FINANCIAL LIBERALIZATION, CRISIS, AND RESCUE:

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FINANCIAL LIBERALIZATION, CRISIS, AND RESCUE

• Lessons for China from
• Latin America and East Asia

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Aims of Presentation

• Introduction
• Challenges facing Chinas financial sector
• Financial liberalization trends LA and EA
• Liberalization and crisis
• Rescue costs
• Lessons for China

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Introduction

• Liberalization has transformed financial system
  in developing countries
• -- Strengthened role of private sector and
  market forces in decision making
• -- Resulted in crises and need for rescues
• -- Created new government role and increased
  foreign ownership

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Chinas Financial Sector

• Peoples Bank of China
• Policy banks
• State-owned commercial banks (Big 4)
• Publicly-listed commercial banks
• Non-bank financial institutions
• Securities markets

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Chinas Successes

• Rapid growth over several decades
• Strong external accounts, including large volume
  of reserves
• Stability in face of Asian Crisis

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Chinas Challenges

• Clean up NPLs and raise capital ratios in banking
  sector
• Improve regulation and supervision, corporate
  governance
• Continue liberalization of financial sector
  (domestic and international) without crisis

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Financial Liberalization Trends

• Definition of liberalization, WB Index
• Almost all countries have liberalized domestic
  financial sector
• LA has been eager, but volatile
• EA has moved more gradually

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Policies Accompanying Liberalization

• Macroeconomic management
• Prudential regulation and supervision
• Capital account opening
• Institutional development

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Liberalization and Crisis (1)

• Theoretical insights in recent literature
• -- New explanations for crises (internal
  oriented, external oriented)
• -- Twin crises
• -- Correlation between liberalization and twin
  crises

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Liberalization and Crisis (2)

• Twin crises in LA and EA (Chile, Mexico,
  Argentina Thailand, Korea, Malaysia, Indonesia)
• Typical syndrome
• -- Liberalization and privatization
• -- Lending boom, ignoring loan quality
• -- Macroeconomic policies leading to capital
  inflows, overvaluation, debt build-up
• -- Twin crisis

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Liberalization and Crisis (3)

• Not all countries have suffered twin crises
• -- Governments took early measures (Brazil,
  Philippines)
• -- Countries received less private capital
  inflows (Peru, Philippines)
• -- Other types of crisis (Colombia, Venezuela,
  Taiwan)

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Rescue (1)

• Four rescue mechanisms commonly used
• -- Assistance to increase liquidity
• -- Assistance to raise capital ratios
• -- Removal of bad loans
• -- Take-over or closing of banks
• Details matter for outcomes

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Rescue (2)

• Crises and rescues are very costly
• -- Fiscal outlays are high
• -- GDP losses are steep
• -- Other costs add to burden

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Rescue (3)

• Costs of crises linger for years
• -- Slower GDP growth
• -- Lower investment ratios
• -- Lack of credit availability

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Lessons for China (1)

• Gradual domestic liberalization preferable
• -- Importance not clear in LA and EA, but
  Chinese banks lack experience
• -- Clean up NPLs, increase capital ratios
• -- Generally improve capacity of financial
  institutions to meet new challenges before full
  liberalization

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Lessons for China (2)

• Policies accompanying liberalization must be
  selected with care
• -- Real macro stability before liberalization
• -- Strong prudential regulation and supervision
  before liberalization
• -- Partial capital account opening after
  liberalization and adjustment

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Lessons for China (3)

• Institutions must be strengthened to support
  liberalized system
• -- Rule of law, judicial system
• -- Ministry of finance, central bank, regulatory
  agencies, credit bureaus
• Improving institutions takes time, furthering
  argument for gradual approach

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Conclusions

• China has opted for a market economy
• Financial sector is a crucial component
• May be some role for public-sector banks
• But main component of financial sector must be
  autonomous banks that operate in stable,
  self-sustaining manner