Learning from China’s economic philosophy and policy — XV

Moreover, once the benefits of the “dual-track” system were well-established—for instance, by securing strengthened and widespread FDI partnerships and developing the economy’s governance, regulatory, and incentive structures—the exchange rate regime was removed from this dual-track framework.

This transition occurred after the economy successfully stabilized its infrastructure, SOEs, and SEZs, and after the market evolved to achieve a more balanced approach to productive and allocative efficiency gains alongside reasonable profit margins.

Consequently, the exchange rate began to play a much more stable, predictable, and supportive role in macroeconomic stability, growth, and resilience.

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However, a dual-track approach continues to apply to strategically important goods and capital where targeted support is still needed. This is especially relevant in a world increasingly prone to aggregate supply shocks in an age of “polycrisis” and artificial intelligence (AI), which may even prompt China to revert to a dual-track mechanism for its exchange rate.

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‘The handbook of China’s financial system’ pointed out in this regard: ‘At the beginning of 1994, the People’s Bank of China (PBC) abolished the dual-tracked exchange rates in favour of a single, market-based managed floating exchange rate regime. RMB was devalued by 33% against the dollar to 8.7:1 (later 8.28:1). The lower value of RMB boosted China’s current account surplus, ending its fluctuation around zero since the early 1980s, In 1996, China made its current account fully convertible, greatly reducing the cost of trade. Thanks to strong FDI inflows and sizable current account surplus, China’s FX reserves quickly rose from its trough of $18.8 billion in mid-1993 to 120.9 billion in mid-1997, a nearly six-fold increase in four years…’

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It is important to note that China’s initial capital account liberalization efforts were never fully unrestricted. The 1997 Asian financial crisis further reinforced China’s cautious approach, prompting the government to maintain strict controls on capital outflows even during the early stages of deregulation. Furthermore, the crisis highlighted the critical value of maintaining high foreign exchange reserves to cushion against exogenous shocks—shocks that have increased in frequency since the neoliberal push for global capital deregulation in the early 1980s.

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Ultimately, China’s measured approach to capital account liberalization has been instrumental in shielding its economy from global crises and containing domestic financial bubbles. This offers a vital lesson for countries like Pakistan, which, under a neoliberal policy mind-set, have failed to guard against the dangers of “shock therapy” and premature capital account liberalization.

Also read: Learning from China’s economic philosophy and policy — X

The same handbook indicated in this regard the following: ‘As an integral part of the socialist market economy proposed by the 14th Communist Party of China’s National Congress in 1992, China released an ambitious plan in 1993 to reach full capital account liberalization by 2000. Unfortunately, the plan was suspended as the 1997 Asian financial crisis (AFC) broke out. Thanks to China’s relatively abundant FX reserves and not-yet-lifted capital outflow controls, RMB’s peg against the dollar remained intact.

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But the crisis clearly demonstrated the destructive power of fickle capital flows, forcing policymakers to think twice before liberalizing portfolio and other investment flows. In response to the crisis, China, like many other Asian countries, had doubled efforts in building up reserves as a precaution. …As the fear of crisis eventually faded away, China assumed its capital account liberalization plan in a cautious manner.’

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With regard to enhancement in reserves and with regard to China in the wake of AFC, the same handbook indicated ‘The build-up of reserves was made possible as China’s accession to the WTO [World Trade Organization] in 2001 fuelled the exponential growth of its exports and current account surplus.

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Moreover, the export sector boosted China’s economic growth and helped to attract more inward FDI, creating both “dual surplus” and, as its mirror image, the rapid accumulation of official reserves. Five years after the crisis, China’s FX reserves doubled again to more than $250 billion in mid-2002…’

To better grasp the advantages of the “dual-track” pricing mechanism for the exchange rate, two aspects must be understood. First, the mechanism protected the domestic economy—especially during the early stages of its development—by shielding the industrial base from exogenous price shocks and imported inflationary pressures. This was particularly vital for State-Owned Enterprises (SOEs) relying on imported inputs.

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Additionally, it insulated consumers with relatively low purchasing power from the cost-push inflation driven by these imported goods. The extensive care taken by Chinese authorities is praiseworthy; they provided layers of protection for domestic production, exports, and consumption by applying the dual-track mechanism to both domestic goods and the price of capital.

Secondly, currency devaluation by itself is not generally a significant determinant of exports—as seen in the case of Pakistan—unless a strong industrial base, effective economic institutions, and a well-regulated market environment are put in place first. The “dual-track” mechanism historically played an important role in establishing these foundations.

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Even when this dual-track provision was removed from the exchange rate once the industrial base and per capita purchasing power reached an appropriate level, protections still remained regarding the prices of both goods and capital.

