Capital controls, the savior or the pullback of the export

Capital Controls,

the Savior or the Pullback of the Export

Bachelor Thesis

University of Amsterdam

Statement of Originality

This document is written by Student Dylan America, who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating

it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

Content

1. Introduction ... 4

2. Capital controls ... 5

2.1 Capital controls around the world ... 5

2.2 Capital account liberalization in China ... 8

3. Effects on the export ... 10

3.2 Foreign Direct Investment ... 14

3.3 The financial sector ... 17

4. Comparative case study ... 19

5. Conclusion ... 23

1. Introduction

China is the second biggest economy in the world, with a GDP of 10.36 trillion US$ in 2014 (The World Bank). In the last ten years, the country outgrew Japan, Germany and the United Kingdom with GDP growth rates between seven and fifteen percent. One of the main reasons for these high growth rates, is China’s export. In the period between 2000 and 2013, the export had increased with 500 percent, and occupied between 26 and 39 percent of GDP. In other words, the export is very important for the Chinese economy.

Except for China, the biggest economies in the world choose for a liberalized capital market and an independent monetary policy to, among others, facilitate international trade, and stabilize the economy. The Chinese economy however, is still captured by numerous capital controls, like currency exchange regulations, and regulations on the entry of foreign banks. From 1978, China slowly started to relax these controls, and since 1993 full

Renminbi convertibility is a goal of the Chinese government (IMF 2004 and Chen, Chang and Zhang 1995). In the long run, China will most likely abandon most of its capital controls. This could have possible effects on the Chinese export. Since export is one of the most influential factors of the Chinese economy, this thesis on the possible effects of capital account liberalization on the export of China, contains relevant information. The different factors discussed in this thesis have separately been analyzed in many articles. However, in the following chapters these different factors are combined, to create a better overview of the possible scenarios after China liberalized its capital account. In addition to the literature review, a case study has been undertaken to compare the theory with an example from reality.

This thesis consists of five chapters. The second chapter will start with a brief introduction into capital controls around the world, and continue with the start of the capital account liberalization in China. The next chapter describes the possible effects of the capital account liberalization on the export of China, using three channels. First, the

exchange rate channel will be discussed by looking into the so called Trilemma. Also, basic economic theory, and related articles are involved to explain this channel. After that, the impact of the second channel, foreign direct investment, on the export of China will be explored, by analyzing the changes after China established the special economic zones. The last channel that will be discussed is the Chinese financial sector. The state-owned

enterprises, which are main exporters, are highly dependent on the financing by the Chinese state-owned banks. These banks could be affected, as a result of the entry of foreign banks,

and therefore have an influence on the export. After all the three channels have been discussed, the main findings will be used in a comparative case study of Turkey, in which the previously found theory will be combined with the experiences of the abandoning of capital controls in Turkey, and connected to the situation in China. Finally, an overall conclusion will be given in the last chapter.

2. Capital controls

Before the effects of a liberalization on the export are being discussed, it is important to have a good overview of what capital controls are, and how they have been used in the past. This will be explained in the first part of this chapter. Firstly, the motives and effectiveness of capital inflows are being discussed, and secondly the same questions are being answered for the capital outflows. The second part of this chapter will describe the liberalization of the Chinese capital account. The main aim will be to show in what way the capital controls have changed over the years in China.

2.1 Capital controls around the world

IMF, 2012

Countries that Liberalized During 1995–2010

Afghanistan Botswana Chile Haiti Jordan Papua New Guinea São Tomé and Príncipe Swaziland

Algeria Bulgaria Cyprus Honduras Korea Romania Senegal Uganda Armenia Burundi Dominica Hungary Malta Russia Seychelles

Azerbaijan Cambodia Ghana Iraq Mauritania Saint Kitts and Nevis Slovakia Bosnia Cape Verde

Between 1995 and 2010, numerous countries have changed their regime from a (partly) closed capital account to an open capital account. Each country used the capital controls in their own way, and they can be separated in two different groups, capital inflow controls and capital outflow controls. These controls are a measure from the central government to keep control over their capital flows, and appear in different forms, like specific restrictions or taxes.

