China’s Financial Floodgates

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.

Most academic research also supports the view that financial and capital-account liberalization should be undertaken warily, and that it should be accompanied by stronger domestic financial regulation. In the case of capital flows, this means retaining capital-account regulations as an essential tool of macroeconomic policy.