Moreover, in the early stages of development, a current account surplus is not advisable due to the high need for investment, which often exceeds domestic savings, to elevate an otherwise low level of economic development—hence why such a nation is called “developing” in the first place.

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Once an appropriate stage of development is achieved, a country can afford a surplus, as China did. Therefore, when a current account surplus is celebrated in Pakistani policy circles, it is actually undesirable, given the country’s low stage of development.

Pakistan has been stuck in a highly sub-optimal economic growth equilibrium for decades. The lack of a strong industrial base, sufficiently deep foreign exchange reserves, and effective controls against imported inflation has meant that even the few years of high growth have ultimately triggered serious balance of payments crises and acute macroeconomic instability.

Unlike sharp and deep liberalization of capital account that leads to sudden changes, and overall creates significant balance of payments issues, China while traditionally adopted a more retrained, cautious, and creative capital liberalization pathway, to open it up in a gradualist way; especially, in the wake of the AFC, it introduced innovative policies to incentivize, and better manage inflow, and outflow of foreign portfolio investment – otherwise also referred to as ‘hot money’ given its volatile nature in general under much more loose capital controls regime, under an overall neoliberal policy – in the shape of ‘Qualified Foreign Institutional Investors (QFII) program’ in 2002, and in 2006 ‘Qualified Domestic Institutional Investors (QDII) program.’

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The same handbook indicated in this regard: ‘The relaxation of portfolio inflow restrictions came first, partly because of the still-fresh memory of the outflow pressure during the AFC.

In late 2002, China unveiled the Qualified Foreign Institutional Investors (QFII) program, ranting greater access to a range of domestic financial markets. The program quickly became popular as global investors diversified into China.’ Here, Pakistan can perhaps learn from this programme to balance caution, with innovation to overall bring greater stability to the capital account so that the gaps produced by departing ‘hot money’ are balanced in a more supportive way by the incoming inflows.

Also read: Learning from China’s economic philosophy and policy — II

That being said, the most important drivers for incentivizing foreign investment remain strong economic fundamentals. China successfully implemented this approach by keeping its capital account insulated—through restricted and gradual liberalization—from the booms and busts that frequently occur in less-developed economies.

Such volatility creates a less attractive environment for long-term investments, particularly given the volatile nature of Foreign Portfolio Investment (FPI), which typically seeks quick returns.

Also read: Learning from China’s economic philosophy and policy – I

Moreover, to better manage the outflow of capital flows, China introduced QDII, whereby the same handbook pointed out the following: ‘The rising concerns about “hot money” inflows, over-accumulation of reserves, and looming inflation pushed policymakers to relax capital outflow restrictions. …For ODI [Overseas Direct Investment], China began to encourage domestic enterprises to “go abroad” to secure the supply of key commodities and move up the value chain… For portfolio outflows, China introduced the Qualified Domestic Institutional Investors (QDII) program in 2006.’

To better understand the QFII scheme, the same handbook indicated: ‘In late 2002, China unveiled the Qualified Foreign Institutional Investors (QFII) program, the first scheme-based liberalization for portfolio investment. QFII are allowed to convert their FX into RMB and to invest in a range of RMB-denominated assets, including the A shares.

The popularity of QFII was evidenced by its rapidly expanding approved quota, from $1.7 billion by the end of 2003 to $10 billion in January 2007, exhausting the maximum quota then allowed. In the next decade maximum QFII quota was raised several times, from $10 billion to $30 billion in 2007, $80 billion in 2012, and $150 billion since 2015. By August 2018, total approved QFII quota had reached $100 billion.’

Regarding QDII, the same handbook pointed out: ‘China introduced the Qualified Domestic Institutional Investors (QDII) program in 2006. This was the first scheme-based liberalization for domestic institutional investors to access overseas financial markets.

Total QDII quota started at $10 billion in 2006, then quickly quintupled to $50 billion by the end of 2007, then to $90 billion since 2015. By June 2018, total approved QDII quota had reached $103 billion… Initially QDIIs could only invest in fixed income securities. A year later in 2007, they were granted access to equities. Over time, QDIIs were allowed to invest in broader sets of assets, and to more flexibly manage asset allocations.’

Moreover, to further liberalize capital account, in 2011, China introduced Renminbi Qualified Foreign Institutional Investors (RQFII) programme, whereby according to the same handbook, ‘RQFIIs are allowed to invest in China’s domestic markets using offshore RMB holdings (as opposed to foreign currency) directly.

In the early days, only Hong Kong (HK) subsidiaries of domestic financial institutions could apply for RQFIIs. Later, RQFII expanded to global asset managers’ HK offices. By the end of 2013, total approved RQFII quota amounted to 157 billion RMB. It then quickly surpassed 300 billion RMB in 2015, and 600 billion in late 2017. By August 2018, the total approved RQFII quota had reached 627 billion RMB…’

(To be continued…)

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