Capital inflows in emerging markets (EMs) are seen as an opportunity to bring in extra capital for countries with low savings. This could benefit investment, risk

diversification, and a more evolved financial system (Ostry, et al. 2010). One of the reasons EMs conduct capital controls on inflows, is to keep their competiveness in international trade. In history, countries with a relatively high interest rate and/or stronger currency expectations compared to other countries, have seen big capital inflows. These flows induce an appreciation of the home currency, and could put a pressure on the export (Carvalho and Garcia 2008). One example of a country that had a capital inflow control is Chile. Between 1991 and 1998 Chile had a selective capital control aimed at the short term inflows. The reason they implemented these controls was the increase in capital inflows after the central bank increased their interest rate to prevent a high inflation. These capital inflows led to an appreciation of the Chilean peso, which worsened their international competiveness. Before 1991 the Chilean central bank participated in sterilized

interventions, a tool to modify the exchange rate by buying or selling foreign currency. When these interventions are sterilized, the central bank has to intervene in a second transaction to neutralize the change in the monetary base. This is often done by buying or selling government securities. In the case of Chile, the central bank had to buy foreign currency to prevent the Chilean peso from appreciating to undesirable levels. Since the Chilean government wanted to keep their monetary base at the same level, they had to sell their government securities. This was a costly case, because of the amount of interest that had to be paid. In 1991, the unremunerated reserve requirement (URR) was realized, a tax only on capital inflows, whereby the tax rate increases when the maturity is decreasing. According to Valdés and Soto (1998), this specific capital control was effective in changing the composition of the capital inflows, but lacked the power to stop a speculative attack.

Edwards, 1999

The main problem Chile wanted to solve was the large amount of short term capital inflow, which accounted for 1.68 trillion US dollar in 1990. As shown in the figure above, these amounts decreased rapidly and accounted for only 70 billion US dollar in 1995 (Edwards 1999). Since the main aim was to reduce the short term capital inflows, and not to stop possible speculative attacks, the example of Chile is widely seen as a success story of how capital controls could work effectively. Especially after the East Asian crisis, more

economists see the importance of controls on the capital inflows. In this crisis an unstable financial situation occurred, due to capital inflows that left the affected countries after a short period of time, to benefit from short term profits. This could have been prevented by the use of capital inflow controls (Eichengreen 1999).

According to Edwards (1999), three different outflow controls can be distinguished. A different exchange rate for capital account transactions, taxes on funds shifting abroad, and the most rigorously, a prohibition on transferring capital abroad. These controls have been implemented mostly during crises, to prevent capital from leaving the country, but failed in effectiveness according to empirical research. Governments can also benefit from a lower cost of capital when the outflow controls keep the capital in the country. These capital controls are therefore more likely to be implemented in countries with a bigger influence of the government on the central bank (Aizenman and Pasricha 2013).

0 200000 400000 600000 800000 1000000 1200000 1400000 1600000 1800000 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Sh o rt te rm c ap ital in flo w s in US $ (x 1000)

Malaysia employed controls on capital outflow during the Asian crisis in 1998. A set of different controls by the Malaysian government is given by Kaplan and Rodrik (2001). Thailand and Korea, countries that also suffered from the Asian crisis, chose for a different approach to recover from this crisis. They accepted support from the IMF, and had to accept a tight schedule for recovery. Kaplan and Rodrik (2001) could not get a clear view whether the recovery of Malaysia has been in favor of Thailand and Korea. The two different approaches used in their research, are both giving a different answer to the question if the capital controls were an improvement in comparison to the IMF support programs. In theory, a control on the capital outflow is implemented to prevent capital from leaving the country, and increases the net capital inflow. Labán and Larraín however, state that a liberalization of the capital account could improve investors trust, and lower the risks of investing in that specific country. This could lead to an increase of the net capital inflows instead of a decrease. Overall, the empirical literature about capital controls is very divided, since there are many cases in which it is not clear in what level the controls have

contributed to the revival of the economy. The controls on capital outflows are believed to be less effective than the capital inflow controls, and are mainly used in times of crises to prevent capital from leaving the country. Capital inflow controls are often used to protect the international competitiveness of a country.

2.2 Capital account liberalization in China

In 1978, after 30 years of economic isolation, China announced their reopening to the world, with their new “open door” policy. Chen, Chang and Zhang (1995) explain, with multiple historical events, why there was a need for alteration of their economic system. The Chinese government established four special economic zones (SEZ) in 1980, Shenzhen, Zhuhai, Xiamen, and Shantou. These zones have been created to improve the economic development, and the national planning of the country. According to Sit (1985), there are three main differences between the SEZ’s and the rest of China. The economy in these areas is based on an open market economy, investment from abroad is encouraged, and the zones serve as an important place for the transfer of management skills and

technology. The Chinese government extended the amount of SEZ’s in 1984 with fourteen cities and Hainan Island. In 2007, 22 percent of the country’s GDP was generated in the SEZ’s, and almost half of the foreign direct investments (FDI) were located in these areas

