Capital Account Liberalisation by China and the Effects on Global FDI and Trade

Abstract

We model the partial liberalisation of the capital account by China using a dynamic computable general equilibrium model of the world economy. Our results indicate that a reduced capital controls on foreign direct investment (FDI) would lead to a significant increase in FDI capital in China and a significant reduction in the cost of capital in China relative to the rest of the world. Furthermore, we observe an increase in capital stocks in most regions, which benefits most regions in terms of GDP and GNP. The Chinese economy grows by 3.3% driven by a significant fall in the rental price of capital that, in turn, lowers domestic costs, causes a real depreciation of the exchange rate and thus increased exports relative to other regions. We also observe an across-the-board increase in the saving rate driven by the rise in the price of consumption relative to investment (saving) in all regions.

Key words:

• Capital controls
• China
• computable general equilibrium
• FDI
• multinational firms
• trade

Jel Classification:

• C68
• E22
• F21
• F23
• F38
• F40

Acknowledgements

The views expressed here are the author’s and do not necessarily reflect those of KPMG Economics. Thanks go to Peter Dixon for extensive advice on this study, to Michael Kouparitsas for suggesting the research topic and Qiaomin Li and two anonymous referees for helpful comments on the paper.

ORCID

George Verikios http://orcid.org/0000-0002-1210-2755

Notes

1 This is according to current price data in US$ (IMF, 2014).

2 China’s current account surplus has averaged 4.5% of GDP between 2001 and 2013; more recently, the surplus has averaged 2.3% of GDP between 2014 and 2016 (IMF, 2014; World Bank, 2018). China’s foreign exchange reserves are the world’s largest holdings and were in the order of US$3 trillion at the end of 2016 (World Bank, 2018).

3 By ‘cost of capital’ we mean the average cost (return) of raising (investing) funds across asset classes, including bonds, equity (or shares), and physical capital. Changes in the return on bonds e.g., the interest rate, affect the return on other asset classes as investors seek to maximise the return on their investment portfolio.

4 According to current price data in US$, the Chinese economy has grown from being 7% of the size of the US economy in 1990 to 56% in 2013 (IMF, 2014).

5 Related to this, the risk tolerance capacity of the financial system is also important in determining the effect of greater exchange rate flexibility on financial risks (Zhang et al., 2016). Liu et al. (2016) show that the interaction of insurance and credit markets in Chinese regions is also important for financial risks and economic growth.

6 An increase in the consumption rate would mean higher domestic prices relative to world prices.

7 The model is implemented and solved using the GEMPACK economic modelling software (Harrison & Pearson, 1996).

8 In the formal presentation of the model theory, we use lowercase Latin characters to represent the percentage change form of a variable (e.g. p), and equivalent uppercase Latin characters to represent the levels form of a variable (e.g. P).

9 In describing the production technology, we omit technical change terms to simplify the exposition.

10 See, for example, Adams et al. (2000), Dixon and Rimmer (2002), Dixon et al. (2011), Horridge et al. (2005) and Wittwer et al. (2005).

11 This is household income from all sources minus income taxes.

12 This treatment of bonds is originally due to McDougall (1993) but its application here more closely follows Hanslow et al. (1999).

13 Such data is available from McDougall et al. (2012).

14 As can take a negative value, the representation of the constraint as is not strictly correct. In Equation (20), this potential problem is handled via the coefficient .

15 More details on the baseline are available in Verikios (2015).

16 See http://www.imf.org/external/pubs/ft/weo.

Additional information

Funding

This work was supported by United States International Trade Commission.