Masahiro Kawai Asian Development Bank Institute “Financial Reforms in China and Latin America”

Capital Account Liberalization: Capital Account Liberalization: Lessons from the Asian Financial Crisis Lessons from the Asian Financial Crisis

and Implications for Chinaand Implications for China

Masahiro KawaiMasahiro KawaiAsian Development Bank InstituteAsian Development Bank Institute

““Financial Reforms in China and Latin America”Financial Reforms in China and Latin America”Organized by ILAS/CASS and IDBOrganized by ILAS/CASS and IDB

Beijing, 7 June 2007Beijing, 7 June 2007

OutlineOutline

I.I. Miracle, Crisis and ReconstructionMiracle, Crisis and Reconstruction

II.II. Lessons of the Crisis for Capital Lessons of the Crisis for Capital Account LiberalizationAccount Liberalization

III.III. Preconditions and Sequencing of Preconditions and Sequencing of Capital Account LiberalizationCapital Account Liberalization

IV.IV. Implications for ChinaImplications for China

V.V. Way ForwardWay Forward

I. Miracle, Crisis and ReconstructionI. Miracle, Crisis and Reconstruction1. Miracle1. Miracle• Low inflation and competitive exchange rates to Low inflation and competitive exchange rates to

support outward-oriented growthsupport outward-oriented growth• Human capital, critical to rapid growth with equityHuman capital, critical to rapid growth with equity• Effective and secure financial system for financial Effective and secure financial system for financial

intermediationintermediation• Limited price distortions for the development of Limited price distortions for the development of

labor-intensive sectors initially and capital-labor-intensive sectors initially and capital-intensive sectors laterintensive sectors later

• Use of foreign technology via licensing and/or FDIUse of foreign technology via licensing and/or FDI• Limited bias against agriculture, key to reducing Limited bias against agriculture, key to reducing

rural-urban income disparitiesrural-urban income disparities

I. Miracle, Crisis and ReconstructionI. Miracle, Crisis and Reconstruction

2. Crisis2. Crisis

• The crisis was a result of interactions between the The crisis was a result of interactions between the forces of financial globalization and domestic forces of financial globalization and domestic structural weaknessesstructural weaknesses

• Forces of financial globalization—financial market Forces of financial globalization—financial market opening, capital account liberalization (double opening, capital account liberalization (double mismatches) and volatile capital flowsmismatches) and volatile capital flows

• Domestic structural weaknesses—financial (mainly Domestic structural weaknesses—financial (mainly banking) sector, corporate sector, and supervisory banking) sector, corporate sector, and supervisory and regulatory frameworksand regulatory frameworks

• Lessons—manage the forces of financial Lessons—manage the forces of financial globalization; strengthen financial & corporate globalization; strengthen financial & corporate sectors; nurture regional financial cooperationsectors; nurture regional financial cooperation


3. Recovery and Reconstruction3. Recovery and Reconstruction

• Financial and corporate sector restructuring, reforms Financial and corporate sector restructuring, reforms and reconstruction, together with the introduction of and reconstruction, together with the introduction of better regulatory and supervisory frameworksbetter regulatory and supervisory frameworks

• Economic recovery facilitated by intra-regional trade Economic recovery facilitated by intra-regional trade linkageslinkages

• Substantial reduction of financial vulnerabilities Substantial reduction of financial vulnerabilities through reduction of short-term external debt and through reduction of short-term external debt and accumulation of foreign exchange reservesaccumulation of foreign exchange reserves

• Nonetheless, some economy, like Indonesia, was Nonetheless, some economy, like Indonesia, was semi-permanently damaged by the crisissemi-permanently damaged by the crisis


4. Regional Cooperation in East Asia4. Regional Cooperation in East Asia• Reforms of the international financial system have Reforms of the international financial system have

been inadequate (CCL, PSI), and national efforts to been inadequate (CCL, PSI), and national efforts to strengthen domestic economic systems take time to strengthen domestic economic systems take time to be effective be effective