(Zeng 2011). Therefore, the creation of the SEZ’s has proven to be a very important factor in the economic growth of the country, and for the increase in FDI’s in China. Over the years, FDI has been more promoted by the Chinese government, and the amount of FDI’s has grown rapidly since 1991. In chapter 3.2, the effect of this increase in FDI’s on the export of China will be discussed. The portfolio capital on the other hand, has always been discouraged, just like external debt. In 2006 the Chinese government started with two different programs, the Qualified Domestic Institutional Investors (QDII), and the Qualified Foreign Institutional Investors (QFII). With the introduction of these programs, Chinese people could finally invest in the rest of the world and vice versa. Although there were still many controls on the inflows and outflows of capital, through pre approval procedures, the Chinese people were able to invest globally. According to Glick and Hutchison (2009), the main reason for the relaxation on the outflow controls was the upward pressure on the Renminbi. An upward pressure on the Renminbi forces the Chinese central bank to buy foreign currency to protect the pegged exchange rate. By relaxing the outflow controls, the government stimulates people to shift their capital abroad, which can replace the

interference of the Chinese central bank in the exchange rate market. The upward pressure on the Renminbi also led to a softer currency conversion policy for the Chinese. By making it easier for Chinese people to convert their Renminbi for foreign currency, the central bank let the people do the interventions to remain the pegged exchange rate policy.

The policy on (partly) foreign owned banks and branches from foreign banks have been more liberal too. Banks are allowed to establish themselves in China, but still need to be approved by the Chinese banking regulator, and need to satisfy a higher capital

requirement than domestic owned banks (Martin 2012). In short, the main changes that occurred after the start of China’s capital account liberalization are firstly, the foundation of the SEZ’s, which resulted in a significant increase of FDI’s. Secondly, the establishment of the QDII and the QFII programs, which allow Chinese to invest abroad and foreigners to invest in China, and finally, the relaxation of the currency conversion policy for Chinese people.

Prasad and Wei, 2007

3. Effects on the export

In this chapter, three different channels through which the abandoning of the capital controls could influence the export of China, will be analyzed. China’s export has

experienced rapid growths over the last two decades. Between 1991 and 2013, the export had an average yearly growth rate of 16.6 percent. In comparison, the U.S. had an average export growth rate of 5.3 percent in the same period. According to Mah (2006), this growing involvement in international trade, has been one of the reasons of the high economic growth in China. Therefore, it is important to see what sort of effects the abandoning of the capital controls could have on the export. The first channel that will be analyzed, is the exchange rate channel. This channel arises from the trilemma problems, and could force China into leaving their (semi) pegged exchange rate for a floating exchange rate policy. The second channel is about the foreign direct investments (FDI’s), which are promoted for some years already, as stated in the previous chapter. Therefore, we analyze if this increase in FDI’s led to an increase in the export, and where this possible increase in export originates from. The last channel will describe the link between the state-owned banks and the state-state-owned enterprises (SOE’s), because the SOE’s provide for a great deal of the export.

3.1 Exchange rate

To start, the so called Trilemma has been noted in many economic articles, including the article of Obstfeld, Shambaugh and Taylor (2005). They recognized the Trilemma, also known as the Impossible Trinity, as a real problem. According to the theory of the Trilemma, a country is not able to sustain all of the following three points: a pegged

exchange rate, a globally liberalized capital market, and an independent monetary policy. A country is only able to sustain two out of these three points. If a country wants to have an independent monetary policy, it has to either have a floating exchange rate, or capital controls that protect the country from capital in- and outflows. For example, if the interest rate of a country is higher than the world interest rate, this country will face capital inflows to profit from the arbitrage opportunities. These capital inflows will lead to a higher

demand of the domestic currency, causing an increase of the value of this currency. As a result of the capital inflows and the associated appreciation, the country will have a floating exchange rate. In case the country wants to aim for a pegged exchange rate policy, they will have to introduce capital controls to prevent the inflow of capital. The other option to keep the exchange rate pegged and allow free capital flows, is for the central bank to intervene, for example by lowering the interest rate or selling the home currency. Measures like these will undermine the central banks independency.

Most of the developed countries, or groups of countries in case of the EU, have a floating exchange rate and a liberalized capital account. This means that they have full control over their monetary policy. Developed countries are often involved in high levels of international trade, and are dependent on the global economy. This involvement in the global economy makes a country vulnerable to economic crises and other problems around the world. Therefore, the need for an independent monetary policy rises. With an

independent monetary policy, countries can react to positive or negative foreign influence, to stabilize economic growth, unemployment or inflation. With China growing into the global economy, the demand of an independent monetary policy could rise. Together with the liberalization of their capital accounts, this could force China into leaving the semi-pegged exchange rate policy, and let its currency float. However, in recent times China has been devoted to their exchange rate stability over their independent monetary policy, but still has some monetary tools left (Glick and Hutchison 2009). When all the capital controls are lifted, and the monetary independency has fully disappeared, China could still leave its pegged exchange rate policy.

