China’s Financial Floodgates

As China’s economy starts to slow, following decades of spectacular growth, the government will increasingly be exposed to the siren song of capital-account liberalization. It should not allow itself to be tempted from its tried and tested course by calls for a policy that has led too many emerging economies onto the rocks.

NEW YORK – As China’s economy starts to slow, following decades of spectacular growth, the government will increasingly be exposed to the siren song of capital-account liberalization. This option might initially appear attractive, particularly given the Chinese government’s desire to internationalize the renminbi. But appearances can deceive.

A new report argues that the Chinese authorities should be skeptical about capital-account liberalization. Drawing lessons from the recent experiences of other emerging countries, the report concludes that China should adopt a carefully sequenced and cautious approach when exposing its economy to the caprices of global capital flows.

The common thread to be found in the recent history of emerging economies – beginning in Latin America and running through East Asia and Central and Eastern Europe – is that capital flows are strongly pro-cyclical, and are the biggest single cause of financial instability. Domestic financial instability, associated with liberalization, also has a large impact on economic performance, as does the lack of control over non-bank financial intermediaries – an issue that China is now starting to face as the shadow banking sector’s contribution to credit growth becomes more pronounced.

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