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VOL. 12, NO. 12 • NOVEMBER 2017

DALLASFED

Economic
Letter
China’s Capital Controls Appear
to Arrest Flight, Stabilize Currency
by J. Scott Davis

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ABSTRACT: China’s yuan and
balance of payments appear
to have stabilized by early
2017. Controls on capital
outflows may have been a key
factor that averted a full-blown
financial crisis in the country.

C

hina’s foreign exchange
reserves and the value of its
currency peaked in 2014. From
mid-2014 to year-end 2016,
foreign exchange reserves fell $1 trillion,
amounting to about 10 percent of gross
domestic product (GDP). Meanwhile, the
yuan lost about 14 percent of its value
against the U.S. dollar.
Chinese foreign exchange reserves
have since stabilized, with the currency
appreciating about 4.5 percent in the first
nine months of 2017.
Two lines of thought have attempted
to explain the currency’s behavior. One is
that Chinese capital controls prevented
the type of capital flight from the country
that could turn balance-of-payments
instability into a broader currency
calamity. The other supposition is that
foreign capital returned to China with
the reemergence of global growth and
investment prospects there.
A review of past emerging-market
balance-of-payments crises suggests that
capital outflows controls may have been
the stabilizing factor that averted a fullblown crisis.
Beginning in the early 2000s, the
Chinese currency was initially a story of
strength through commerce. After the
peg between the yuan and the U.S. dollar
was broken in 2005, yuan/dollar trade

was nearly always a one-way bet through
the end of 2013. Apart from a two-year
period when China reinstated the peg
following the 2008 global financial crisis,
the yuan appreciated for nearly 10 years.
The currency reversed course and depreciated from early 2014 through 2016,
trading toward the end of that period at
levels last seen in early 2008.
The yuan’s earlier appreciation starting in 2005 signaled significant upward
pressure on the currency from capital
flows into China through its trade surplus and capital account. The flows
came from foreign investors who sought
Chinese assets given the prospects for
the local economy.
China’s central bank responded and
intervened in the exchange rate market
to relieve the upward pressure on the
yuan, amassing a mountain of foreign
exchange reserves. Between July 2005
(when China dropped its exchange
rate peg) and June 2014 (when reserves
peaked), foreign exchange reserves held
by China’s central bank increased from
$700 billion to $4 trillion.
The situation changed when China’s
economic prospects dimmed in 2014 and
international investors no longer sought
assets. Capital inflows declined, depressing the currency and forcing the central
bank to reverse its policy of reserve

Economic Letter
Chart

1

China’s Capital Inflows Turn Negative in 2014,
Leading to Balance-of-Payments Deficit

Percent of gross domestic product*

18
15
12
Change in reserves

9
6

Current account

3
0
Capital and financial account (net inflows)

–3
–6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

*Two-quarter moving average.
SOURCE: Chinese State Administration of Foreign Exchange.

Chart

2

China’s Currency Outflows Rise in 2016
Before Returning to Normal; Inflows Recover

Flows as a percent of gross domestic product*

16

measure of the net flow of capital into a
country from private financial transactions (purchase or sale of stocks, bonds,
etc.).
The fundamental balance-of-payments identity states that a country’s current account plus its capital and financial
account must equal the net change in
official reserves held by the central bank.
From 2004 to 2014, capital flows into
China through either the current account
or the capital and financial account
resulted in strong demand for Chinese
currency, pressuring the exchange rate
higher (Chart 1).
Starting in 2014, the positive flow of
capital into China through the financial
account reversed. Net capital flows into
China through the capital and financial
account went from +5 percent of GDP to
−5 percent over a two-year period. This
decline forced the central bank to sell
reserves to stabilize the currency; foreign
exchange reserves fell at a rate of 1 to 3
percent of GDP per quarter though much
of 2015 and 2016.1
After bottoming out in 2016, net
financial inflows began to recover and
headed toward positive territory. As a
result, reserves stabilized, growing in
recent months.

12

8

Inflows

Outflows

4

0

–4

–8

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

*Two-quarter moving average.
SOURCE: Chinese State Administration of Foreign Exchange.

accumulation. Foreign exchange reserves
were deployed to plug the resulting
balance-of-payments hole.
Chinese balance-of payments instability in 2014–16 could have fomented a
crisis by early 2016. Instead, an environment characterized by a rapidly falling
currency valuation and depleting foreign
exchange reserves stabilized by early
2017.