Now it has become clear that there is a conceivable scenario of China leaving their pegged exchange rate policy, the possible effects of this decision on the export need to be analyzed. This floating exchange rate policy could lead to three different scenarios. The currency could appreciate, depreciate, or remain more or less the same. Firstly, when the Chinese currency appreciates, foreign countries have to pay more of their own currency to obtain the Renminbi. In other words, the relative price of the Renminbi increases. When the relative price of the Chinese currency increases, the relative price of the Chinese products increases as well. Looking at some basic economics, the supply and demand curves, the conclusion can be made that a relative increase of the price leads to a decrease in demand. Therefore, an appreciation of the currency would most likely lead to a relative decrease in export. This phenomenon has been examined by Thorbecke and Smith (2010) for the Chinese economy. They have found that, if the Renminbi appreciates with ten percent, the ordinary export decreases with almost twelve percent, and the processed export with only four percent. Ordinary export consists mainly of labor intensive products, and processed export involves high-tech products. The difference between the decrease of ordinary and processed export, is caused by the differences of the two, concerning competitive

advantages of China. The international competitive advantage of China in the ordinary export, is much lower than the competitive advantage in the processed export. Therefore, the ordinary export will shift much more to countries which, before the appreciation of the Renminbi, had only a slightly less competitive advantage in comparison to China. The processed export on the other hand, would mainly shift to the US and Europe, where the competitive advantage for China is much higher, due to lower labor costs and a lower cost of capital. Even though the Chinese currency gets more expensive, only four percent of the processed export shifts abroad, because of the high competitive advantage in this sector. The manufactured goods are the main exporting products of China, with 94 percent of the total export in 2013. The two biggest sectors within the manufactured goods are the machinery and the electronic equipment. Together they represent almost 43 percent of the manufactured goods in 2013. These sectors are high-tech productions, and are covered by the processed goods. Therefore, according to the research of Thorbecke and Smith (2010), the main exporting sectors will be less vulnerable for an appreciation of the Renminbi.

Funke and Rahn (2005) state that the effects of an appreciation of the Renminbi on the labor intensive export, are only short term effects. In the long run, Chinese firms could move their companies inland, where the labor costs are even lower, to match the loss of

competitiveness. This would mean that there will be no significant loss of the labor

intensive export in China. For a depreciation of the currency, the opposite will occur as for the appreciation. A decline in the relative price of the currency will lead to an increase of the export. Furthermore, when the exchange rate remains the same, the relative price does not change and will not have an effect, through this channel, on the export. It is impossible to know exactly what is going to happen with the exchange rate after China will let it float, but there have been numerous researches about the over- or undervaluation of the

Renminbi. There is of course a motive for the Chinese government to keep the exchange rate undervalued. This would benefit the export, a leading component for the economic growth in China. According to most researchers who used the behavioral equilibrium exchange rate (BEER) method, a very general approach, the Renminbi is undervalued (Funke and Rahn 2005 and; Coudert and Couharde 2007). On the other hand, in these same articles, both authors also showed another research method, which could not prove a

substantial undervaluation of the Chinese currency. Cheung, Chinn and Fujii (2007) also found that, with the basic specifications, the Renminbi is undervalued, but using

conventional significance levels, there was not enough support to state that the currency was undervalued. All these researches show that it is hard to tell if the Renminbi is under- or overvalued. The only way to find out is to wait until the Chinese government has stopped the semi-pegged exchange rate policy.

Aside the exchange rate channel described above, China could also experience higher fluctuations of their exchange rate, after leaving the semi-pegged policy for the floating exchange rate. Chou (2000) analyzed these effects of the exchange rate variability on the export of different exporting sectors for China. He found a negative effect of exchange rate variability on the export of manufactured goods and mineral fuels. There were no effects found for foodstuffs, beverages and tobacco, and a positive effect on industrial materials. The manufactured goods cover 94 percent of all the exports from China, so this makes them more vulnerable for exchange rate fluctuations. As a side note, when China abandons their capital controls, the future market could grow. The future market is a virtual place where companies can buy a contract to sell certain goods at a specific moment in the future, at an upfront agreed price. In this case, they could sell the home currency for foreign currency, or the other way around, to hedge against the exchange rate risks. This could possibly eliminate the negative effects of exchange rate fluctuations on the export.

In short, the Trilemma could force China into leaving their pegged exchange rate policy, and continue with a floating exchange rate. With this new policy, three different scenarios are possible, namely the exchange rate could appreciate, depreciate or remain the same. For each of the three scenarios there is a certain effect on the export, however it is not clear in which direction the exchange rate will go. In other words, the effect on the export depends on the direction of the exchange rate. Furthermore, the fluctuations could lead to negative effects on the export, although these effects could be eliminated by the growth of the future market.

