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| How Do Differences Between Internal and External Financial Factors Affect China's Capital Flows？ |
| SUN Tianqi, WANG Xiaoxiao
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State Administration of Foreign Exchange;
Research Institute, the People's Bank of China |
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Abstract Cross-border capital flows have a huge effect on the boom-bust cycles of an open economy. Since the 1980s, the financial liberalization of many emerging market economies has attracted large capital inflows and increased the prosperity of these countries. However, sharp fluctuations and reversals of international capital flows have also undermined their financial stability, triggering currency crises, financial market turbulence, and even long-term recession. These crises have shown that China must manage the risk involved in the international capital flows that result from financial opening-up.
To reduce the risks from cross-border capital flows, it is important to know what drives them. Existing studies distinguish between domestic and international factors based on Pull Factor and Push Factor analysis. This analytical framework has been adopted by many studies, which have provided abundant empirical evidence. As the flow of capital is generally determined by the economic and financial situation and the return on investment in both the home country and abroad, there is a trade-off in terms of opportunity cost between potential benefits from the home country and returns from overseas markets. Therefore, understanding cross-border capital flows means considering the difference between domestic and international economic and financial factors, rather than isolating them.
In many prior studies, changes in economic and financial indicators are mainly used to measure the economic and financial cycle. For example, the change of GDP growth rate is often used as an economic cycle indicator. Interest rates, exchange rates, asset prices, and the level of market risk are considered manifestations of the financial cycle. Prior studies have also provided evidence of a significant relationship between internal and external factors and cross-border capital flows. Currently, China is accelerating the opening up of its financial markets, and the interaction between China and the world has increased dramatically. Numerous financial indicators are changing more rapidly under the influence of internal and external factors. Therefore, for China, the impact of internal and external financial cycles on cross-border capital flows is particularly important.
This study develops a model to shed light on the impacts of these differences on capital flows and empirically tests it using quarterly data between 1998Q1 and 2018Q1 for China and the U.S. The model is developed based on linear regression, the SVAR model, and the time-varying parameter VAR method, and is used to carry out a range of empirical tests and robustness analyses.
A number of findings emerge. (1) The fluctuations of China's capital flows are mainly driven by changes in short-term capital flows, especially from other investment items (currency and deposits, loans, trade credit, etc.). Capital inflows tend to be more volatile than outflows. (2) The differences between domestic and foreign factors, including interest rates, exchange rate changes, asset price changes (i.e. stock price changes and real estate price changes), and risk factors, have significant effects on China's capital flows. (3) From the perspective of the transmission path, these differential factors have a more significant impact on capital inflow than outflow, and the net inflows are mostly affected by inflows. (4) The impact of the interest rate spread on capital flows has weakened in recent years, but the influences of the differences of exchange rate change and asset price change have become stronger.
These results suggest that Chinese authorities should pay more attention to other investment items to prevent the risk of capital flow fluctuations. Moreover, because the effect of the interest rate spread weakens over time, it is possible to increase the independence of China's monetary policy. In terms of promoting financial market reform and opening up, Chinese authorities should pay more attention to exchange rate and asset price fluctuations to prevent potential resonance shocks to capital flows.
We contribute to the literature in several ways. (1) We analyze international capital flows from the perspective of financial cycle discrepancy. (2) We identify and analyze the time-varying impacts of financial cycle discrepancy and international capital flows. (3) We identify the most volatile sectors of China's capital flows and analyze the driving force behind fluctuations in capital flows.
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Received: 29 January 2019
Published: 30 March 2020
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