Learning from China’s economic philosophy and policy — XVI

A related aspect of the external sector is exchange rate management: while Pakistan — guided generally by the International Monetary Fund (IMF) — has maintained a flexible exchange rate regime, or at most a managed float, this approach has not allowed the authorities to be more ambitious in improving macroeconomic fundamentals.

Consequently, sources of foreign exchange — such as exports, foreign investment, and import substitution — are not being developed in a targeted, mission-oriented way through stronger government focus on private-sector incentives (like effectively developing Special Economic Zones [SEZs]) and the meaningful, broad-based utilization of State-Owned Enterprises (SOEs).

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

Instead, the country could benefit from pegging its currency to a more stable and predictable currency, such as the US dollar or the RMB, to support exports and foreign investment in general.

This progression from a managed float to pegging the currency to a more stable one should be the goal to achieve the greater stability required by the economy.

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

However, this transition requires strong economic fundamentals to ensure a more predictable and deeper inflow of foreign direct investment (FDI). This includes encouraging domestic companies to establish a presence abroad—or relocate if a high concentration of companies already exists in that specific sector—in an overall effort to enhance exports and foreign exchange inflows. This, in turn, will attract less volatile, large-scale foreign portfolio investment (FPI) from institutional investors targeting equities, including those of State-Owned Enterprises (SOEs).

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

Within this framework, greater private sector involvement — while retaining government decision-making power — can transform less strategically important SOEs into mixed-ownership enterprises (MOEs), as successfully demonstrated by China, leaving only the least important enterprises to be fully privatized.

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

Here, the sequence of capital account management should most probably follow the path adopted by China, which allowed the country to benefit from greater predictability and establish a support system to lay a strong base for its economy.

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

First, China adopted a “dual-track” exchange rate system, which the People’s Bank of China abolished in 1994. This was followed by a managed float. Then, in 1997, it introduced a pegged exchange rate regime, which the country was able to sustain during the Asian Financial Crisis (AFC) due to its deep foreign exchange reserves and strong economic fundamentals. In 2005, the country ended the currency peg and returned to a managed float.

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

In the wake of the 2007–08 Global Financial Crisis (GFC), China again pegged its currency to the US dollar to protect the country from the considerable volatility in global financial markets. In order to maintain economic growth in terms of both domestic production and exports, China practiced an aggressive counter-cyclical policy to combat the strong recessionary headwinds of the GFC. This included an overall substantial stimulus package to support the export industry amid falling global demand.

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

Moreover, the stimulus protected domestic aggregate demand and, in turn, sustained domestic production by keeping China attractive for both domestic and foreign investment, even in the aftermath of the crisis. Finally, China emphasized a non-neoliberal policy by placing tighter controls on capital outflows—an overall policy approach that holds significant lessons for Pakistan.

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

‘The handbook of China’s financial system’ pointed out in this regard: ‘China rushed out a plethora of expansionary policies to shelter its economy from the global financial crisis (GFC) shockwave.

Since mid-2008, China re-pegged RMB to the dollar at 6.8 for two years to provide relief for its hard-hit export sector, and also briefly tightened capital outflow controls to stabilize domestic financial conditions. In 2009, China announced the controversial “four trillion RMB” stimulus package to make up for the depressed external demand.’

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

It needs to be indicated here that the author favours provision of this stimulus, and does not think that the stimulus package should be made controversial, given it provided much-needed support to protect the economy from significant recessionary headwinds created in global economy in the wake of GFC. In fact, the stimulus package of such a substantial nature also fell short of domestic demand for financing.

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

Hence, the same handbook indicated that not only the positive benefits of the package came forth, larger borrowing needs meant tapping greater sources of financing, for which the country in a proactive way allowed external borrowing. Here, it needs to be indicated that the country under a prudent external debt management strategy had earlier allowed such borrowing in a very restrictive way and, in turn, focussed more on enhancing foreign exchange reserves through enhancing exports, and inducing greater investments to overall provide more sustainable sources of financing.

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

This prudently managed external debt allowed greater borrowing scope when economy needed a boost in the wake of GFC, making it possible to have a greater room for borrowing to finance greater spending/investment appetite, with the overall benefit of contributing to economic growth.

The same handbook pointed out in this regard: ‘Domestic demand rebounded sharply, especially in infrastructure, and real estate. China’s banking system, however, was unable to satisfy the spiking demand for funds. Chinese enterprises therefore sought financing elsewhere, including previously tightly regulated borrowing from overseas.’