3.2 Foreign Direct Investment

After analyzing the exchange rate channel in the previous paragraph, the next channel that will be discussed is the foreign direct investment (FDI) channel. An important deviation of the FDI channel in relation to the other two channels discussed in this thesis, is the fact that controls on FDI’s already are lifted by the Chinese government in 1980. This gives the opportunity to look into the outcomes of this important decision, and use this information to acquire knowledge about the influence of FDI’s on the export. Firstly, the reasons to deploy FDI’s will be discussed, and why these FDI’s are important for China’s economy.

Secondly, the effects of the growth of FDI’s on the export in China are being analyzed by making a distinction between export based FDI, and domestic market FDI, which could also play a role influencing the export by their positive spillovers.

In 1980, China established their first special economic zones (SEZ’s). Due to this establishment, FDI’s also made their start in the country. A capital inflow gets counted as FDI, if the concerned party has a minimum of ten percent of the voting shares of a

company. The first couple of years after the establishment of the SEZ’s, the amount of FDI’s was disappointing. Between 1986 and 1990, the Chinese government raised a set of laws which promoted and protected the FDI inflows (Chen, Chang and Zhang 1995). Following these law modifications, the FDI’s grew enormously from 3.49 billion US dollar in 1990 to 347.85 billion in 2013, and since 2009, China is the country with the most FDI’s worldwide. According to Schneider and Frey (1985), the biggest economic reason to choose a country for FDI’s is the level of development (measured as per capita GNP), and the height of the balance of payment. In the case of China, the GNP per capita has been growing for decades, with growing rates between six and fourteen percent, and the current

account always showed big surpluses. This could be a reason for the growth in FDI’s in China. FDI in developing countries is a result from a competitive advantage from a foreign firm over a domestic firm. Domestic firms often have a better understanding of the local laws and business environments, so the competitive advantage is most of the time a consequence of a more evolved management system or a higher level of technology. Important reasons for China to remove the controls on FDI therefore, were the transfer of experienced higher management, and the transfer of high technologic developments (Borensztein, De Gregorio and Lee 1998). These transfers of knowledge and technology could also have positive spillovers to the rest of the economy. Liu (2002) did an empirical research about the positive effects of spillovers in the Chinese economy between 1993 and 1998. The result was a significant impact of manufacturing FDI, on the growth of the productivity of their component industries. A one percent increase in the FDI’s, led to a 0.5 percent increase in the productivity of their component firms. This could indicate that there have been technological transfers between the firms. In other words, FDI could increase the GDP of a country, but has it also effect on the export of a country?

A firm has the option to sell its products to the domestic market, or to export them. This is also the case for companies funded by FDI’s. Obviously, when such a company is exporting, the export value of that country increases. When the firm decides to exploit the domestic market, the effects on the export are less obvious.

Buckley and Meng (2005) analyzed the FDI market of China. According to them, the domestic market FDI’s had a slightly higher share of FDI than the export based FDI’s, fluctuating between 52 and 59 percent of the total FDI market in the years from 1992 to 2002. The FDI export market is represented highly by Overseas Chinese investors, mainly from Hong Kong, Macau and Taiwan. These investors invest mostly in labor intensive and low tech sectors of manufacturing, and try to get high short term profits, by exporting most of their products. Investors from the US, EU and Japan are more interested in the domestic market, and focus on the high tech share of this market. Although they mostly start with export based FDI, Western investors try to establish long term profits in the domestic market. On average, Western investors have a lower share in the firm they invest in than the Overseas Chinese investors. With 41 to 48 percent of the FDI share being export orientated FDI, almost half of the FDI is intended to export from China to the rest of the world. Therefore, the increase in FDI’s over the last decades in China have contributed much to the growth of their export.

The domestic market share of FDI does not directly increase the export of China, although there could be positive spillovers influencing China’s export. Borensztein, De Gregorio and Lee (1998) imply that the FDI of multinational corporations, are the main source of technology and management knowledge transmission in developing countries. These inflows of new technology and knowledge will increase the economic growth of the country. The main condition for the economy to grow is the availability of human capital. There is not much data available on the school enrollment of China, however the data available shows that only 27 percent of the Chinese on high school continue their

education. On the other hand, this enrollment to so called tertiary education, has been fast growing over the years, with only three percent having higher education in 1990. Therefore, depending on the human capital resources in China, the GDP of the country will grow because of these FDI inflows. The new technologies and knowledge resulting from FDI, could lead to more globally competitive companies in China, and could therefore increase their involvement in the exporting sector. On the contrary, Blomström and Sjöholm (1999) did an empirical research on microeconomic data in Indonesia, and concluded that the FDI only had positive technological spillovers on non-exporting domestic firms. They state that exporting firms, already facing global competition, have the same technology or do not need new technologies. Another point they analyzed was the relation between the share of foreign investors in a firm, and the technological spillovers. The conclusion was that there

was not a significant effect of the part of foreign share on the spillovers. Indonesia differs from China, among others, by having no capital controls, a lower GDP, and a lower GDP growth, so it is impossible to attract these conclusions to the Chinese economy.

