Yuan Tian and Kevin P. Gallagher
China is taking significant steps to open up its capital account, while easing controls on its interest rates and currency exchange. The prospects for further capital account liberalization will depend on how China avoids the potential pitfalls of a more open system. Our new paper “Housing Price Volatility and the Capital Account in China” focuses on the effects of the capital account policy changes on China’s housing market.
China experienced significant housing-market volatility from 2005 to 2013. Economists analyzing the determinants of volatility in these markets find that the recent housing bubble was largely driven by factors specific to the Chinese economy and Chinese economic policy. In our paper, we examine the extent to which a) short-term international capital flows may have impacted prices and volatility in the Chinese housing market and b) whether China’s 2006 Capital Account Regulations (CARs) on foreign purchases of Chinese real estate were effective in reducing the level and volatility of prices in China’s housing markets.
We found that short-term capital flows from abroad had a modest impact on price increases in the Chinese housing market, but a more significant impact in increasing market volatility. The 2006 CARs, meanwhile, did not appear to have an impact in reducing housing prices, but did have a strong impact in reducing housing-market volatility. Short-term “hot money” flows magnified the impacts of capital flows on housing prices during upward surges in housing prices.
In terms of market volatility, our findings suggest that the more volatile the housing market became, the larger the impact that short-term capital flows had on accentuating volatility. Furthermore, we find that the 2006 CARs continued to have a strong impact on reducing volatility in the Chinese housing market during the period under study.
As is known worldwide, Chinese leaders are determined to speed up the pace of capital account liberalization. In the March government work report, they pledged to work towards full convertibility of the yuan. Regulators have also been working to facilitate personal investments in and outside China, to further open the country’s capital markets to global investors, and to revamp the regulation of foreign exchange.
China used to maintain tight restrictions on its capital account, but has been gradually liberalizing in a sequenced manner for a decade. However, there are no international rules to constrain, discipline, or indeed legitimize restrictions that countries put on their capital account. Our research suggests that capital-flow liberalization in China might cause the bursting of the housing bubble, while regulation would work to stabilize the housing market.
Although China’s housing bubble has appeared to ebb to some degree, this paper contains lessons for China’s ongoing discussions regarding capital account liberalization. As China liberalizes its capital account, it will have to devise mechanisms to evaluate the impact of capital flows on asset prices, and may need to resort to temporary regulations on capital inflows. This paper shows that such policies can be modestly effective.
China’s recent stock-market crash will probably lead to a more gradual easing of capital controls. (The Shanghai Composite Index of shares has tumbled 29 percent from its peak in June.) Policymakers will be more hesitant about widening foreigners’ access to China’s capital markets for fear of exacerbating volatility.
While China will not stop easing capital controls, the steps will likely be weaker than originally planned. Since the regulatory changes of 2006, China has widened the appeal of the yuan by expanding access to its domestic capital markets as well as encouraging issuance of yuan-denominated securities beyond its borders. Though the future of yuan internationalization remains a long way ahead, from our research, proper regulation has an important role to play in controlling market volatility.
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