• An effective regional financial architecture can close An effective regional financial architecture can close the gap between the global and national efforts for the gap between the global and national efforts for crisis prevention (ASEAN+3 ERPD, ABMI), crisis crisis prevention (ASEAN+3 ERPD, ABMI), crisis management (CMI), and crisis resolutionmanagement (CMI), and crisis resolution

• On the trade front, the region has recently shifted to On the trade front, the region has recently shifted to a three-track approach of multilateral (WTO) cum a three-track approach of multilateral (WTO) cum trans-regional (APEC), regional (ASEAN+1’s), trans-regional (APEC), regional (ASEAN+1’s), and bilateral (FTA) liberalization of trade & FDIand bilateral (FTA) liberalization of trade & FDI

II. Lessons of the Crisis for Capital II. Lessons of the Crisis for Capital Account LiberalizationAccount Liberalization

1. Benefits and Costs of Capital Account 1. Benefits and Costs of Capital Account LiberalizationLiberalization

• Benefits: The country can smooth its consumption Benefits: The country can smooth its consumption and face greater opportunities than a closed economy. and face greater opportunities than a closed economy. Savings and investment decisions can be made Savings and investment decisions can be made independently of each other.independently of each other.

• But empirical evidence on the relationship between But empirical evidence on the relationship between capital account openness and economic performance capital account openness and economic performance is mixed.is mixed.

• Costs: The country can face greater risks of a Costs: The country can face greater risks of a currency crisis. A surge in capital inflows and a currency crisis. A surge in capital inflows and a sudden reversal of capital flows can induce crises, sudden reversal of capital flows can induce crises, often due to contagion & external shocks, not often due to contagion & external shocks, not necessarily domestic factorsnecessarily domestic factors

Table 1. Capital Controls in China and Other Major Emerging Market EconomiesTable 1. Capital Controls in China and Other Major Emerging Market Economies

ChinaChina BrazilBrazil IndiaIndia RussiaRussia

Status under IMF Articles of AgreementStatus under IMF Articles of Agreement Article VIIIArticle VIII Article VIIIArticle VIII Article VIIIArticle VIII Article VIIIArticle VIII

Controls on payments for invisible transactionsControls on payments for invisible transactions yesyes nono yesyes nono

and current transfersand current transfers

Controls on capital transactionsControls on capital transactions

Capital market securitiesCapital market securities yesyes yesyes yesyes yesyes

Money market instrumentsMoney market instruments yesyes nono yesyes yesyes

Collective investment securitiesCollective investment securities yesyes not regulatednot regulated yesyes yesyes

Derivatives and other instrumentsDerivatives and other instruments yesyes yesyes yesyes yesyes

Commercial creditsCommercial credits yesyes not regulatednot regulated yesyes nono

Financial creditsFinancial credits yesyes nono yesyes yesyes

Guarantees, sureties, and financial backup facilitiesGuarantees, sureties, and financial backup facilities yesyes nono yesyes nono

Direct investmentDirect investment yesyes yesyes yesyes yesyes

Liquidations of direct investmentLiquidations of direct investment yesyes nono yesyes nono

Real estate transactionsReal estate transactions yesyes nono yesyes nono

Personal capital transactionsPersonal capital transactions yesyes nono yesyes yesyes

Provisions specific to:Provisions specific to:

Commercial banks and other credit institutionsCommercial banks and other credit institutions yesyes yesyes yesyes yesyes

Institutional investorsInstitutional investors nono yesyes yesyes nono

SourceSource: IMF, Annual Report on Exchange Arrangements : IMF, Annual Report on Exchange Arrangements nd Exchange Transactions, 2006nd Exchange Transactions, 2006


2. Capital Account Openness and Crises2. Capital Account Openness and Crises

• First generation model: Worsening economic First generation model: Worsening economic fundamentals (e.g. expanding money supply due to fundamentals (e.g. expanding money supply due to large budget deficits) can cause a currency crisis.large budget deficits) can cause a currency crisis.

