Capital Flight: Chinas Experience* by Yin-Wong Cheung University of California, Santa Cruz and XingWang Qian SUNY, Buffalo State College This Version: September 2009 * Cheung acknowledges the financial support of faculty research funds of the University of California, Santa Cruz. Corresponding address: Yin-Wong Cheung, Department of Economics E2, University of California, Santa Cruz, CA 95064, USA. Email: cheungucsc.edu. Capital Flight: Chinas Experience Abstract We study the empirical determinants of Chinas capital flight. In addition to the covered interest differential, our empirical exercise includes a rather exhaustive list of macroeconomic variables and a few institutional factors. Overall, our regression exercise shows that Chinas capital flight is quite well explained by its own history and covered interest differentials. The other possible determinants offer relatively small additional explanatory power. It is also found that Chinas capital flight responds differently to the components of covered interest differentials and to the positive and negative components of these variables. The response pattern, however, depends on the choice of data frequency. The general impression is that the monthly results are more intuitive than the quarterly ones. JEL Classification: F3, F32, G15 Keywords: Covered Interest Differential, Forward Premium, Expected Depreciation, Asymmetric Response, Macro Determinants 11. Introduction In the midst of the current financial crisis, it is hard to under-state Chinas role in the global economy. Since its open door policy was initiated in 1978, China has swiftly ascended to the league of major players in the world economy. Echoing its growing economic prowess, China has stepped up its interactions with the rest of the world apace. Over the last two decades, China has strengthened its levels of trade and financial integration with the world economy, albeit at uneven paces. There is a plethora of analyses on Chinas trade integration. These studies usually emphasize Chinas supercharged export performance, the pressure of her demand on commodity prices, and the link between Chinese renminbi valuation and global imbalances.1 Chinas ability to draw in huge amounts of foreign direct investment (FDI); especially compared with its role as a provider in the world capital market, and its astonishing rate of accumulating international reserves in the new millennium also have attracted consideration attention in both academic and policy circles.2 While a large collection of studies has accumulated in the last decade or so, there are still lots to be done to understand the intricate relationship between China and the world economy. The current study examines Chinas capital flight an illicit financial channel through which China interacts with the world economy. Capital flight could be seen as a consequence of distortions induced by the political structure and the fiscal, monetary, and exchange rate policies. Indeed, Chinas capital flight is quite substantial. A quick check on the data shows that, in the 2000s, quarterly illicit capital outflows and inflows could be larger than the official FDI or the change in the external debts in the corresponding period. Given its non-trivial size, capital flight could have significant implications for the Chinese economy. For instance, it could adversely affect Chinas economy by draining needed resources from the domestic market and reduce the effectiveness of monetary and exchange rate policies. Capital flight also has implications for Chinas policy of further liberalizing its capital management policy. In general, a sudden and severe capital flight could inflict huge pains on an economy the recent crises abound with examples of the detrimental impact of capital flight.3 1 See, for example, Blanchard and Giavazz (2006), Cheung et al. (2007a, b), Feenstra and Wei (2009), Lane and Schmukler (2007), Obstfeld (2006), and Rodrik (2006). 2 See, for example, Eichengreen and Tong (2007), Cheung and Qian (2009), Jeanne (2007), Hale and Long (forthcoming), and Prasad and Wei (2007). 3 See, for example, Harrigan et al. (2002), Pastor (1990), and Rojas-Suarez (1990). 2Given Chinas current stage of development and its proclaimed gradualism reform approach, one expects the conditions and environment that give rise to capital flight will exist and persist for awhile. The extant academic studies focus on measuring Chinas capital flight and, at the same time, recognize a few determinants including exchange rate policy, preferential treatments for foreign capital, domestic and foreign return differentials; see, for example, Gunter (1996, 2004), Ljungwall and Wang (2008), Sicular (1998), and Wu and Tang (2000).4 One hurdle facing studies on capital flight is the measurement issue. There are different interpretations of the term capital flight. One definition equates capital flight to cross-border fund movements that are taken to ev