A Model of Chinese Capital Account Liberalisation

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In shaping the evolution of the global financial system in the decade ahead, few events will likely be more significant than capital account liberalisation in China and the internationalisation of the renminbi. This paper provides a theory-based inquiry into the contours of China's international balance sheets after the renminbi becomes convertible under the capital account. We construct a two-country general equilibrium model with trading in equities and bonds and calibrate the model with U.S. and Chinese data. We interpret Chinese capital account liberalisation as a removal of restrictions that prohibit agents from trading Chinese bonds and U.S. equities. We explore how international risk-sharing can be achieved through portfolio diversification in each of these asset market configurations. We also look at how these holdings would change as China gradually re-balances its production with a higher share of labour income, and as the productivity gap between China and the U.S. narrows. We find that both U.S. and Chinese residents would have incentives to increase their holdings in each other's equities, and to issue debt in each other's currency. We interpret the latter observation as the co-existence of the U.S. dollar and the renminbi as major international currencies.