• Second generation model: Expected policy change Second generation model: Expected policy change (e.g. macroeconomic stimulus due to recession or (e.g. macroeconomic stimulus due to recession or high unemployment) can induce a crisis.high unemployment) can induce a crisis.

• Third generation model: Presence of double Third generation model: Presence of double mismatches, liquidity constraints on firms with mismatches, liquidity constraints on firms with external debt, and speculative runs on banks can external debt, and speculative runs on banks can cause a currency crisis. cause a currency crisis.

Table 2. Three Models of Currency CrisesTable 2. Three Models of Currency Crises

First GenerationFirst Generation Second GenerationSecond Generation Third GenerationThird Generation

Cause of CrisisCause of Crisis Bad fundamentals:Bad fundamentals: Coordination failure:Coordination failure: Coordination failure:Coordination failure:

Excessive expansion of Excessive expansion of Expectation of macro-Expectation of macro- Double mismtach; Double mismtach;

money supply due to, e.g., money supply due to, e.g., economic stimulus due toeconomic stimulus due to Liquidity constraint;Liquidity constraint;

large fiscal deficitslarge fiscal deficits recession, high recession, high Bank runsBank runs

unemployment, etcunemployment, etc

Number of EquilibriaNumber of Equilibria OneOne MultipleMultiple MultipleMultiple

Major EpisodesMajor Episodes Latin America (1970s-80s)Latin America (1970s-80s) EMS (1992)EMS (1992) East Asia (1997-98)East Asia (1997-98)

Main DefectsMain Defects No government No government Not obvious as to how one particular equilibruim is Not obvious as to how one particular equilibruim is

optimizationoptimization chosen out of manychosen out of many


3. Crisis Prevention Rather than Cure3. Crisis Prevention Rather than Cure• Do not try to achieve the “impossible trinity”Do not try to achieve the “impossible trinity”• Be cautious about the pace and scope of capital Be cautious about the pace and scope of capital

account liberalizationaccount liberalization• Avoid large current account deficits and double Avoid large current account deficits and double

mismatchesmismatches• Secure adequate foreign exchange reserves for self-Secure adequate foreign exchange reserves for self-

protectionprotection• Strengthen monitoring of capital flows and exchange Strengthen monitoring of capital flows and exchange

market developments and supervision over domestic market developments and supervision over domestic financial systemsfinancial systems

• Develop regional mechanisms to prevent crisesDevelop regional mechanisms to prevent crises

III. Preconditions and Sequencing of III. Preconditions and Sequencing of Capital Account LiberalizationCapital Account Liberalization

1. Preconditions1. Preconditions• Establish capacity to collect reasonably good Establish capacity to collect reasonably good

statistical data on capital flows statistical data on capital flows • Set the domestic macroeconomic conditions right Set the domestic macroeconomic conditions right

(solid fiscal situations and macroeconomic (solid fiscal situations and macroeconomic stabilization)stabilization)

• Introduce an independent central bank for credible Introduce an independent central bank for credible monetary policymonetary policy

• Develop liquid money markets for the conduct of Develop liquid money markets for the conduct of monetary policy and financial stabilitymonetary policy and financial stability

• Establish a sound financial system and strong Establish a sound financial system and strong prudential supervisory and regulatory frameworksprudential supervisory and regulatory frameworks


2. Sequencing2. Sequencing• Liberalization of trade and foreign direct investment Liberalization of trade and foreign direct investment • Liberalization of money and capital markets where Liberalization of money and capital markets where

interest rates are market determined and business interest rates are market determined and business scope and entry are deregulatedscope and entry are deregulated

• Enforcement of domestic competition policy to Enforcement of domestic competition policy to foster efficiency in the real and financial sectorsfoster efficiency in the real and financial sectors

• Establishment of strong regulation and supervision, Establishment of strong regulation and supervision, legal and accounting systems to cope with systemic legal and accounting systems to cope with systemic financial crisesfinancial crises

• Liberalization of long-tem capital flows, followed Liberalization of long-tem capital flows, followed by short-term capital flowsby short-term capital flows


3. Capital Account Liberalization as Part of 3. Capital Account Liberalization as Part of a Comprehensive Reform Programa Comprehensive Reform Program

• Capital account liberalization should not be Capital account liberalization should not be considered as an isolated policy issue.considered as an isolated policy issue.

