Download Capital Account Liberalization

Capital Account Liberalization:
Lessons from the Asian Financial Crisis
and Implications for China
Masahiro Kawai
Asian Development Bank Institute
“Financial Reforms in China and Latin America”
Organized by ILAS/CASS and IDB
Beijing, 7 June 2007
Outline
I. Miracle, Crisis and Reconstruction
II. Lessons of the Crisis for Capital
Account Liberalization
III. Preconditions and Sequencing of
Capital Account Liberalization
IV. Implications for China
V. Way Forward
I. Miracle, Crisis and Reconstruction
1. Miracle
• Low inflation and competitive exchange rates to
support outward-oriented growth
• Human capital, critical to rapid growth with equity
• Effective and secure financial system for financial
intermediation
• Limited price distortions for the development of
labor-intensive sectors initially and capital-intensive
sectors later
• Use of foreign technology via licensing and/or FDI
• Limited bias against agriculture, key to reducing
rural-urban income disparities
I. Miracle, Crisis and Reconstruction
2. Crisis
• The crisis was a result of interactions between the
forces of financial globalization and domestic
structural weaknesses
• Forces of financial globalization—financial market
opening, capital account liberalization (double
mismatches) and volatile capital flows
• Domestic structural weaknesses—financial (mainly
banking) sector, corporate sector, and supervisory
and regulatory frameworks
• Lessons—manage the forces of financial
globalization; strengthen financial & corporate
sectors; nurture regional financial cooperation
I. Miracle, Crisis and Reconstruction
3. Recovery and Reconstruction
• Financial and corporate sector restructuring, reforms
and reconstruction, together with the introduction of
better regulatory and supervisory frameworks
• Economic recovery facilitated by intra-regional trade
linkages
• Substantial reduction of financial vulnerabilities
through reduction of short-term external debt and
accumulation of foreign exchange reserves
• Nonetheless, some economy, like Indonesia, was
semi-permanently damaged by the crisis
I. Miracle, Crisis and Reconstruction
4. Regional Cooperation in East Asia
• Reforms of the international financial system have
been inadequate (CCL, PSI), and national efforts to
strengthen domestic economic systems take time to
be effective
• An effective regional financial architecture can close
the gap between the global and national efforts for
crisis prevention (ASEAN+3 ERPD, ABMI), crisis
management (CMI), and crisis resolution
• On the trade front, the region has recently shifted to
a three-track approach of multilateral (WTO) cum
trans-regional (APEC), regional (ASEAN+1’s),
and bilateral (FTA) liberalization of trade & FDI
II. Lessons of the Crisis for Capital
Account Liberalization
1. Benefits and Costs of Capital Account
Liberalization
• Benefits: The country can smooth its consumption
and face greater opportunities than a closed economy.
Savings and investment decisions can be made
independently of each other.
• But empirical evidence on the relationship between
capital account openness and economic performance
is mixed.
• Costs: The country can face greater risks of a
currency crisis. A surge in capital inflows and a
sudden reversal of capital flows can induce crises,
often due to contagion & external shocks, not
necessarily domestic factors
Table 1. Capital Controls in China and Other Major Emerging Market Economies
China
Brazil
India
Russia
Article VIII
Article VIII
Article VIII
Article VIII
yes
no
yes
no
Capital market securities
yes
yes
yes
yes
Money market instruments
yes
no
yes
yes
Collective investment securities
yes
not regulated
yes
yes
Derivatives and other instruments
yes
yes
yes
yes
Commercial credits
yes
not regulated
yes
no
Financial credits
yes
no
yes
yes
Guarantees, sureties, and financial backup facilities
yes
no
yes
no
Direct investment
yes
yes
yes
yes
Liquidations of direct investment
yes
no
yes
no
Real estate transactions
yes
no
yes
no
Personal capital transactions
yes
no
yes
yes
Commercial banks and other credit institutions
yes
yes
yes
yes
Institutional investors
no
yes
yes
no
Status under IMF Articles of Agreement
Controls on payments for invisible transactions
and current transfers
Controls on capital transactions
Provisions specific to:
Source:
IMF, Annual
Report2006
on Exchange Arrangements
nd Exchange
Transactions,
II. Lessons of the Crisis for Capital
Account Liberalization
2. Capital Account Openness and Crises
• First generation model: Worsening economic
fundamentals (e.g. expanding money supply due to
large budget deficits) can cause a currency crisis.
• Second generation model: Expected policy change
(e.g. macroeconomic stimulus due to recession or
high unemployment) can induce a crisis.
• Third generation model: Presence of double
mismatches, liquidity constraints on firms with
external debt, and speculative runs on banks can
cause a currency crisis.