Concluding, the amount of FDI’s in China has grown rapidly in the last decades, which was a leading component of the GDP growth of the country. Almost half of the FDI’s were export based, which contributed to the spectacular growth of the export of China. Additionally, the domestic market FDI could also have contributed to the increase in export with their positive spillovers. This is certainly not a fact, although there are no researches that indicate a negative effect of domestic market FDI on export.

3.3 The financial sector

The last channel that will be discussed is the financial sector. After analyzing the exchange rate and the FDI, the relationship between the state-owned banks and the state-owned enterprises will be discussed. This is necessary to find out the possible effects on the export, after the entry of foreign banks as a result of the liberalization of the capital

account. In 1999, a little more than half of the total export of China was produced by state-owned enterprises (SOE’s). However, SOE’s are believed to be inefficient, and to be highly dependent on the financing of state-owned banks. Therefore, the link between the SOE’s and the state-owned banks will be analyzed. After that, the possible influence of the entry of foreign banks on the Chinese state-owned banks will be discussed. Furthermore, the effects the allowance of portfolio investments could have on Chinese banks, will be mentioned. First, this paragraph will start with a brief overview of the Chinese financial system.

To start, it is important to know what the Chinese financial system looks like, and what reforms have been implemented in the last decades. From 1950 until 1978, there was only one bank, the People’s Bank of China (PBC). This bank acted as the national central bank and as a commercial bank, also it was fully state-owned. After that, more different banks have been established. Nowadays, three different policy banks exist, which all have their own purpose, and they are fully state-owned. These banks are funded by government grants, and can issue bonds on their name. The main purpose of these policy banks is to invest in the country. These banks own eight percent of the total banking assets, which has proven not to be enough to implement all of the government objectives. This is the part

where the commercial banks have to step in (Chen, Skully and Brown 2005). The five biggest banks, the ”Big Five”, account for almost fifty percent of the total market share. These banks are mostly state-owned and they are forced, by local and national government, to step in when the policy banks have a lack of financial power. According to Fung and Leung (2001), around 75 percent of the bank lending goes to SOE’s, in the years leading to 2001. SOE’s have a high debt/equity ratio, because the firms were not funded by much equity of the Chinese government. Therefore, they needed to obtain loans from banks, that were mainly state-owned. In other words, SOE’s in China are highly reliable on the loans from state-owned banks. If the SOE’s suffer losses, there is not much equity to prevent the SOE’s from having non-performing loans (NPL’s). According to Gang (2003), China has a high rate of NPL’s, which in 2001 accounted for 27.3 percent of GDP. The actual number should be much higher, because China made a construction to sterilize some NPL’s, in so called asset management companies (AMC’s). These NPL’s account for 13.7 percent of GDP. In recent years, there was a big debate about the NPL’s and if they are maintainable (Gang 2003).

China Statistical Yearbook, 2014

Looking at the balance sheet of the depository corporations in China, excluding the monetary authority, the Chinese banks have 30.77 percent of all the liabilities in personal deposits and 33.66 percent in corporate deposits, excluding deposits from other depository and financial corporations. In comparison, the foreign funded banks in China only have

33% 31% 1% 12% 7% 16%

Liabilities depository corporations

2013

(excluding monetary authority)

Corporate Deposits

Personal Deposits

Liabilities to Central Bank

Liabilities to other depository and financial corporations

7.87 percent of their liabilities in personal deposits (Chinese Statistical Yearbook 2014). According to the research of Zheng, Liu, and Bigsten (1998), the SOE’s in China are highly inefficient. Therefore, foreign banks will probably require a higher interest rate from the SOE’s than the Chinese state-owned banks. This is why the link between the SOE’s and the state-owned banks is likely to remain intact. However, what will happen to the personal deposits of the Chinese people, when new foreign banks become available? Not enough researches have been performed on the effects more foreign banks have on the bank choice of the Chinese people, to give a clear statement about this issue. On the other hand, it seems logical that if there are more banks to choose from, the existing banks could lose part of their personal deposits. This hypotheses should be tested through a specific empirical research. If the decrease in personal deposits turns out to be significant, the funds from the state-owned banks to the SOE’s could be restricted, and could therefore indirectly decrease the Chinese export.

The amount of inflows and outflows of portfolio investments, is analyzed in multiple articles (Bayoumi and Ohnsorge 2013; Sedik and Sun 2012; and He, Cheung, Zhang and Wu 2012). According to these researches, both portfolio investment inflows and outflows will increase. The main conclusion of these articles is that due to diversification of the Chinese investors, outflows would increase at a much higher pace than inflows. These net outflows could affect the balance sheet of the banks in China, what could lead to a crimp of the funds to finance the SOE’s.

