Foreign currency deposits of firms and individuals with banks in China

In principle, an economy with capital controls can maintain a stable exchange rate and set domestic interest rates independently. In practice, enforcement of capital controls is never easy and some leakage can be expected. Thus, a certain amount of capital flight can be the unwanted side effect of low domestic interest rates in the presence of imperfect capital controls. China’s recent experience, which has combined a stable exchange rate, capital controls and falling domestic interest rates in relation to dollar interest rates, highlights an unappreciated means to limit this unwanted side effect. In China, foreign currency accounts are allowed within the system of capital controls. These serve to keep foreign exchange in the domestic banking system, in effect domesticating capital flight. In this section, we analyse foreign currency deposits in the Chinese banking system. Their growth appears to reflect the disappearance of the yield premium on renminbi deposits relative to foreign currency deposit rates in China in the course of 1998 and the subsequent rise in the yield premium on US dollar deposits. The scale of foreign currency deposits suggests that the Chinese banking system is, in this respect at least, more open than has generally been recognised.