention to strengthen its competitiveness by depreciating its currency. We do not have such a desire, nor have the necessity. The People's Bank of China provides foreign exchange liquidity to the market, in a bid to guard against overshooting of foreign exchange rate and the herd effect, and to maintain market stability. China's endeavor to strike a balance between enhancing the elasticity and maintaining stability of the foreign exchange rate is conducive to the international community, and can effectively avoid the negative spillovers from disorderly adjustment of the RMB exchange rate and the competitive depreciation of major currencies.
(The original text is available in the May 2017 issue of the Modern Bankers)
