A new study by the IMF calls China foolish for liberalizing its capital controls before adjusting its exchange rate regime. The study criticized China for recently allowing capital to enter and exit the country more freely than before. Chinese banking officials believe looser controls on capital inflow and outflow are a prerequisite to a floating exchange rate, but experts argue that this theory is fallacious. In reality, the ability for foreign and domestic firms to exchange Yuan for foreign currency- and vice versa- may exert extreme pressure on the Yuan, to the point of instability. Currently, all international capital movement must be approved by Chinese government officials, so that the central bank can offset changes with commensurate changes in forex reserves. After China opened its borders to foreign capital to boost economic growth, the demand for Yuan soared. In order to maintain the fixed exchange rate with the USD, the central bank was forced to purchase massive blocks of USD, which now total over $600 Billion. China tried to offset these inflows by allowing select Chinese companies to invest abroad, but this only triggered more foreign investment in China. The Economist reports:

The combination of fixed exchange rates and open capital accounts has caused financial crises in many emerging economies, especially when financial systems are fragile. China would therefore be wise to move cautiously in liberalising its capital account, but should move more rapidly towards greater exchange-rate flexibility. 

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