Should China accelerate the liberalization of capital accounts? From the perspective of policy simulation based on the dynamic stochastic general equilibrium model

YANG Xiaohai1 LIU Hongzhong1 WANG Dihai1

(1.School of Economics, Fudan University 200433)

【Abstract】Since the People’s Bank of China issued a report in 2012, stating that the conditions for China’s capital account liberalization were roughly mature, worldwide concern has been aroused. There has also been heated domestic debate over the issue of capital account liberalization, with the focus on whether priority should be given to domestic structural reforms or capital account liberalization. Due to China’s role in the world economy, its capital account liberalization will be one of the most important inputs added to the international financial architecture in the coming years. China now faces the dilemma of whether to further liberalize its capital account. The RMB exchange rate marketization reform has not yet been completed. Moreover, the local governments’ debt leverage, shadow banking and asset bubbles are regarded as potential triggers of systematic financial risk in China. Therefore, accelerating the capital account liberalization may result in speculative shock. However, the internationalization of the RMB as an invoicing currency and its inclusion in the special drawing rights basket would speed up China’s capital account liberalization. The risk assessment of capital account liberalization can be performed by analyzing its impact on China’s international investment position. Till now, the relevant empirical studies of China’s capital account liberalization have been questioned for their lack of micro-foundations or failure to effectively use the dynamic stochastic general equilibrium (DSGE) model. In the traditional DSGE model, it is impossible to obtain steady-state asset allocation from the perspective of the rate of return, as the rates of return on different assets are equal in the steady state. Otherwise, arbitrage opportunities will arise. As the risks of equity and bonds are different, this provides an alternative perspective to portfolio allocation. Devereux and Sutherland (2011) successfully obtain analytic solutions in this regard. Following Devereux and Sutherland (2011), we establish a DSGE model focused on the circumstance that the transactions of outward foreign equity investment face quantitative constraints, which includes both outward direct investment and stock market transactions. We then apply the model to the policy simulation. In the two-country DSGE model, we introduce adjustment costs to reflect the degree of capital control on outward foreign equity investment and eliminate the instability of the model compared with He and Luk (2013). Based on the GDP and capital stock of China and the United States, the parameters are calibrated with Bayesian estimation. In order to address the potential risks of China’s capital account liberalization, three scenarios are simulated: completely liberalized capital account, completely closed capital account and the status quo. We try to identify the effects of four key variables on China’s international investment position (loosening capital control, the narrowing total factor productivity gap between China and the United States, the lowering capital-to-income ratio of China and the risk aversion coefficient). According to the simulation, we acquire the following findings: (1) with the gradual relaxation of China’s control over outward foreign equity investment and China’s decreasing capital-to-income ratio, China’s counterparty has the motivation to reduce its holdings of China’s equity assets, which means that China faces a gigantic capital outflow pressure; (2) in all the scenarios, with the relaxation of capital control, China’s counterparty is always inclined to reduce its holdings of China’s equity assets; (3) reducing the risk aversion coefficient of Chinese residents eases the pressure of capital outflow; (4) the effects of outward foreign equity investment on home countries (China and its counterparty) are asymmetric. The main reason behind this asymmetry is the US dollar’s exorbitant privileges. In other words, the net foreign assets (assets minus liabilities) of the United States enjoy positive excess return. We conclude that the economic structural reform should lead capital account liberalization and that strengthening the domestic financial system through reform can help ease the pressure of capital outflows. Especially in view of the capital outflows and the depreciation expectation of the RMB, China should be very prudent in loosening its control of capital outflows.

【Keywords】 policy simulation; capital outflows; foreign reserves; outward foreign equity investment;

【Funds】 General Program of the National Natural Science Foundation of China (71473041, 71673049) Major Program of the National Social Science Fund of China (16ZDA043)

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    [1]. ① This includes residents’ outward foreign direct investment and their sale and purchase of foreign stocks. According to Zhou (2012), promoting the convertibility of the RMB capital account is a very complicated process, which has a lot to do with the research progress of the academia, and China now needs a policy simulation of capital account liberalization; moreover, the research on the convertibility of residents’ outward foreign investment is still immature and needs to be vigorously promoted.

    [2]. ① A simple example is that according to the data from the World Bank, China’s total savings were USD 5.07 trillion in 2014, while the total US savings were only USD 2.93 trillion in the same year. Therefore, capital account liberalization means the possibility of the outflow of USD 5.07 trillion, which will be a big shock even for the entire international financial system.

