By Dong Fu Federal reserve Bank of Dallas

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What If China Removed Capital Controls Completely?
China has recently adopted measures to permit more flexible capital flows in response to increasing pressures on its currency. But there is much evidence that China continues to be concerned not only about capital inflows but also about capital outflows. Creating opportunities for Chinese citizens to invest abroad could lead to outflows of deposits from China's already troubled commercial banks.

A few days before China's central bank announced its new exchange rate regime, the government announced that Chinese multinationals would be permitted to acquire more foreign currency and lend the foreign currency to their subsidiaries. The new rules still limit the ability of Chinese to place their money abroad. However, if large outflows were to take place, Chinese banks that now rely on the government to preserve their captive deposit markets would have much more difficulty in stanching fund outflows that would erode the balance between assets and liabilities.

China's Policy Priority Lies in Bank Recapitalization and Privatization
On Dec. 31, 2003, the Chinese government conducted the third large-scale bank bailout in six years. The two previous bailouts had involved procedures that are standard across the world-the injection of domestic-currency-denominated capital and an exchange with the government of bad assets (impaired loans) for good assets (government securities).3

As part of the third bailout, however, the government injected $45 billion of foreign-currency-denominated reserve assets (dollar- and other currencydenominated bonds) to two SCBs-the Bank of China and China Construction Bank.4 The two banks have since been restructured into joint-stock companies, and they are planning an initial public offering both domestically and overseas in an effort to diversify ownership and privatize, at least partially.

Even though Chinese banks' nonperforming loan ratios have fallen as a result of government intervention and the two newly restructured state-owned banks' financial footings have strengthened significantly, China's domestic banks have far to go before they are viable. Thus, the government's motivations to use capital controls to preserve a captive domestic deposit base remain strong.

China's Exchange Rate Question
The majority of recent disputes over China's foreign exchange rate have involved China's trade balance. Although China's overall current account surplus is small by Asian standards, its large surplus with the United States and other industrialized countries has ignited complaints that an undervalued Chinese currency bestows an unfair advantage on Chinese exporters. China's latest move to let its currency appreciate 2 percent against the U.S. dollar and the simultaneous change from a dollar peg to a basket peg are at least partly aimed at addressing the trade problem. Decisions about China's exchange rate regime are driven by factors other than the trade balance, in particular, the health of the banking system.

China's still-fragile banking conditions are likely to continue to motivate exchange rate intervention even under the new basket peg system. So far, three of China's big four banks have received bailouts involving the exchange of bad loans for dollar- and other foreign-currency-denominated bonds.5 The Chinese currency's appreciation means a reduction in the value of these foreign-currency-denominated assets relative to the banks' Chinese-currency-denominated liabilities and an accompanying move back in the direction of insolvency. The 2 percent appreciation on July 21 may not have a severe impact immediately in this regard. However, if it leads to further appreciation, there would be a more significant impact on the current bank reform plan.

Conclusion
The current debate on the Chinese currency involves two related but separateissues that have often been confused. One is capital controls, and the other is the exchange rate at which the Chinese currency is pegged, whether to the dollar or to a basket of foreign currencies.

The debate has largely focused on trade effects. Banking conditions and bank reform in China provide an alternative perspective in analyzing the country's foreign exchange policy. China's latest move from a de facto dollar peg to a basket peg, together with a simultaneous 2 percent appreciation of its currency against the U.S. dollar, represents a major step toward a more flexible foreign exchange policy.

Meanwhile, combined with the loosening of capital controls, this new basket peg adds an increasing urgency for China to resolve its banking problem. In fact, the quicker the banking problem is resolved, the sooner a more flexible foreign exchange policy can truly materialize in China.

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Notes:
3.- In 1998, the four SCBs received a capital injection of 270 billion yuan. In 1999-2000, four asset-management companies were set up and purchased 1.4 trillion yuan of nonperforming loans at book value from the four SCBs and one government policy bank.

4 However, for the time being, the banks are not allowed to sell the foreign reserve assets.

5 In April 2005, the Industrial and Commercial Bank of China-the largest of the four SCBs-received a $15 billion capital injection of foreign reserve assets.