Masahiro Kawai Asian Development Bank Institute “Financial Reforms in China and Latin America”

1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

9. 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.

11. 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

12. 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

13. 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

14. 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

15. 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

17. 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

18. 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

19. 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 infrastructure—well-defined property and creditor rights; better accounting standards; strong corporate governance; clear minority shareholder rights; stringent prudential & regulatory regimes

20. Thank you Dr. Masahiro Kawai Dean Asian Development Bank Institute mkawai@adbi.org +81 3 3593 5527 www.adbi.org