    [3]. ① Unlike most of the literature, this paper does not take the government as a separate part in the model, and instead treats ordinary residents and the government as the same rational economic man without distinguishing them.

    [4]. ② Imperfect substitutability exits between the home country’s goods and the foreign country’s goods. See Engel and Matsumoto (2009) and Heathcote and Perri (2002).

    [5]. ③ A large number of studies have shown that consumption has home bias. See Heathcote and Perri (2013) and Sorensen et al. (2007).

    [6]. ① In this paper, represents the value of the variable xt in the steady state. This assumption for the TFP intends to illustrate the differences between the home country and the foreign country in the steady state.

    [7]. ② Coeurdacier et al. (2010) have measured the TFP of different countries and found that the correlation coefficients between different countries are significantly greater than zero.

    [8]. ③ For discussions on investment shock, see Greenwood et al. (1997) and Justiniano et al. (2010). Fisher (2006) uses CPI / (investment deflator) to measure the investment shock μi, t.

    [9]. ④ For an empirical discussion of investment shock, see Coeurdacier et al. (2010).

    [10]. ⑤ Coeurdacier et al. (2010) have found through empirical research that the correlation coefficient Corr (εai, t, εμi, t) between TFP and investment shock is close to zero, which leads us to the above assumption.

    [11]. ⑥ On the basis of Backus et al. (1994) and Coeurdacier et al. (2010), considering the calculation simplicity and the robustness of the impact of the value set for the preference for foreign goods in investment on the results, this paper does not distinguish between investment and consumption with respect to the preference for goods.

    [12]. ⑦ See He and Luk (2013) and Devereux and Sutherland (2009).

    [13]. ① The expression of the national debt’s price pbF, t-1 can be derived from the first-order condition of bHF, t-1. In the following analysis, the price expression of equity assets is obtained in a similar way.

    [14]. ② For the adjustment cost, see Bush et al. (2005).

    [15]. ① Equity securities, which are generally referred to as shares, can be roughly divided into common shares and preferred shares.

    [16]. ② Here, the liberalization degree of outward foreign equity investment is not the liberalization degree of the capital account, and they do not necessarily have connections. This concept is proposed to better study the process of gradual liberalization of outward foreign equity investment and to more clearly investigate the current capital outflow pressure and the potential risks behind the liberalization of the capital account for outward foreign equity investment.

    [17]. ③ Existing literature has not provided an answer about the corresponding solution, but we have developed a rigorous proof process, which is available upon request.

    [18]. ④ China, as an emerging market economy, has limited wealth creation and store-of-value capabilities and is a country with “asset shortage.” According to the data released by the State Administration of Foreign Exchange of China, the Chinese bond assets held by foreign investors were USD 144.9 billion in 2014, which only accounted for a very small proportion, namely 1.4%, of China’s GDP in the year. Moreover, foreign investors need to invest in Chinese bond assets through QFII. In order to reduce unnecessary noise, we do not consider the home country’s bond asset market clearing and do not include it in the model.

    [19]. ① For the details, see the working paper version of this paper:

    [20]. ② See [Argentina] George McCandless. The ABCs of RBCs: An Introduction to Dynamic Economic Models. Duan, P. (trans) Dalian: Dongbei University of Finance & Economics Press (2011).

    [21]. ③ The excess return from the asset portfolio makes this model different from the traditional model, which has been applied by Devereux and Sutherland (2010) to the analysis of valuation effects.

    [22]. ④ Because the calculation process is complex and lengthy, it is not discussed here, which is available upon request.

    [23]. ⑤ In terms of the robustness, as revealed by the figures about policy simulation on the basis of comparative static analysis, the impacts of the values set for the parameters on the results are robust in this paper. Due to the space limitation, detailed discussion is not presented here and the doctoral thesis of Yang Xiaohai, one of the authors of this paper, which is a policy simulation study on the liberalization of China’s capital account, is available upon request. In addition, if the values of the parameters in this paper are slightly different from the actual values in the Chinese economy and the US economy, the impact will not be big and the conclusions of this paper will not be affected. This is because the elasticity of substitution between the home country’s goods and the foreign country’s goods could be slightly adjusted to make the circumstance of maintaining the status quo of outward foreign equity investment consistent with the actual data of China.

    [24]. ⑥ The observations in this paper are about GDP and capital formation. Moreover, the existing studies on the TFP of China and the US, capital’s share of income and the reciprocal of the elasticity of intertemporal substitution in consumption have been quite mature. Therefore, Bayesian estimation, which will lose the degrees of freedom and influence the estimation accuracy for other parameters, is not very suitable. Hence, this paper refers to the existing studies for the values of the parameters.

