Capital Flows, Overheating, And the Nominal Exchange Rate Regime in China‪.‬

China's historic entry into the World Trade Organization (WTO) in 2001 has increased the pace of reform and opening up, and the Chinese economy has gathered further momentum with real GDP growth reaching a phenomenal 9.5 percent in 2004. That spectacular growth performance and China's status as a "world factory" have led to massive capital inflows, pushing up official foreign exchange reserves to more than $600 billion by end of 2004. While there is much to celebrate, there is also cause for concern. The Chinese economy has begun to show signs of overheating and inflation. At the same time, the massive capital inflows and soaring reserves have put a new spotlight on the country's de facto currency peg--an increasing source of friction with leading trading partners such as the United States and Japan. Instead of moving toward greater exchange rate flexibility, the Chinese authorities have responded by stepping up sterilized intervention, easing restrictions on selected capital outflows, and tightening inward portfolio investment. Despite the success of the Qualified Foreign Institutional Investor (QFII) program introduced in December 2002, the authorities have temporarily stopped approving new applications for the QFII program mainly to limit further portfolio investment inflows. The evidence of "hot money" clearly shows that China's cumbersome system of capital controls is not as effective as officials claim. There is no doubt that the greater openness of China's economy will certainly generate growing tensions with the country's closed capital account. China must put in place a sound institutional framework and financial infrastructure to accommodate increasing freedom of cross-border capital flows. Provided China can make meaningful progress in banking reform in the next three to five years, full currency convertibility remains a highly worthwhile and realistic medium-term policy goal.