In short, the SOE’s represent a large part of the Chinese export. However, these firms are highly inefficient, and therefore depend on the financing of Chinese state-owned banks. As a result of the entry of foreign banks, state-owned banks could lose part of their personal deposits. If this decrease in deposits does happen, it could lead to a shrinkage of the financing to the SOE’s, and therefore have a negative effect on the Chinese export.

4. Comparative case study

In the previous chapter, three different channels have been discussed that could have an influence on China’s export, when abandoning its capital controls. By analyzing the theoretical side of these channels, a representative view has been formed, of the different scenarios China could end up in after the liberalization of their capital account. To extend this acquired knowledge, it is important to bring in an historical example of a country that

already abandoned their capital controls. In 1980, Turkey experienced a similar situation as China is in nowadays. The effects of this situation on the export of Turkey can, in

combination with the previously discussed theory, be used to extend our view on China’s case. Although Turkey differs from China in many ways, it is still useful to compare the two cases, because reality can turn out differently than expected from theory. The case study of Turkey will start with the necessary background information on the initial situation in the country before the abandoning of the capital controls. After that, the effects on the export after liberalization of the capital controls of Turkey, will be analyzed on the basis of the three channels, discussed in the previous chapter. During this analysis, connections will be made with the case of China. The main points will be summed up in a conclusion at the end of the case study, whereby the most important similarities and differences with China will be highlighted. All of the given data of Turkey originates from The World Bank.

During the oil shock of 1973, the world witnessed the power of the oil producing countries. With oil prices rising from three to almost twelve US$ per barrel, many countries had problems dealing with this rapid increase. Turkey was one of those countries. In

paragraph 2.1, it was stated that capital controls are more likely to be implemented by countries in which the government has a significant influence on the central bank. This was the case in Turkey, where the central government was very dependent on monetary

financing, issuance of new money by the central bank to pay for the government deficits (Civcir 2003). Therefore, when the deficits increased because of the high oil price, the financing of this resulted in a decrease of the reserves of Turkey’s central bank, and also massive amounts of foreign borrowings. According to Merih Celasun (2001), these were the reasons for the crisis that occurred between 1978 and 1980. This crisis was important for Turkey, since the country was covered by many capital controls and government financial regulations, and after the crisis, attempted to open up their markets to start a market-based economy. This reform went gradually, and started with two mayor changes. The exchange rate, which was always pegged, changed to a crawling pegged policy with intensions to release it entirely in the following years. The second change was the

abandoning of the controls on the interest rates on bank deposits and lending (Civcir 2003). Referring to the Trilemma, described in paragraph 3.1, the change of exchange rate policy was a clear message of the Turkeys government, to accompany the liberalized capital account with an independent monetary policy. This change of policy had a big impact on the export of Turkey. For China, it is still a question what will happen to the

exchange rate after the pegged policy is abandoned. However, in Turkey this change of policy already happened. Therefore, it is possible to describe in what direction the exchange rate went, and how this influenced the export of Turkey. After the government released the pegged exchange rate, the direction was perfectly clear. In the first ten years of the crawling pegged exchange rate, the currency devaluated very rapidly, from 31.08 Turkish Lire per US$ in 1979, to 2122 Lire in 1989. However, a big side note on these numbers is the high inflation rate in Turkey. By adjusting the exchange rate for inflation, the real depreciation in that period accounted for 24.8 percent. This is still a big decrease in the relative price of Turkeys goods, and would, according to the theory described in

paragraph 3.1, result in an increase of their export. The export indeed increased by large amounts in the years between 1979 and 1990. In just over ten years, the export increased from 2,876 million US$ to 20,138 million US$. This could be an effect of the depreciation, although other factors are involved as well. After the exchange rate was fully loosened in 1989, it kept depreciating to 29,600 Lire per dollar in 1994, and in 2005 they created the “new” Turkish Lira which had an exchange rate of 1:1,000,000 to the old Lire. The depreciation of the Turkish currency is a very extreme case and is accompanied with high rates of inflation. In China, the outcome of the floating exchange rate could be very different. This is due to differences in the economic conditions of both countries, such as the high stable GNP growth of China, against the more volatile GNP growth of Turkey, and the level of inflation of both countries. Furthermore, China still has to make a decision about the Trilemma.

