Capital Account Liberalization -Japan’s Experience and its Implications to China-

1. Capital Account Liberalization-Japan’s Experience and its Implications to China- September 13, 2014 Kenji Aramaki Tokyo University

2. Outline • (1) Post‐war Legal Framework • (2) Overall Process-Three staged Liberalization • (3) Main Features of Liberalization of Capital Account • (4) Regulatory Response to Unstable Capital Flow in the 1960s and 1970s 1. Japan’s Experience • 2. Implications to China • (1) Characteristics of China’s Capital Account Liberalization • (2) Implications from Japan’s Experience

3. 1. Japan’s Experience(1) Post‐war Legal Framework • The Foreign Exchange Law (1949) (and the Foreign Capital Law (1950)) wholly controlled both trade and foreign exchange after the war • For trade, imports were placed under the approval system

4. Four major features of foreign exchange regulations under the post‐war legal framework ① General prohibition ・A principle of “general prohibition with liberalization for exceptions” adopted ② Foreign exchange concentration system ・All foreign exchange centrally controlled by the government

5. ③ Foreign exchange budget system ・The amounts and items to be imported were regulated by this budget ④ Authorized foreign exchange bank system ・The authorized foreign exchange banks were used as a management mechanism of foreign exchange and capital account transactions

6. (2) Overall liberalization process-Three staged liberalization • Capital account liberalization substantively started in the early 1960s and completed in the late 1990s, i.e., nearly 40 years later • The whole process may be divided into three stages: 1st stage: Liberalization of trade and current account transactions (～mid‐1960s) 2nd stage: Gradual easing and a major shift to a system of general liberalization (latter half of 1960s～end 1970s) 3rd stage: Completion of liberalization (1980s～latter half of 1990s)

7. The 1st stage: Liberalization of trade and current account transactions (～mid‐1960s) • In 1960, “the Basic Plan for Liberalization of Trade and Foreign Exchange” adoptedby the government • It called for an increase in import liberalization, and the general liberalization of current account transactions within two years • In April 1964, Japan accepted IMF Article Ⅷ obligations, abolished the foreign exchange budget system, and generally liberalized current account transactions

8. The 2nd stage: Gradual easing and a major shift to a system of general liberalization (later half of 1960s ～70s) • “The Basic Plan” showed a cautious stance on capital account transactions and only stated that regulations would be eased gradually • In a testimony before the Diet in February 1962, then Minister of Finance SATO, Eisaku stated that the effects of international capital account transactions would be long and deep and therefore care needs to be paid to their treatment

9. Gradual easing of regulations continued over more than a decade, started with the significant inward direct investment liberalization in 1967 • The foreign exchange concentration system abolished and holdings of foreign exchange by residents liberalized in 1972 • The regulatory framework thoroughly revised and a major change from general prohibition to general liberalization implemented by the 1979 reform

10. The 3rd stage: Abolition of remaining regulations and completion of capital account liberalization (1980s～latter half of 1990s) • Even under the 1979 reform, certain transactions were placed under the approval/prior notification requirements • In 1997, the foreign exchange law was revised again, basically abolishing approval/prior notification requirements and liberalizing foreign exchange business, completing liberalization of capital accounts in Japan

11. (3) Main features of capital account liberalization ①　Main feature (1): Cautious and gradual sequencing of liberalization taking into account of the type of transactions ・Substantive liberalization of capital account started after the liberalization of current account transactions ・Liberalization of inward investment generally preceded to liberalization of outward investment e.g., While liberalization of inward direct investment started in 1967, liberalization of outward direct investment started in 1969

12. Liberalization of direct investment generally preceded to liberalization of other types of transactions e.g., After the major liberalization of direct investment started with the first foreign capital liberalization package in 1967, liberalization of other type of transactions such as portfolio investment followed ・Certain transactions were treated cautiously until the very late stage e.g., Such transactions included foreign currency denominated lending between residents and cross-border issuance of banks

13. ② Main feature (2): Use of foreign exchange banks as a mechanism for foreign exchange control • Under the Foreign Exchange Law, authorized foreign exchange banks played a major management role by tracking overseas transactions and verifying their legal appropriateness • These functions basically maintained even after the 1979 reform

14. Approval/prior notification requirements for some transactions exempted for business activities by authorized foreign exchange banks, thus encouraging capital flows to be channeled through foreign exchange banks • The 1997 reform, which liberalized foreign exchange business, greatly reduced the management function of banks

15. ③ Main feature (3): Neutral stance for the internationalization of the yen • The use of yen allowed for foreign payments in 1960 • At the same time, non-resident free yen account was introduced • Non-residents were allowed to deposit with free yen account not only those yen received for current account transactions such as import to Japan but also those yen they obtained through the sale of foreign currency to banks • This treatment opened a channel for the inflow of short-term capital for the first time