2

Capital Flows Reversal
The current account is a measure of
the net flow of capital into a country from
currently produced goods and services.
The current account includes the trade
balance (exports minus imports), the net
income from investments held abroad
and some unilateral transfers such as
remittances and foreign aid. Separately,
the capital and financial account is a

Causes of the Decline
Capital inflows are defined as the
net purchase of domestic assets by foreign residents, and outflows are the net
purchase of foreign assets by domestic
residents. While both a fall in capital
inflows and an increase in capital outflows have the same effect on net capital
flows—both put downward pressure on
the currency—they may have very different causes.
An increase in capital outflows could
be due to Chinese investors diversifying
their international holdings, while a fall
in capital inflows would be a sign that
foreign investors are losing confidence in
China’s growth prospects and are withdrawing investments.2
A fall in capital inflows is referred to
as a “sudden stop,” and an increase in
outflows is known as “capital flight.” Both
lead to a drop in net capital inflows. The
fall in Chinese net capital inflows during
2014–16 was due to a fall in inflows, a
sudden stop (Chart 2).

Economic Letter • Federal Reserve Bank of Dallas • November 2017

Economic Letter
The subsequent recovery that
extended into early 2017 was due to a
recovery in inflows. In fact, capital outflows remained steady though much of
2014 and 2015 as inflows fell. Starting in
early 2016, outflows started increasing,
an early sign of capital flight as Chinese
residents moved capital out of the country. The increase in outflows did not last;
they have since returned to normal levels.

to a strict limit on foreign ownership or
a limit on the value of foreign assets that
domestic residents are allowed to buy in
a given year.
By definition, there is a sharp drop in
capital inflows and net capital inflows in
period 0 in both charts. Capital inflows
are much larger and more volatile in

Chart

3

Balance-of-Payments Crises
Barring unforeseen events, the most
recent period of Chinese balance-ofpayments instability is over.
Why did the situation stabilize and
what kept this episode from becoming
a full-blown emerging-market financial
crisis? Was a crisis averted because foreign money starting flowing back in or
because there was no rush by domestic
residents to move capital out?
Both of these effects kept the fall in
Chinese net capital inflows from worsening, as Chart 2 shows. To better understand the role of outflows and inflows in
the averted Chinese crisis, it is useful to
look at past episodes of emerging-market
sudden stops, subsequent recoveries and
how factors such as the use of capital
controls affect those recoveries.
Charts 3 and 4 present the paths of
capital inflows, capital outflows and net
capital inflows, averaged across a sample
of emerging-market countries in the
12 quarters before and the 12 quarters
after a sudden-stop episode.3 The charts
depict the average behavior of capital
flows across 37 sudden-stop episodes
from 1980 to 2014. Chart 3 shows the
average paths of capital flows in the 23
episodes in which the country had high
capital controls, and Chart 4 presents the
paths of capital flows in the 14 episodes
in which the country had low or no capital controls.4
Capital controls are restrictions
that the government of a country may
place on the cross-border movement of
capital. These could either be restrictions on foreign resident purchases of
domestic assets (capital inflows controls)
or restrictions on domestic resident purchases of foreign assets (capital outflow
controls). These restrictions could vary
from a tax that investors must pay when
buying or redeeming cross-border assets,

countries with low capital account
restrictions and thus a relatively open
capital account, but the behavior of net
capital inflows is similar in both charts.
Prior to the sudden-stop episode, net
capital inflows were about +8 percent
of GDP in both sets of countries, and in
the sudden stop, net capital inflows fell

Emerging Economies with High Capital Controls
Benefit from Net Inflow Recovery After ‘Sudden Stop’ Crisis

Percent of gross domestic product

30
25
20
15
10

Inflows

5
Outflows
0
Net inflows

–5
–10
–12 –11–10 –9 –8 –7 –6 –5 –4 –3 –2 –1

0 1

2

3 4

5

6

7

8

9 10 11 12

NOTE: The chart depicts a sample of emerging-market economies, 1980–2014. “0” denotes a decline in capital inflows
known as a sudden stop; 12 quarters before and after the sudden stop are shown.
SOURCE: International Monetary Fund.

Chart

4

Emerging Economies with Low Capital Controls
Confront Capital Outflows Following Crisis

Percent of gross domestic product

35
30
25
20

Outflows

15
10
5

Inflows

0
Net inflows

–5
–10
–15
–12 –11–10 –9 –8 –7 –6 –5 –4 –3 –2 –1

0 1

2

3 4

5

6

7

8

9 10 11 12

NOTE: The chart depicts a sample of emerging-market economies, 1980–2014. “0” denotes a decline in capital inflows
known as a sudden stop; 12 quarters before and after the sudden stop are shown.
SOURCE: International Monetary Fund.

