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

Capital Account Liberalization-Japan’s Experience and its Implications to China- Kenji Aramaki Tokyo University

Outline • (1) Post‐war Legal Framework and its four major restrictive features • (2) Overall Process-Three staged Liberalization • (3) Main Characteristics of Japan’s Liberalization of Capital Account • (4) Summary of Japan’s experience 1. Japan’s Experience • 2. Implications to China • (1) Characteristics of China’s Capital Account Liberalization • (2) Implications from Japan’s Experience

1. Japan’s Experience(1) Post‐war Legal Framework and its four major restrictive features • The Foreign Exchange Law (1949) (and the Foreign Capital Law (1950)) wholly controlled both trade and foreign exchange after the war and its four major restrictive features were: ① A principle of “general prohibition with liberalization for exceptions” ② All foreign exchange centrally controlled by the government (FX concentration system) ③The amounts and items to be imported regulated by the foreign exchange budget ④The authorized foreign exchange banks used as a management mechanism of foreign exchange and capital account transactions, tracking and verifying transactions

(2) Overall liberalization process-Three staged liberalization • Capital account liberalization took nearly 40 years, basically started in the early 1960s and completed in the late 1990s • The whole process may be divided into three stages: The 1ststage: Liberalization of trade and current account transactions (～mid‐1960s) ・In 1960, “the Basic Plan for Liberalization of Trade and Foreign Exchange” adoptedby the government ・ In April 1964, Japan accepted IMF Article Ⅷ obligations, abolished the foreign exchange budget system, and generally liberalized current account transactions

The 2ndstage: Gradual relaxation and a framework shift to a generally liberalized system (latter half of 1960s～end 1970s) ・After a cautious relaxation of regulations over more than a decade (including the abolishment of the foreign exchange concentration system in 1972), a legal framework shift from a general prohibition to a generally liberalized system implemented by the 1979 reform

The 3rd stage: Completion of liberalization (1980s～latter half of 1990s) • Even under the 1979 reform, certain transactions were placed under the approval/prior notification requirements and use of authorized foreign exchange banks as a management mechanism basically maintained • 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 (all 4 restrictive elements after the war eliminated/substantially modified)

(3) Main characteristics of Japan’s capital account liberalization ① Cautious sequencing taking into account the type of transactions ・Liberalization of inward investment generally preceded to liberalization of outward investment • Liberalization of direct investment generally preceded to liberalization of other types of transactions ・Certain transactions were treated cautiously until the very late stage

②Use of foreign exchange banks as an effective mechanism for foreign exchange control • Use of authorized foreign exchange banks as a management mechanism (tracking and verifying transactions) basically maintained even after the 1979 framework shift (*) e.g., 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

③Frequent use of direct control measures to deal with the unstable short-term capital flows in the 1960s and 1970s • In the liberalization process, facedwithdestabilizing capital flows in the late 1960s and 1970s, Japan extensively used capital control measures • Direction of policies frequently reversed under the changing international environments

(Ⅰ) (Ⅲ) (Ⅳ) (Ⅱ) Trade Balance Current Account Exchange Rate (right scale) Foreign Reserve (left scale) Source) MOF"Balance of Payments", IMF"International Financial Statistics" Japan: Short-term Capital Controls and Developments in Balance of Payments, Exchange Rate and Foreign Reserves 1965-1981 Inflow restriction Inflow promotion Inflow restriction Inflow promotion

Periods are characterized as below: PeriodⅠ (late 1960s to around mid-73) : Switch from inflow promotion to inflow restrictions under rising foreign reserves toward the Nixon shock Period II (end-73 to 74) : Change to inflow promotion after the 1st oil shock Period III (75 to 78): Easing of regulations, followed by a return to inflow restrictions under a massive inflows of short-term capital and the yen appreciation from late 1977 Period VI(79 to 80): Re-switching to inflow promotion under the yen depreciation with the breakout of the 2nd oil shock

Most typical inflow episode is the one in Period Ⅰ(late 1960s to mid 1973) Behind the sharp rise in foreign reserves around end 1960s and early 70s were short-term capital inflows through three main channels; • external liabilities by banks, including non resident free yen accounts • portfolio investment in bonds by non-resident • yen conversion of export pre-payments Policy responses (quantitative restrictions) • a balance limit imposed on free yen accounts, together with the imposition of a ceiling on banks’ external liabilities • de-facto ban on the acquisition of bonds by non-resident • ban on the yen conversion of export pre-payments

④Neutral stance for the internationalization of the yen • In 1960, the use of yen for foreign payments allowed and non-resident free yen account introduced, opening a channel for the inflow of short-term capital for the first time (*)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