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

Moreover, to better tap a loose monetary policy stance globally in the wake of GFC, capital flows were attracted all the more by China, through liberalizing capital account in a proactive way.

The same handbook pointed out in this regard: ‘In the meantime, major global central banks slashed policy rates to or near the zero lower bound and carried out massive quantitative easing (QE) programs. …The country then relaxed many capital inflow regulations to accommodate for the stimulus-driven financing needs. For FDI, the registration procedures were substantially streamlined in 2012.

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

For portfolio inflows, China raised the maximum allowed QFII quota, and introduced the Renminbi Qualified Institutional Investors (RQFII) program in 2011. For other (lending related) inflows, in 2010 China relaxed qualifications on overseas loans under domestic guarantee (“neibao waidai”), allowing domestic companies, guaranteed by domestic banks, to borrow from overseas banks via their subsidiaries abroad.’

It is important to note that lessening of caution in capital account liberalization, where although did benefit China in terms of greater inflow of capital, yet also created balance of payments issues on the current account side for the Chinese economy due to lax financial conditions in the wake of GFC, and adoption of loose monetary policy by central banks in advanced countries in general. This highlights the importance, nonetheless, with regard to cautiously managing capital account in terms of liberalization.

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

With regard to the issue at hand, the same handbook indicated: ‘Once the overseas borrowing restrictions were relaxed, the strong domestic demand and excess global liquidity created a perfect storm of capital pouring into China. …Global crisis, domestic stimulus, and inflow liberalization had dramatically changed the structure of China’s balance of payments.

As a result of falling global demand and a stimulus-driven domestic investment boom, the current account surplus fell from 10 percent of GDP in 2007 to less than 2 percent in 2011. Capital account surplus, by contrast, continued to rise as inflow liberalization measures kicked in, dominating current account surplus in 2010, 2011, and 2013. While FDI inflows remained the biggest contributor to capital account fluctuations.’

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

So, within the overall balance of payments situation deteriorating due to a diminishing of healthy relationship between current account, and capital account, such weakening of relationship was also due to the rising ‘carry trade’ volume, as the same handbook pointed out: ‘In particular, the lax regulation of cross-border lending, the wide China-Developed Market interest rate spread, and the resumption of RMB’s appreciation since 2010, had invited sizeable short-term carry trade inflows. Consequently, FX reserves continued to rise, reaching an unprecedented $3.8 trillion at the end of 2013… But unlike FDI, carry trade inflows are much more volatile and short-term in nature [similar to the nature of foreign portfolio investment (FPI), which is still better than carry trade, in terms of being more purpose-oriented in terms of investment, and overall, less volatile]; they may take profit and withdraw at any moment.’

Regarding China’s response to these balance of payments issues, the same handbook indicated: ‘It turned out that the carry trade inflows from 2010 to 2013 had sowed the seed of a sharp reversal in the not-so distant future. Since 2013, China’s capital account management has undergone a paradigm shift. A “negative list” approach initially gained favour. Instead of relying on ex-ante review and approval, regulators refocused on ex-post monitoring and regulation for an expanding set of cross-border transactions, especially outflows. A number of factors contributed to the shift.

Cyclically, China had become increasingly concerned about “hot money” inflows and over accumulation of reserves, therefore more willing to relax outflow controls. Structurally, China encouraged more companies to invest abroad, especially to the “Belt and Road” countries. In addition, RMB’s accelerated internationalization called for broadening its global usage, hence relaxing controls.’

This serves as an important lesson for countries in general—including Pakistan—that are dealing with issues stemming from the mismanagement of capital accounts. Specifically, it highlights the need to create a healthy link between the current and capital accounts, and to implement better monetary policies where interest rates do not artificially induce volatile capital flows, thereby ensuring a sustainable balance of payments.

To achieve this, Pakistan should adopt a detailed negative list to curb non-essential imports. This strategy would yield positive consequences by reducing the overall import bill and mitigating imported inflationary pressures. Furthermore, Pakistan should practice less stringent monetary and fiscal austerity policies to address these two concerns, which would likely bolster foreign exchange reserves.

The country must avoid using high interest rates and unnecessarily loose capital controls to lure “hot money,” given that it is a highly volatile source for building reserves. Relying on hot money also deters Foreign Direct Investment (FDI) due to the higher cost of capital and the diminished aggregate demand that such monetary and fiscal austerity policies inevitably cause.

(To be continued…)

Copyright Business Recorder, 2026