Economic Letter • Federal Reserve Bank of Dallas • November 2017

3

Economic Letter

to about −4 percent of GDP in countries
with high capital controls and −6 percent
of GDP in countries with low capital
controls.
Capital inflows recover quickly following the sudden stop in both sets of
countries. Capital inflows returned to
about half of their pre-sudden-stop level
within eight quarters after the sudden
stop.
In countries with high capital controls, there is also a recovery in net
inflows. Capital outflows after the
sudden-stop episode are contained, so
the recovery in capital inflows leads to a
recovery in net inflows. But in countries
with low capital controls, there is an
increase in capital outflows in the wake
of the sudden stop and, thus, despite the
increase in capital inflows, there is little
recovery in net inflows.
China has tight capital controls, and
the index used to distinguish between
high and low capital-control countries
ranks China as having a nearly closed
capital account. In particular, China
has tight controls on capital outflows by
Chinese residents. The government tightened these in early 2016 when net capital
inflows were at their lowest and foreign
exchange reserves were falling at a rate of
$100 billion a month.5
Examples of sudden-stop episodes in
other emerging-market countries seem
to suggest that capital controls may have
arrested the fall in net capital inflows and
prevented a deeper crisis in 2016.
The Chinese data show there was a
sharp increase in capital inflows after
the bottom was reached in early 2016.

DALLASFED

Previous sudden-stop episodes show
that this V-shaped recovery in capital
inflows is common. The Chinese data
also show there was an initial increase in
capital outflows in early 2016 that began
to resemble a capital flight, but it quickly
receded.
The limited response of capital outflows in China in 2016 closely resembles
what occurred in other sudden-stop
episodes in emerging-market countries
with high capital controls, suggesting
that China’s controls may have limited
the capital flight and allowed a recovery
in net capital inflows and a return of
balance-of-payments stability.
Davis is a senior research economist in
the Research Department at the Federal
Reserve Bank of Dallas.

Notes
The International Monetary Fund’s Balance of Payments Manual 6 (BMP6) sign convention is used when
discussing capital outflows. In this simple asset/liability
approach, a positive net purchase of foreign assets by
domestic residents is recorded as a positive capital
outflow. Alternatively, some studies use the Balance
of Payments Manual 5 direction-of-flow principle that
would say when the net purchase of foreign assets is
positive, there is capital flowing out of a country and
capital outflows are recorded with a negative sign. In this
case, net capital flows would equal capital inflows plus
capital outflows.
2
Many articles in the press assume that negative capital
inflows are the same as positive capital outflows, though
they aren’t. In fact, they are far from being opposites,
and several papers have found that capital inflows and
capital outflows are positively correlated. See “Capital
Flow Waves: Surges, Stops, Flight, and Retrenchment,”
1

Economic Letter

is published by the Federal Reserve Bank of Dallas.
The views expressed are those of the authors and
should not be attributed to the Federal Reserve Bank
of Dallas or the Federal Reserve System.
Articles may be reprinted on the condition that
the source is credited to the Federal Reserve Bank
of Dallas.
Economic Letter is available on the Dallas Fed
website, www.dallasfed.org.

by Kristin J. Forbes and Frances E. Warnock, Journal
of International Economics, vol. 88, no. 2, 2012, pp.
235–51; “Gross Capital Flows: Dynamics and Crises,”
by Fernando Broner, Tatiana Didier, Aitor Erce and
Sergio L. Schmukler, Journal of Monetary Economics,
vol. 60, no. 1, 2013, pp. 113–33; and “Globalization
and the Increasing Correlation Between Capital Inflows
and Outflows,” by J. Scott Davis and Eric van Wincoop,
National Bureau of Economic Research, NBER Working
Paper no. 23671, August 2017.
3
A sudden stop is defined as a fall of more than two
standard deviations in capital inflows and net capital
inflows over a one-year period.
4
Low and high capital controls are defined using the
Chinn–Ito capital control index from “A New Measure of
Financial Openness,” by Menzie D. Chinn and Hiro Ito,
Journal of Comparative Policy Analysis, vol. 10,
no. 3, 2008, pp. 309–22 (using the data updated through
2015). The index is normalized on a 0–1 scale (where
0 indicates a closed capital account and 1 indicates an
open capital account). Low-capital-control countries
are those nations in which, prior to the sudden-stop
episode, the Chinn–Ito index was greater than 0.5;
high-capital-control countries are nations in which, prior
to the sudden-stop episode, the Chinn–Ito index was
less than 0.5.
5
One well-known Chinese capital outflow control limits
the value of foreign assets that a Chinese resident is
allowed to buy in any given year to $50,000.

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