16. International use of the yen progressed gradually in the 1970s e.g., While the ratios of yen-denominated export and import are respectively 17.5% and 0.9% in 1975 and 29.4% and 2.4% in 1980, these ratios for West Germany were greater than 80% and 40-50% respectively around that time. • Policy stance at that time seems to have been a neutral one; the internationalization of the yen would proceed as a result of internationalization and liberalization of Japan’s economy and the government should not employ intentional measures to promote it

17. Debates on internationalization of the yen in the “Yen-Dollar Committee” in 1984 • The internationalization of the yen became a hot issue in the “Yen-Dollar Committee” that was established by the agreement between Japan’s Minister of Finance and the U.S. Treasury secretary in late 1983

18. The U.S. argued as follows: ・The yen/dollar exchange rate issue underlying the trade imbalances between Japan and the U.S. is caused by the lack of appropriate valuation of the yen due to the closed nature of Japan’s financial and capital markets ・Japan needs to liberalize financial and capital markets and internationalize the yen

19. In relation to the former (i.e., liberalization of domestic markets), Japan took a position that liberalization of financial and capital markets was beneficial to Japan’s economy and therefore Japan would cope with the issue on its own initiative. • As for the latter (internationalization of the yen), Japan took a position that may be described as a “Natural Evolution” approach as below: The internationalization of the yen will proceed basically as a result of choice made by parties concerned in transactions The role of policies is to remove barriers to the use of the yen when parties concerned chose to use it.

20. While Japan implemented measures incorporated in the Committee’s report such as the abolition of yen conversion limit (a type of over-sold position limit) and the internationalization of the yen progressed to a certain extent in the latter half of the 1980s, the international role of the yen stayed relatively low or decreased subsequently partly reflecting stagnation of Japan’s economy since the 1990s

21. (3) Regulatory responsesto the unstable short-term capital flows in the 1960s and 1970s • In the liberalization process, Japan extensively used capital control measures to cope with destabilizing capital flows in the late 1960s and 1970s • Direction of policies frequently reversed under the changing international environments

22. Japan: Short-term Capital Controls and Developments in Balance of Payments, Exchange Rate and Foreign Reserves, 1965-1981

23. Period Ⅰ：late 1960s to mid 1971 • Sharp rise in foreign reserves toward end 1960s • Major policy reversal from inflow promotion to inflow restriction (a switch from “heater” to “cooler”) • Three main channels of short-term capital inflow at the “Nixon Shock” • non resident free yen accounts • portfolio investment in bonds by non-resident • export pre-payments • Policy responses • balance limit imposed on free yen accounts • de-facto ban on the acquisition of bonds by non-resident • ban on the yen conversion of export pre-payments

24. A very rough estimate: The inflow of short-term capital, at an annualized rate, was equivalent to more than 10 % of Japan’s GDP • Outstanding balance of free yen accounts; $ 0.6 bil. at end Feb.1971 to $ 0.8 bil at end May 1971 • Purchase of bonds by non-residents; $ 0.001 bil/year in the past to $ 0.1 bil./Month in Mar. and Apr. 1971 • Export prepayment; $ 0.05 bil./month to $ 2 bil. in Aug. 1971 • Annualized amount of these three inflows combined is 26billion/year (0.2/3＋0.1＋2）×12） and equivalent to 12 % of Japan’s GDP in 1971(80.7 trillion yen or $ 224.2 bil. If converted by the rate of 360 yen to the dollar)

25. Period Ⅱ：end 1971 to around mid-1973 • Relaxation of restrictions immediately after the Smithsonian Accord • Re-strengthening of controls under a massive inflow of short-term capital • Some relaxation of purchasing and holding of foreign currency by residents

26. Period Ⅲ:end 1973 to mid 1974 • Return to the inflow promotion policy under a sharp depreciation of the yen after balance of payments deteriorations under a rising inflation and the first oil crisis • e.g., Reserve rate for increases in free yen account significantly lowered • Some outflow restrictions also adopted Period Ⅳ: 1975 to mid1977 • Under the relative stability of the international financial markets, both inflow and outflow restrictions eased

27. Period Ⅴ: end 1977 to 1978 • With resurgence of massive inflow of short-term capital, policies switched again to inflow restrictions e.g., Reserve rate for increases in free yen account raised (0%→50％→100％)

28. Period Ⅵ: 1979 to 1980 • With a sharp depreciation of the yen after the second oil crisis, policies reversed again to inflow promotion Subsequent situations • With the capital account liberalization promoted by the comprehensive revisions to the Foreign Exchange Law (1979), and with Japan's continued growth and its further strengthened external position, such policy ceased to be observed after entering the 1980s

29. Summary of Japan’s experience (1) Substantive capital accounts liberalization started in the early 1960s and liberalization was completed in the late 1990s, taking nearly 40 years, and it proceeded through three stages; current account liberalization, a switch to a generally liberalized system, and abolition of remaining restrictions.

30. (2) With regard to the type of capital account transactions, the liberalization of inward investment generally preceded the liberalization of outward investment, liberalization of direct investment preceded to liberalization of other investment, and investments with higher risk were treated cautiously until the last stage of liberalization.