The second measure that was implemented to get Turkey ready for their capital account liberalization, was the removal of the fixed interest rates. This was necessary to get the banks ready for the competition that was expected to happen after the foreign

investment controls were removed. This led to a “deposit war” between banks, who

increased their interest rates, to obtain the highest amount of deposits possible. It soon was clear that these banks were unable to cover these high interest costs, which led to a banking crisis in 1982 whereby six banks went bankrupt (Civcir 2003). This is way different from China, where banks are allowed to choose their own interest rates. However, many Chinese banks are state-owned, causing the government to indirectly decide their interest rates. A point made in paragraph 3.3, was the negative effect, competition from abroad could have on state-owned banks in China. This could also affect the SOE’s, and therefore the export. Cevdet Denizer (2000) did a research about the effects of foreign banks entry in Turkey.

The results showed that the foreign banks had a beneficial effect on the domestic banks, by reducing their overhead expenses and making them more competitive. If this is similar for China, a negative effect on the export, as suggested in paragraph 3.3, is not necessarily the case. Although, a big difference between the banks in both countries, is the amount of NPL’s of the SOE’s. These non-performing loans could put a pressure on the

competitiveness of the Chinese banks, and therefore, the scenario stated in paragraph 3.3 could still be realistic.

In 1989, together with the full floating exchange rate policy, it was allowed for foreigners to invest in Turkey and vice versa. This could have been the start of the FDI’s in Turkey, that were on a very low level before 1980. After 1989, the FDI’s had increased a bit, but still were only around 0.5 percent of GDP. China on the other hand, increased their FDI inflows enormously. What was the difference between these countries that led to this inequality of FDI inflows? In paragraph 3.2, two conditions were mentioned why a country would be the destination of foreign direct investment, namely the high GNP (growth), and the height of the balance of payment. At this point, the difference with China becomes clear. Turkey had a very volatile GNP growth, instead of the high steady GNP growth of China, and Turkey had a current account deficit for years. These two facts could explain why China has become the main FDI country and Turkey remained untouched.

In the end, there are some similarities between the situation of Turkey in 1980, and China’s situation at the moment. China has to make the choice whether to keep the pegged exchange rate, or use monetary policy as a tool to stabilize the economy. This is the same decision Turkey had to make in 1980, whereby they chose for an independent monetary policy. In other words, Turkey got a floating exchange rate, which resulted in a large depreciation, and an increase of their export. In contrast to Turkey, China does not have the problems that arose with the liberalization of the interest rates. However, China could face problems with the NPL’s, which could undermine the competitiveness of their banks. Therefore, it is interesting to find out if the increase in competitiveness of Turkish banks, which arose after the introduction of more foreign banks, will happen to Chinese banks as well. In the last part became clear how important it is to satisfy the criteria for FDI. Turkey opened their capital markets and barely experienced FDI’s, opposite to China who

5. Conclusion

As China is growing into the biggest economy in the world, mainly because of its increasing export, there are some changes to be made in their economic landscape. The Chinese government wants to eliminate their capital controls on the long run, and tries to make the Renminbi a world leader on the currency market. Therefore, it is important to understand the possible consequences of the capital account liberalization on the export of China. Since China eventually will develop into an industrialized country, it is likely they switch to a floating exchange rate, due to the Trilemma. Depending on the under-or overvaluation of the Renminbi, the floating exchange rate will lead to respectively, a decline or a rise of the export. In Turkey, the decision to let the exchange rate float, led to an enormous depreciation of the currency. This resulted in an increase of Turkey’s export. However, the direction of the exchange rate of the Chinese currency could differ from Turkey’s case, because of the differences in the economic conditions of both countries. The exchange rate fluctuations, due to the floating exchange rate, could create a negative effect on the export, although these effects could be offset by the rise and development of the future markets. Another change evident on the abandoning of the capital controls, is the entry of foreign banks. As a result of this, Chinese banks could experience losses of their personal deposits. State-owned enterprises are mainly financed by these state-owned banks, so a shrinkage of the financial power of the state-owned banks could negatively affect the state-owned enterprises. Since state-owned enterprises are responsible for a large part of the export, a change like this could have a significant influence on the Chinese export.

However, in Turkey the entry of foreign banks caused the domestic banks to reduce their overhead expenses, and to become more competitive. If this also happens in China, there might not be a negative effect on the export. A side note to this research is the high amount of non-performing loans, owned by Chinese state-owned banks. These are caused by the inefficiency and low equity levels of the state-owned enterprises, and could undermine their competitiveness. One capital control that already has been lifted, is the restriction on

foreign direct investment. This resulted in an increase of the export, mainly caused by the export-based foreign direct investments. Additionally, foreign direct investments in general have benefited the economy of China, and possibly the export as well, by its positive spillovers.

This thesis has led to a clear overview of the different scenarios China could end up in, after liberalizing its capital account. However, to improve this review, a more clear

forecast has to be given for the direction of the exchange rate after China abandons the pegged exchange rate policy. Also, an extra empirical research would be necessary on the bank choice of Chinese people after the entry of foreign banks.

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