Capital inflow needs care
By Sun Lujun (China Daily)
Updated: 2004-06-10 10:14

[The author Sun Lujun is with the State Administration of Foreign Exchange.]

One of the most significant characteristics of the Chinese economy in recent years is its dramatic increase in capital inflow.

China has kept an average annual growth in foreign capital inflow of 28.9 per cent since 1992 and now has become the world's second largest destination of foreign investment only after the United States.

Capital inflow under the capital account was US$128.3 billion in 2002 and the figure was US$97.09 billion in the first six months of last year.

As capital inflow maintains strong growth momentum, the items on China's international balance sheet have seen substantial changes.

The international surplus and foreign exchange reserve saw remarkable growth between 1997 and 2000, thanks to the rise in the current account surplus.

But the current account surplus was no longer the major source of the international surplus after 2001. The capital account surplus took 79.97 per cent of all international surplus in the first half of 2003.

The "error and omission" item was negative before 2001, which means a large amount of capital outflow. The figure turned into a positive number in 2002, indicating capital inflows that are not easy to trace.

Given the interest rate difference between renminbi and foreign currencies and the expectation to renminbi revaluation, it is likely that some short-term and speculative capital will flow in.

The huge amount of capital inflow has not only eased the thirst for capital in the country, but also brought about advanced technology, rich information and management expertise, which in turn stimulates domestic economic development.

However, the sustained capital inflow has also influenced the exchange rate of the renminbi, the monetary policy and the stability of the economy.

On the one hand, it worsened China's international imbalances. The "dual-surplus" under the current account and the capital account occurred annually after 1994 except in 1998. And the amount of the "dual-surplus" has been climbing year by year.

On the other hand, given the current exchange rate regime, the huge capital inflow brings pressure to both the supply-demand relation in domestic foreign exchange market and the central bank's operation in the foreign exchange market.

The assets in foreign currencies, the major part of which is in foreign exchange reserves, is taking up an increasing proportion of the central bank's total assets. The ratio rose from 10.5 per cent in 1993 to 50.22 per cent last year.

This has led to a credit expansion in the domestic market, which has far outpaced economic growth. The imbalance has affected the stability of the overall economy.

And as the share of capital "frozen" as foreign exchange reserve expands, the central bank is left with limited leeway to keep the economy stable.

Some experts suggest taking measures to restrict capital inflows so that the imbalance of international payments can be eased.

However, solely restricting capital inflow may not work given the complication of the domestic economy.

Instead, a comprehensive solution involving all necessary means is needed.

First of all, the pro-active fiscal policy should phase out gradually as the economy develops.

A strict and effective supervisory system upon fiscal budgets should be established so that fiscal expenditures can be used efficiently.

The adjustment in fiscal policy should also be compatible with the changes in monetary policy. A combination of fiscal and monetary policies can amplify the policy effects on one another.

Second, the monetary policy should aim to improve the structure of bank credits and maintain the growth of money supply and bank loans at a reasonable pace.

The interest rate should gradually be allowed to float on the market so that it can act as a real leverage upon economic development.

A mechanism co-ordinating the policies governing renminbi and foreign currencies should be established and the monetary tools should be diversified.

Third, policies governing foreign trade should also be changed.

Given the energy shortages in the country, authorities should limit the export of resource-consuming primary products, upgrade the structure of exports and improve the competitiveness of Chinese exports.

On the other hand, measures should be taken to encourage the imports of products that China needs, such as high-tech products, electronic machineries and resources and energy in shortage in the country.

Fourth, the management and supervision of the financial sector should be improved.

The treasury bond market should be developed so that the central bank will be able to properly manage the money supply through active treasury bond transactions.

The current capital market should be expanded into a comprehensive capital market system including the short-term inter-bank market, the short-term bank note market and the discount market. Such markets will provide the central bank with more effective tools to manage the financial market.

On top of all these, a mechanism co-ordinating the operation and development of these markets should be established.

Financial supervision should be further enhanced to regulate the financial institutions' capital adequacy, interest rate, credit risks, pricing and management. This way, the financial institutions will be more competitive compared with their foreign counterparts and become more able to withstand the frequent fluctuations in their asset prices.

Fifth, authorities should try to find a proper time to reform current foreign exchange systems.

When a country's economy sees an international imbalance, a proper arrangement for exchange rates will function as an automatic adjusting rod and help the economy find its balance again.

Last but not the least, the goal of capital inflow management should be clearly defined.

To maintain a sustained development of Chinese economy, it is certainly out of the question to block capital inflows.

Instead, the management should focus on limiting the inflow of speculative capital or other short-term "hot money."

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