31. (3) Throughout the liberalization process, the authorized foreign exchange banks were used as an effective foreign exchange management mechanism. (4) Non-resident free-yen accounts were introduced at an early stage, which later became one of the key channels for the inflow of short-term capital. Portfolio securities investment and trade-related payments also became key channels for the short-term capital flow.

32. (5) Foreign exchange controls and regulations on capital transactions were frequently adopted in order to manage short-term capital flows and are thought to have had effectiveness of a certain degree in preventing market instability

33. (6) Regarding the internationalization of the yen, while the yen settlement was allowed as early as in 1960, and the government made efforts to remove obstacles to internationalization of the yen partly in response to the request from the U.S., international use of the yen has not come to the level that matches the size of Japan’s economy.

34. 2. Implications to China • Characteristics of China’s capital account liberalization ・In around mid-1980s, China had a total state control of external transactions ・Subsequently, it liberalized the current account transactions in 1996, and gradually liberalized capital account transactions, while maintaining overall regulatory framework.

35. In terms of three stage division of Japan’s process, China is in stage 2 • There are many commonalities with Japan, including the adoption of a firm gradualism, and sequencing of liberalization by type of transactions with inward direct investment coming first and the cautious treatment given to risky investment • While China’s liberalization somewhat accelerated after entering the 2000s, the most distinctive feature is the fact that the pace of progress of liberalization for the internationalization of renminbi seems to be faster than the pace of liberalization in other areas.

36. Implications from Japan’s experience(a) Control of risk • The most important thing is to control concomitant risk when liberalizing capital account • In Japan’s experience, the most important inflow channels included capital flows through foreign exchange banks, purchase of securities by non-residents, and trade-related capital flows

37. Trade-related flows can be very significant and in this respect China may be already facing risk of huge capital outflows There was a huge outflow of "other investment", amounting to -$25.50 billion in 1997, and -$43.70 billion in 1998 . China: Trends of Portfolio Investment and Other Investment, 90-03

38. Behind the outflow of other investment, there was a massive outflow of trade credit (increase in assets) from China under devaluation expectation of renminbi during the Asian crisis China: Trends of Trade Credits, 97-03

39. That is just the same (while in an opposite direction) with what happened to Japan under the revaluation expectation of the yen around the Nixon shock Japan: Trends of Trade Credits, late 60s to early 70s

40. A few points may be noted regarding the control of risk • First, the effectiveness of management will be enhanced if capital transactions are basically conducted through financial institutions including banks. • Second, in the case of Japan, it was direct quantitative measures that finally effectively managed short-term capital flows under major external shocks

41. In this regard, we should take not that, in the case of Thailand before and after the Asian crisis, what flew in most and what flew out most was “Other investment”, mainly composed of bank credit Balance of payments: Thailand (in Billions of U.S. dollar)

42. More specifically, an abrupt reversal of externalbank credit flows seems to have been a major cause of Thai crisis in 1997-98 Outstanding balance of net assets held by BIS reporting banks vis-à-vis Thailand

43. The less affected countries in the Asian currency crisis (China, Vietnam, and India) had a system of quantitatively regulating foreign borrowings by banks

44. Major regulation of foreign borrowings by banks in less affected countries (as of 1996)

45. However, such a situation may have already changed even for China. In 2012, China experienced a huge outflow of other investment amounting to $260 billion. i.e., six times as large as in 1998

46. What flew out most from China in 2012 are① Currency & Deposits, ② Loans, and ③ Trade Credit

47. Third, one more important thing to be examined is whether to maintain a regulatory system for the unlikely adverse events, as was instituted in the 1979 revision in Japan • In other words, will China jump to and complete stage 3 or proceed step by step? • In this connection, it is noteworthy how China will handle negotiations of a bilateral investment treaty with the U.S. The U.S. insisted to the very final stage on total abandonment of capital transaction regulations in the negotiations with Singapore and Chile, and this became a major issue.

48. (b) Internationalization of renminbi • In order to promote internationalization of the renminbi, it is necessary to allow holding and free disposal of renminbi by non-residents • In Japan’s experience, free holding of local currency by non-residents would lead to abrupt rise and fall of capital flows, significantly affect liquidity position of financial institutions and stability of foreign exchange rate and can influence effectiveness of monetary policy.

49. It is also difficult to promote internationalization of a currency, separately from the liberalization of domestic financial and capital markets. • It should be asked whether the policy of promoting internationalization of renminbi aims at economic goals based on assessment of benefits/costs and risk or aims at political goals such as strengthening autonomy of the nation

50. (c) Foreign exchange rate determination system • Under what is called “Impossible Trinity” argument in international finance, it is not possible to achieve three goals at the same time, stability of exchange rate, free flow of capital and independent monetary policy. • China as a big economy with its own economic cycle cannot give up independent monetary policy, then it has to choose either free capital flows or stable exchange rate