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Opinion: Building a Door Instead of a Wall for China’s Financial Liberalization

By He Fan, Zhu He and Li Chaohui

The State Council of China recently issued a statement on the further opening-up of such industries as banking, bonds and insurance. This sparked heated discussion in China. The “2017 Jingshan Report,” published by the China Finance 40 Forum, merits our attention.

The theme of the report is “opening China’s financial industry gradually and steadily.” The report analyzes the status quo and potential risks of opening the Chinese financial industry and offers significant suggestions for policymakers. The discussions about the related issues of opening China’s financial industry are insightful and comprehensive. It is one of the few reports in recent years that have systematically studied the benefits and problems that may be brought about by opening China’s financial market. The report makes an important statement that in the process of further opening up China’s financial industry, moderate and temporary control over cross-border capital flows can facilitate financial stability and monetary policy independence.

Academia had held high expectations of financial globalization before the subprime crisis in 2008. Well-known financial economist Frederic Mishkin strongly backed financial globalization in his book “The Next Great Globalization,” in which he listed a number of benefits of financial globalization, such as promoting economic growth and innovation. However, the subprime crisis made us realize that financial globalization does not necessarily promote economic growth, but may increase the risks of financial crises and promote a rapid spread of the crises to more countries. As a result, after the global financial crisis in 2008, mainstream economists have done more and more reflections on financial globalization.

As a matter of fact, more and more people began to question financial globalization after the outbreak of the financial crisis in Southeast Asia. The Thai economy experienced rapid growth in the 1980s and 1990s. In order to further attract international capital to participate in domestic construction, the Thai government liberalized its control over capital projects. This meant removing all barriers to cross-border flow of short-term capital. Since then, a large amount of international capital flowed into Thailand, which first affected the real economy, and later began to interfere with the real estate industry and stocks. The instant the Thai economy began to show signs of trouble, capital was withdrawn. The outcome was devastating. The Thai government tried to use foreign exchange reserves to hedge against capital outflows, but eventually failed and could only watch the Thai baht devalue. At this point, the Southeast Asian financial crisis officially kicked in. South Korea, Malaysia, Indonesia, one by one became the targets of international capital attacks and followed the tragic path of Thailand. In contrast, China had implemented strict capital controls, not allowing the access of short-term foreign capital, thus escaping the international hot-money attack.

In retrospect, we can see obvious distortions in the internal economic structure of these countries. In addition, there were flaws in their domestic macroeconomic policies. These are the root cause of the financial crisis. Opening up the financial market too hastily is also one of the main causes of the crisis. Harvard economist Dani Rodrik pointed out that developed countries, especially the United States, need to accept the proper control over capital flows.

For developing countries, managing the capital account is a key measure in promoting economic growth. This statement was confirmed by Dani Rodrik in his 2011 book “The Globalization Paradox.”

Since financial openness is not always good, it is necessary for China to rethink the benefits and costs of financial opening to the outside world. On the one hand, large state-owned financial institutions dominated the Chinese financial market, resulting in the remarkable lack of competition. At the same time, with the banking industry dominating the financial sector, the financial market lacks diversity. In addition, financial support services failed to keep up, such as the credit system and rating system. In this case, if the opening of the domestic financial market is done gradually, we will be able to improve the efficiency of the domestic financial market by strengthening competition. This will be beneficial to the establishment of the domestic financial ecosystem. In the face of strong competitive pressures, domestic financial institutions may have to push forward substantive business and governance reform and improve operational efficiency, which in turn will enable domestic financial systems to become more efficient and improve their resilience.

On the other hand, opening the financial industry may require opening capital accounts as well. This may present considerable potential risks. The flowing of short-term capital in and out on of the country on a large scale will not only affect the stability of China’s financial market, but also cause unnecessary fluctuations in its economy. Given the continuous decline in the rate of return on investment in China, attention should be given even to the long-term capital coming from other countries. Such capital may flow to domestic capital market through various forms, thus influencing the prices of assets of various kinds.

In sum, opening financial market now will bring about both benefits and problems. The benefits will be mainly in the financial sector. Chinese domestic financial institutions have become more and more competitive over the years. Therefore, we should not worry about foreign financial organizations coming into China. The downside of opening up the financial market mostly lies in the potential risks to China’s economy posed by relaxation in capital controls. It is necessary that we weigh the gains and side effects when introducing policies concerning the opening of the financial market. In other words, we should maximize the benefits and take cautious measures to prevent possible risks.

It all comes down to supervision. After the global financial crisis, the world has experienced varying degrees of deglobalization. The trend of trade protectionism and financial protectionism are rising increasingly. Objectively speaking, the traditional liberal laissez-faire of globalization should be brought to a halt. The two financial crises have long confirmed that the risk of financial globalization is greatly underestimated. Countries need a buffer to cushion the blow of external financial market. However, it is unrealistic to return to a world of isolation and separation, which would result in the hindrance of communication and loss of vitality.

An alternative approach is to build a “door.” The idea is that all foreign trade must come through the door — the door is open, but there still exists a barrier. Compared with a door, a “wall” blocks out all transactions.

The idea of having a door has three significant advantages. First, the existence of the door ensures that the government can always monitor the flow of capital. It differs from setting up a wall as it legitimizes capital flow and ensuring people have no incentive to illegally do so. Second, having a door gives the state power to shut the door in a crisis. For example, strengthening capital control is necessary in the event of large-scale capital flight. Many countries implemented measures of capital control when hit by the financial crises in 2008. These countries include developing countries such as South Korea, Brazil, India, Mexico, South Africa, Russia and Poland, as well as developed countries such as France and Germany. Of course, a “closing the door” strategy should be only temporary. Third, the door gives clearer signals to the public. During a crisis, simply closing the door sends the signal to the public that everything is temporary and in turn could inflict less panic in the market.

To open up the financial industry, new strategies must be in line with new circumstances. The opening-up of the financial industry must be done by the building of a door. Meanwhile, China must lay down clear guidelines and specific practices, making sure that the market and financial institutions understand the intention of the government so as to achieve effective interaction between the market and regulatory authorities.

He Fan is a professor of economics at the HSBC Business School, Peking University, and executive director of the Research Institute of Maritime Silk Road (RIMS). Zhu He is a postdoctoral research fellow at HSBC Business School, Peking University. Li Chaohui is a research assistant of RIMS and an undergraduate at Peking University.

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