Capital Account Liberalization: Lessons from the Asian Financial Crisis and Implications for China

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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

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Outline

• Miracle, Crisis and Reconstruction
• Lessons of the Crisis for Capital Account
  Liberalization
• Preconditions and Sequencing of Capital Account
  Liberalization
• Implications for China
• Way Forward

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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

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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 globalizationfinancial
  market opening, capital account liberalization
  (double mismatches) and volatile capital flows
• Domestic structural weaknessesfinancial (mainly
  banking) sector, corporate sector, and
  supervisory and regulatory frameworks
• Lessonsmanage the forces of financial
  globalization strengthen financial corporate
  sectors nurture regional financial
  cooperation

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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

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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 (ASEAN3 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
  (ASEAN1s), and bilateral (FTA) liberalization
  of trade FDI

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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

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

  China Brazil India Russia
Status under IMF Articles of Agreement Article VIII Article VIII Article VIII Article VIII
Controls on payments for invisible transactions yes no yes no
and current transfers        
Controls on capital transactions        
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
Provisions specific to        
Commercial banks and other credit institutions yes yes yes yes
Institutional investors no yes yes no
Source IMF, Annual Report on Exchange Arrangements nd Exchange Transactions, 2006

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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.

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

  First Generation Second Generation Third Generation
Cause of Crisis 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 Not obvious as to how one particular equilibruim is
  optimization chosen out of many  
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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
  self-protection
• Strengthen monitoring of capital flows and
  exchange market developments and supervision over
  domestic financial systems
• Develop regional mechanisms to prevent crises

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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

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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

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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

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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 Peoples 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

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Table 3. Balance of Payments of China, 2000-2006 Table 3. Balance of Payments of China, 2000-2006 Table 3. Balance of Payments of China, 2000-2006 Table 3. Balance of Payments of China, 2000-2006 Table 3. Balance of Payments of China, 2000-2006 Table 3. Balance of Payments of China, 2000-2006 Table 3. Balance of Payments of China, 2000-2006 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
Current Transfers Balance 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
Net Errors and Omissions -11.7 -4.7 7.5 18.0 26.8 -16.4 -12.9
Overall Balance 10.7 47.4 75.2 116.6 206.2 207.3 247.0

Sources IFS Online, CEIC and IIF estimates (2006). Sources IFS Online, CEIC and IIF estimates (2006). Sources IFS Online, CEIC and IIF estimates (2006).
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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

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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 policythat is, slower
  pace of reserve accumulation and RMB appreciation
• Over time, China needs to allow greater
  flexibility and more rapid appreciation of RMB

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V. Way Forward

• Capital account liberalization needs to be
  well-sequenced 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 infrastructurewell-defined
  property and creditor rights better accounting
  standards strong corporate governance clear
  minority shareholder rights stringent
  prudential regulatory regimes

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Thank you
Dr. Masahiro Kawai Dean Asian Development Bank
Institute mkawai_at_adbi.org 81 3 3593
5527 www.adbi.org