• There is a strong linkage among capital account There is a strong linkage among capital account liberalization, domestic financial sector reform, and liberalization, domestic financial sector reform, and the design of monetary and exchange rate policythe design of monetary and exchange rate policy

• Capital account liberalization should be considered Capital account liberalization should be considered as an integrated part of a comprehensive reform as an integrated part of a comprehensive reform program, and paced with the strengthening of program, and paced with the strengthening of domestic financial systems and implementation domestic financial systems and implementation of appropriate macroeconomic and exchange rate of appropriate macroeconomic and exchange rate policies policies

IV. Implications for ChinaIV. Implications for China1. Sound Macroeconomic Management1. Sound Macroeconomic Management

• Before capital account liberalization, China must Before capital account liberalization, China must maintain stable macroeconomic conditions, i.e., by maintain stable macroeconomic conditions, i.e., by reining in over-investment and incipient asset price reining in over-investment and incipient asset price bubblesbubbles

• Before capital account liberalization, China must put Before capital account liberalization, China must put in place market-oriented policy frameworks and in place market-oriented policy frameworks and instruments for effective macroeconomic managementinstruments for effective macroeconomic management

• Make the People’s Bank of China independent of the Make the People’s Bank of China independent of the government so that it can achieve low and stable government so that it can achieve low and stable inflationinflation

• Strengthen the fiscal base through tax reform and Strengthen the fiscal base through tax reform and prudent debt managementprudent debt management

Table 3. Balance of Payments of China, 2000-2006Table 3. Balance of Payments of China, 2000-2006(US$ (US$

Billion)Billion)

20002000 20012001 20022002 20032003 20042004 20052005 20062006

Current AccountCurrent Account 20.5 20.5 17.4 17.4 35.4 35.4 45.9 45.9 68.7 68.7 160.8 160.8 249.9249.9

Trade balanceTrade balance 34.5 34.5 34.0 34.0 44.2 44.2 44.7 44.7 59.0 59.0 134.2 134.2 217.7217.7

Services BalanceServices Balance -5.6 -5.6 -5.9 -5.9 -6.8 -6.8 -8.6 -8.6 -9.7 -9.7 -9.4 -9.4 -8.8-8.8

Income BalanceIncome Balance -14.7 -14.7 -19.2 -19.2 -14.9 -14.9 -7.8 -7.8 -3.5 -3.5 10.6 10.6 11.811.8

Current Transfers BalanceCurrent Transfers Balance 6.3 6.3 8.5 8.5 13.0 13.0 17.6 17.6 22.9 22.9 25.4 25.4 29.229.2

Capital AccountCapital Account 0.0 0.0 -0.1 -0.1 0.0 0.0 0.0 0.0 -0.1 -0.1 4.1 4.1 4.04.0

Financial AccountFinancial Account 2.0 2.0 34.8 34.8 32.3 32.3 52.8 52.8 110.7 110.7 58.9 58.9 6.06.0

Direct Investment BalanceDirect Investment Balance 37.5 37.5 37.4 37.4 46.8 46.8 47.2 47.2 53.1 53.1 67.8 67.8 61.9 61.9

Portfolio Investment BalancePortfolio Investment Balance -4.0 -4.0 -19.4 -19.4 -10.3 -10.3 11.4 11.4 19.7 19.7 -4.9 -4.9 -58.4 -58.4

Equity Securities BalanceEquity Securities Balance 6.9 6.9 0.9 0.9 2.2 2.2 7.7 7.7 10.9 10.9 20.3 20.3 ----

