The Necessity of Normalized Capital Controls: An Analysis based on a DSGE Model with the Perspective of Different Economic Development Stages between the Developing and Developed Countries

Liu Jianfeng; Pan Yingli

doi:doi:10.16538/j.cnki.jfe.2019.01.009

Summary

The debate over whether capital controls are needed is very common at home and abroad. By improving the DSGE model of China’s open economy with some important features such as high economic growth, which was originally established by Chang et al. （2015）, and applying it to a different situation with the original case, this paper demonstrates the difficulties of international monetary long-term cooperation about the policy interest rates and inflation rates between China and the United States and the necessity to implement a normalized capital control for China, because of their different stages of economic development. Obviously, this conclusion not only implies that it is difficult for each country in the world to conduct the long-term international currency cooperation on policy target interest rates and inflation rates in the normal period, but also implies that it is difficult for Western and Eastern European countries in the eurozone to implement the unified policy target interest rate and inflation rate, due to their different stages of economic development. Its policy implication is that the process of China’s capital account liberalization must be compatible with the present and future stages of China’s economy development. And this is an objective economic law that we need to follow. Only when China’s economy development level is similar to the developed countries such as the United States, and when its economic growth rate converges with the growth rates of the developed countries, it is possible for China to complete the full capital account liberalization, thereby completely abandoning the long-term normalized capital controls. Of course, this paper is not intended to prevent the normal opening process of China’s financial service industry and the normal capital account liberalization process that is compatible with the stage of economic development. Especially in the case of the US " increasing the interest rate, shrinking the Fed’s balance sheet and cutting the government’s taxes”, which has led to increase the capital outflow pressure, the acceleration of the opening process of China’s financial service industry and the implementation of appropriate capital outflow controls are complementary, and not contradictory. 　　Compared with those developed countries, the capital controls in China and some other developing countries are the combination of a long-term normalized capital control and a loose or tight temporary countercyclical capital outflow or inflow control. The function of normalized capital controls is to maintain the stability of the open economy that is compatible with the development stage; while the role of temporary countercyclical capital outflow or inflow controls is a macro-prudential management tool. The contribution of this paper is that it demonstrates the necessity of the former for the developing countries such as China, and consolidates the former and the latter under the same theoretical framework. This is the main difference between this paper and other literature.　　It should be emphasized that although this paper demonstrates the reasons for international monetary long-term non-cooperation and the necessity to implement a normalized capital control over a longer period of time, this does not mean that the capital controls have always been required in the real economy. Obviously, the result of the combination of long-term normalized capital control and temporary countercyclical capital outflow or inflow control in the real economy is that some periods are capital outflow controls; some periods are capital inflows; some periods may also be free movement of capital. Currently, a typical example for the latter is that under the background of the increasing of interest rate of the US dollar, the shrinking of the Fed’s balance sheet and the tax cutting of the US government, if those other conditions remain unchanged, for China and some other developing countries, the implementing of interest rate rules about the monetary policy and the floating exchange rate system, combined with a moderate temporary countercyclical capital outflow control, will be more beneficial to the stability of their macroeconomic variables such as capital accounts, output and social welfare. At present, the developing countries such as Turkey are suffering from the consequences of a sharp fall in the exchange rate and capital flight because they have not properly managed their domestic and international economic and financial issues. In contrast, another typical example is that when faced with the impact of the cutting of the US dollar’s interest rate, if the interest rate rule is adopted, the exchange rate of RMB will experience a larger appreciation, and the export will decline. And if other conditions remain unchanged, in order to promote economic growth and improve social welfare, the Chinese government needs to moderately tighten the capital inflow control at this moment.