José Antonio Ocampo and Kevin P. Gallagher
José Antonio Ocampo is a professor and Member of the Committee on Global Thought at Columbia University. Kevin P. Gallagher is a co-director of the Global Economic Governance Initiative at Boston University’s Pardee School for Global Studies and a regular Triple Crisis contributor. This is an excerpt from an article originally published at Project Syndicate. The full article can be read here.
As China’s economy starts to slow, following decades of spectacular growth, the government will increasingly be exposed to the siren song of capital-account liberalization. This option might initially appear attractive, particularly given the Chinese government’s desire to internationalize the renminbi. But appearances can deceive.
A new report argues that the Chinese authorities should be skeptical about capital-account liberalization. Drawing lessons from the recent experiences of other emerging countries, the report concludes that China should adopt a carefully sequenced and cautious approach when exposing its economy to the caprices of global capital flows.
The common thread to be found in the recent history of emerging economies – beginning in Latin America and running through East Asia and Central and Eastern Europe – is that capital flows are strongly pro-cyclical, and are the biggest single cause of financial instability. Domestic financial instability, associated with liberalization, also has a large impact on economic performance, as does the lack of control over non-bank financial intermediaries – an issue that China is now starting to face as the shadow banking sector’s contribution to credit growth becomes more pronounced.
Most academic research also supports the view that financial and capital-account liberalization should be undertaken warily, and that it should be accompanied by stronger domestic financial regulation. In the case of capital flows, this means retaining capital-account regulations as an essential tool of macroeconomic policy.
Indeed, during the 1990s, China – and also India – taught the rest of the developing world the importance of gradual liberalization. It was a lesson that many countries fully learned only in the wake of the economic and financial crises that began in East Asia in 1997, spread to Russia in 1998, and affected most of the emerging world. By maintaining strong capital-account regulation, China avoided the contagion.
Even the International Monetary Fund, in late 2012, adopted a cautious approach. The IMF now recognizes that capital-account liberalization comes with risks as well as benefits, and that “liberalization needs to be well planned, timed, and sequenced in order to ensure that its benefits outweigh the costs.” Moreover, the Fund now regards capital-account regulations as part of the broader menu of macro-prudential measures that countries should be free to use to prevent economic and financial instability.
To the extent that capital-account volatility is the major pro-cyclical financial shock in emerging economies, regulation should be the major macro-prudential instrument used to counter it. These regulations should complement, not substitute for, other countercyclical macroeconomic policies. The IMF recommends giving higher priority to those other policies, whereas we have previously recommended using them and capital-account regulations simultaneously.
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