Debt Securities BalanceDebt Securities Balance -10.9 -10.9 -20.3 -20.3 -12.6 -12.6 3.7 3.7 8.8 8.8 -25.3-25.3 ----

Other Investment BalanceOther Investment Balance -31.5 -31.5 16.9 16.9 -4.1 -4.1 -5.9 -5.9 37.9 37.9 -4.0 -4.0 70.4 70.4

Net Errors and OmissionsNet Errors and Omissions -11.7 -11.7 -4.7 -4.7 7.5 7.5 18.0 18.0 26.8 26.8 -16.4 -16.4 -12.9-12.9

Overall BalanceOverall Balance 10.7 10.7 47.4 47.4 75.2 75.2 116.6 116.6 206.2 206.2 207.3 207.3 247.0247.0

SourcesSources: IFS Online, CEIC and IIF estimates (2006).: IFS Online, CEIC and IIF estimates (2006).

IV. Implications for ChinaIV. Implications for China

2. Financial Sector Reform2. Financial Sector Reform

• Strengthen the banking system, i.e. both banks Strengthen the banking system, i.e. both banks (particularly SOCBs) and their clients (particularly (particularly SOCBs) and their clients (particularly SOEs)SOEs)

• Make the supervisory agency independent of the Make the supervisory agency independent of the political systempolitical system

• Allow interest rate liberalization, greater scope of Allow interest rate liberalization, greater scope of financial business, and freer entry to the financial financial business, and freer entry to the financial industryindustry

• Encourage more entry of foreign financial institutions Encourage more entry of foreign financial institutions so that it can make the financial system vibrantso that it can make the financial system vibrant

• Develop local-currency bond markets Develop local-currency bond markets

IV. Implications for ChinaIV. Implications for China3. Exchange Rate Regime3. Exchange Rate Regime

• Capital account liberalization will require Capital account liberalization will require substantially flexible exchange rates if the central substantially flexible exchange rates if the central bank wishes to have autonomous monetary policybank wishes to have autonomous monetary policy

• Exchange rate regime must be consistent with the Exchange rate regime must be consistent with the overall macroeconomic policy frameworkoverall macroeconomic policy framework

• The present macroeconomic conditions in China The present macroeconomic conditions in China require tighter monetary policy—that is, slower pace require tighter monetary policy—that is, slower pace of reserve accumulation and RMB appreciationof reserve accumulation and RMB appreciation

• Over time, China needs to allow greater Over time, China needs to allow greater flexibility and more rapid appreciation of RMB flexibility and more rapid appreciation of RMB

V. Way ForwardV. Way Forward• Capital account liberalization needs to be well-Capital account liberalization needs to be well-

sequenced and well-spaced as part of an integrated, sequenced and well-spaced as part of an integrated, comprehensive reform package, including reforms to comprehensive reform package, including reforms to strengthen the macroeconomic management framework strengthen the macroeconomic management framework and the financial systemand the financial system

• It is critical to quickly but prudently establish the It is critical to quickly but prudently establish the preconditions for a successful reform package and lay preconditions for a successful reform package and lay out the blueprint for reforms including capital account out the blueprint for reforms including capital account liberalizationliberalization

• Most important is the establishment of core Most important is the establishment of core institutional infrastructure—well-defined property and institutional infrastructure—well-defined property and creditor rights; better accounting standards; strong creditor rights; better accounting standards; strong corporate governance; clear minority shareholder corporate governance; clear minority shareholder rights; stringent prudential & regulatory regimesrights; stringent prudential & regulatory regimes

Thank youThank you

Dr. Masahiro Kawai Dr. Masahiro Kawai Dean Dean

Asian Development Bank InstituteAsian Development Bank [email protected] +81 3 3593 5527

www.adbi.org

Masahiro Kawai Asian Development Bank Institute “Financial Reforms in China and Latin America”

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