    [25]. ① Due to the space limitation, this paper does not perform a comparative static analysis of the Frisch elasticity of labor supply. The impact of the value of this parameter on the results is robust and it is unnecessary to distinguish between the home country and the foreign country in terms of the parameter’s value, so its value is set as 1 in this paper.

    [26]. ② Regarding the value set for the capital control intensity, many existing studies have provided analysis and it is a very controversial research topic. Bayesian estimation is not very suitable for this parameter, because it is unreasonable to use the data about GDP and capital stock to derive the information of capital control intensity. Considering that the adjustment cost is the square of the sum of several types of assets in this paper, the values of ψH and ψF should not be too large. Otherwise, the settings will be inconsistent with the common sense in economics. In addition, the comparative static analysis shows that the impact of these values on the results is robust, so the values are set as above.

    [27]. ③ Firstly, because the autocorrelation coefficients and standard deviations of the technology progress shocks and investment shocks of the home country and the foreign country are important for the results, the Bayesian estimation method is adopted in order to avoid the influence of subjective value assignment. Secondly, this paper uses the observations about GDP and capital stock, which are closely related to technology progress and investment shock, and thus it is scientifically rigorous to estimate the values based on these observations. However, other structural parameters are not directly related to the observations, the estimation of which may thus deviate from the actual values. For these parameters, it is better to directly refer to existing mature research. Thirdly, considering the limited observed variables, the introduction of too many parameters will damage the estimation accuracy and lose the degrees of freedom. Therefore, the parameters estimated by the Bayesian method in this paper only include the autocorrelation coefficients and standard deviations of technology progress shock and investment shock.

    [28]. ④ In terms of the base period’s capital stock, this paper adopts the Chinese data estimated by Zhang et al. (2004), namely USD 136.3 billion in 2010 US dollars. At the same time, this paper uses the method of Hall and Jones (1999) and estimates that the US capital stock was USD 1792.6 billion in 1960 (in 2010 US dollars). Then, the annual capital stock of China and the US in 2010 US dollars is estimated on the basis of the annual capital formation data from the World Bank with consideration of depreciation.

    [29]. ① Accordingly, the liberalization degree of outward foreign equity investment can be calculated, which is 0.0244/0.3230=7.55%. This indicates that China is currently in the primary stage of the liberalization of outward foreign equity investment.

    [30]. ② This shows that under the law of one price and the policy arrangement of complete liberalization of outward foreign equity investment without any quantitative constraint, the current foreign reserves may not be sufficient if all the Chinese residents are suddenly allowed to freely purchase US stocks and make outward foreign direct investment.

    [31]. ③ According to the data released by the State Administration of Foreign Exchange of China, the sum of China’s outward foreign direct investment and equity securities investment was USD 1044 billion in 2014, accounting for 6.02% of the US GDP in the same year. Meanwhile, the sum of foreign direct investment in China and foreign holdings of Chinese equity securities was USD 3250.4 billion in 2014, accounting for 31.4% of China’s GDP in the year.

    [32]. ① This paper was written in March 2015. The actual situation of capital outflow and RMB depreciation pressure in China from 2015 till now can still be explained by the results of the model in this paper, which shows the strong reliability of our model.

    [33]. ① The NGDP will also grow continuously during this process. The absolute quantity of the Chinese equity assets held by the US will also increase, while its growth rate will be slightly lower than that of the NGDP.

    [34]. ② Here, the economic explanation is as follows: as the TFP increases, China’s GDP will grow continuously and the wealth of residents will increase as well, which will trigger the demand of using a part of the increased wealth for overseas equity investment; in this case, the maintenance of strict quantitative constraints will depress such demand and cause distortion.

    [35]. ① Given the detailed discussion in the dimension of continuously increasing outward foreign equity investment during the comparative static analysis on the TFP, the following analysis focuses on the circumstance of a decline in capital’s share of income in order to avoid repetition.

    [36]. ① For the economic mechanism behind the wage income risk caused by technology progress shock, see Coeurdacier et al. (2010).

    [37]. ② According to the data from the Bank for International Settlements, the share of RMB in all the money-market transactions was approximately 1.1% in 2013.


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This Article


CN: 11-1081/F

Vol 52, No. 08, Pages 49-64

August 2017


Article Outline



  • 1 Introduction and literature review
  • 2 Micro-level model
  • 3 Solution to the model
  • 4 Parameter calibration
  • 5 Analysis of the results
  • 6 Conclusion and implications
  • Footnote