Table 2. Three Models of Currency Crises
First Generation
Cause of Crisis
Second Generation
Third Generation
Bad fundamentals:
Coordination failure:
Coordination failure:
Excessive expansion of
Expectation of macro-
Double mismtach;
money supply due to, e.g.,
economic stimulus due to
Liquidity constraint;
large fiscal deficits
recession, high
Bank runs
unemployment, etc
Number of Equilibria
One
Multiple
Multiple
Major Episodes
Latin America (1970s-80s)
EMS (1992)
East Asia (1997-98)
Main Defects
No government
Not obvious as to how one particular equilibruim is
optimization
chosen out of many
II. Lessons of the Crisis for Capital
Account Liberalization
3. Crisis Prevention Rather than Cure
• Do not try to achieve the “impossible trinity”
• Be cautious about the pace and scope of capital
account liberalization
• Avoid large current account deficits and double
mismatches
• Secure adequate foreign exchange reserves for selfprotection
• Strengthen monitoring of capital flows and exchange
market developments and supervision over domestic
financial systems
• Develop regional mechanisms to prevent crises
III. Preconditions and Sequencing of
Capital Account Liberalization
1. Preconditions
• Establish capacity to collect reasonably good
statistical data on capital flows
• Set the domestic macroeconomic conditions right
(solid fiscal situations and macroeconomic
stabilization)
• Introduce an independent central bank for credible
monetary policy
• Develop liquid money markets for the conduct of
monetary policy and financial stability
• Establish a sound financial system and strong
prudential supervisory and regulatory frameworks
III. Preconditions and Sequencing of
Capital Account Liberalization
2. Sequencing
• Liberalization of trade and foreign direct investment
• Liberalization of money and capital markets where
interest rates are market determined and business
scope and entry are deregulated
• Enforcement of domestic competition policy to
foster efficiency in the real and financial sectors
• Establishment of strong regulation and supervision,
legal and accounting systems to cope with systemic
financial crises
• Liberalization of long-tem capital flows, followed
by short-term capital flows
III. Preconditions and Sequencing of
Capital Account Liberalization
3. Capital Account Liberalization as Part of a
Comprehensive Reform Program
• Capital account liberalization should not be
considered as an isolated policy issue.
• There is a strong linkage among capital account
liberalization, domestic financial sector reform, and
the design of monetary and exchange rate policy
• Capital account liberalization should be considered
as an integrated part of a comprehensive reform
program, and paced with the strengthening of
domestic financial systems and implementation
of appropriate macroeconomic and exchange rate
policies
IV. Implications for China
1. Sound Macroeconomic Management
• Before capital account liberalization, China must
maintain stable macroeconomic conditions, i.e., by
reining in over-investment and incipient asset price
bubbles
• Before capital account liberalization, China must put
in place market-oriented policy frameworks and
instruments for effective macroeconomic management
• Make the People’s Bank of China independent of the
government so that it can achieve low and stable
inflation
• Strengthen the fiscal base through tax reform and
prudent debt management
Table 3. Balance of Payments of China, 2000-2006
(US$
Billion)
2000
2001
2002
2003
2004
2005
2006
Current Account
20.5
17.4
35.4
45.9
68.7
160.8
249.9
Trade balance
34.5
34.0
44.2
44.7
59.0
134.2
217.7
Services Balance
-5.6
-5.9
-6.8
-8.6
-9.7
-9.4
-8.8
Income Balance
-14.7
-19.2
-14.9
-7.8
-3.5
10.6
11.8
6.3
8.5
13.0
17.6
22.9
25.4
29.2
Capital Account
0.0
-0.1
0.0
0.0
-0.1
4.1
4.0
Financial Account
2.0
34.8
32.3
52.8
110.7
58.9
6.0
Direct Investment Balance
37.5
37.4
46.8
47.2
53.1
67.8
61.9
Portfolio Investment Balance
-4.0
-19.4
-10.3
11.4
19.7
-4.9
-58.4
Equity Securities Balance
6.9
0.9
2.2
7.7
10.9
20.3
--
Debt Securities Balance
-10.9
-20.3
-12.6
3.7
8.8
-25.3
--
Other Investment Balance
-31.5
16.9
-4.1
-5.9
37.9
-4.0
70.4
-11.7
-4.7
7.5
18.0
26.8
-16.4
-12.9
10.7
47.4
75.2
116.6
206.2
207.3
247.0
Current Transfers Balance
Net Errors and Omissions
Overall Balance
Sources: IFS Online, CEIC and IIF estimates (2006).
IV. Implications for China
2. Financial Sector Reform
• Strengthen the banking system, i.e. both banks
(particularly SOCBs) and their clients (particularly
SOEs)
• Make the supervisory agency independent of the
political system
• Allow interest rate liberalization, greater scope of
financial business, and freer entry to the financial
industry
• Encourage more entry of foreign financial institutions
so that it can make the financial system vibrant
• Develop local-currency bond markets
IV. Implications for China
3. Exchange Rate Regime
• Capital account liberalization will require
substantially flexible exchange rates if the central
bank wishes to have autonomous monetary policy
• Exchange rate regime must be consistent with the
overall macroeconomic policy framework
• The present macroeconomic conditions in China
require tighter monetary policy—that is, slower pace
of reserve accumulation and RMB appreciation
• Over time, China needs to allow greater
flexibility and more rapid appreciation of RMB
V. Way Forward
• Capital account liberalization needs to be wellsequenced and well-spaced as part of an integrated,
comprehensive reform package, including reforms to
strengthen the macroeconomic management framework
and the financial system
• It is critical to quickly but prudently establish the
preconditions for a successful reform package and lay
out the blueprint for reforms including capital account
liberalization
• Most important is the establishment of core
institutional infrastructure—well-defined property and
creditor rights; better accounting standards; strong
corporate governance; clear minority shareholder
rights; stringent prudential & regulatory regimes
Thank you
Dr. Masahiro Kawai
Dean
Asian Development Bank Institute
[email protected]
+81 3 3593 5527
www.adbi.org