International use of the yen progressed gradually in the 1970s but 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 either to encourage or to discourage it • In the “Yen-Dollar Committee” established between Japan and the U.S. in late 1983, the US argued for the need to internationalize the yen from a view point of addressing the issue of bilateral trade imbalance

While Japan implemented measures incorporated in the Committee’s report in order to remove obstacles to the international use of the yen (such as the abolition of yen conversion limit (a type of over-sold position limit imposed on banks), which had been one of the major restrictions that controlled inflow of foreign capital through banks) 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

(5) Summary of Japan’s experience • Capital account liberalization took nearly 40 years • It proceeded through three stages; ① current account liberalization ② a framework shift to a generally liberalized system ③ abolition of remaining restrictions • Less risky transactions liberalized first and authorized foreign exchange banks used as an effective management mechanism.

Quantitative control measures frequently adopted to manage volatile capital flows in the 1960s and 70s with an effectiveness of a certain degree in preventing market instability • While the government made efforts to remove obstacles to internationalization of the yen partly in response to the request from the US, international use of the yen has not come to the level that matches the size of Japan’s economy.

2. Implications to China • Characteristics of China’s capital account liberalization ・In around mid-1980s, China had a total state control of external transactions (similar to Japan’s post war regime) ・Subsequently, it liberalized the current account transactions by 1996 (as was done by Japan by 1964), and gradually liberalized capital account transactions, while maintaining overall regulatory framework.

In terms of three stage division of Japan’s process, China is in stage 2, i.e., a framework shift (as implemented in Japan in 1979) has not been seen yet • While China’s liberalization somewhat accelerated after entering the 2000s, it is very distinctive that the pace of liberalization for the internationalization of renminbi seems to be faster than the pace of liberalization in other areas.

(2) 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 volatile inflow channels included capital flows through foreign exchange banks (external liabilities including nonresident free yen account), purchase of securities by non-residents, and trade-related capital flows • Retention of effective regulatory tools to deal with unstable capital flows including direct control measures and appropriate utilization of management function of financial institutions seem to be important

(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 light of 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.

It is also difficult to promote internationalization of a currency, separately from the liberalization of domestic financial and capital markets (*) In Japan, it took at least two decades to late 1990s to liberalize interest rate and abolish the specialized financial institutions system but, meantime, Japan had a huge asset price bubble in the late 1980s and a severe banking crisis in late 1990s. Liberalization of financial markets needs to be accompanied first by strengthening of authorities’ supervisory ability and risk management by financial institutions and second measures to prevent and resolve financial crises • 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

(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

While it may not be a choice between all or nothing, in other word there may be some middle ground in between, it has to be asked whether China is ready to modify its current stable exchange rate regime with limited fluctuation (classified as crawling peg like system by the IMF) in accordance with the schedule of capital account liberalization.

Some reference charts in relation to risk control: China weathered well in the Asian crisis. However, the situation may have already changed for China. In 2012 and 2014, China experienced a huge outflow of other investment amounting to $250-260 billion. i.e., about six times as large as in 1998

What flew out most from China in 2012 and 2014 are: ① Currency & Deposits, ② Loans, and to a less extent ③ Trade Credit

In the outflows of other investment, the share of bank related flows sharply increased in most recent outflow episodes Breakdown of type of outflows in four episodes of major capital outflows(peak year) (100 mil.$)

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

After entering 2010s, China might have been experiencing bank credit inflow bubble as was observed in Thailand or Korea before the Asian crisis

Crises very often come with capital flows, particularly bank credit Asian crisis Latin American crisis

That was the same with Greece and Ireland, i.e., even with developed economies

Internationalcommunity still do not have effective tools to deal with capital outflow driven international financial crises • Traditional approach (official finance + economic adjustment) cannot handle a capital account crisis • Un-orthodox tools such as capital controls and PSI (Private Sector Involvement, i.e., maintenance of exposure by creditors) need to be explored (*) Role of capital outflow controls has been developed by the IMF but their actual use is very limited: Only recent successful case may be Iceland (2008-) (*) As for PSI, the existing framework (Prague framework(2000)) is too vague and cannot be operational: There have not been many successful cases after the leading case in Korea (1977-98)

Thank you謝々 ご清聴、有難うございました

Annex table1: Sequencing of Japan's Liberalization of Foreign Exchange and Capital Account Transactions

Annex Table 2 Regulatory responses to unstable short-term capital flows in the 1960s and 70s

(note) 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 direct control measures as used until end-1970s essentially ceased to be observed after entering the 1980s

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