Cons of deregulating finance

Updated: 2013-08-06 10:06

By Kevin P. Gallagher (China Daily)

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Capital flight would also jeopardize China's exchange rate reform, which has deepened over the past two years. Exchange rate reform has made the yuan appreciate significantly, with estimates of yuan appreciation now at 35-50 percent.

Capital flight could cause a major depreciation of the yuan, which, in turn, could hurt consumers by further weakening their purchasing power, and stall reform.

China will also need to continue financial regulatory reform. The country's big banks are still indirectly responsible for large amounts of non-performing loans and are increasingly intertwined with a shadow banking system that is not properly regulated.

These banks need serious reform - or they will not be able to compete with international financial companies on liberalization.

The global record is clear: When Latin America prematurely opened its doors to foreign finance in the 1990s domestic banks got wiped out. Next, the new dominant players in the market - foreign banks - didn't lend to domestic enterprises with innovative new ideas. That undermined growth and economic transformation. The result has been anemic investment rates, de-industrialization and very little inclusive growth.

The International Monetary Fund's own (and other) studies show that capital flows are susceptible to massive surges and sudden stops. These trends have only intensified since the global financial crisis.

For a while, there was a surge in capital flows into emerging markets because of low interest rates in the industrialized world, which made things look good. But now that the US Federal Reserve has hinted that its bond buying programs would slow down, capital is fleeing from emerging market economies.

But even before that change in trend occurred, things were more bubbly than rosy. During the 2009-2013 period, when capital flowed in, exchange rates appreciated. That hurt export prospects and created asset bubbles. Now that exchange rates are falling, all those loans from the credit bubble are more expensive because they are denominated in US dollars.

China's ambitions aside, the fundamental economic lesson is clear: Regulating capital flows is essential for the exchange rate to fluctuate relative to economic fundamentals - rather than the irrational whims of speculative finance.

Indeed, there is now a consensus among economists and international financial institutions that capital account liberalization is not associated with economic growth in emerging markets, and that it causes banking crises (especially in countries with fixed exchange rates).

Such evidence has even prompted the IMF - the very institution that once saw rapid capital account liberalization as top priority - to change its tune. It now officially recommends the cautious sequencing of capital account liberalization.

China should remember with pride that it was not as severely hit by the financial crises of the 1980s and 1990s in Latin America and East Asia. These were crises where capital account liberalization played a big role. Large countries such as Indonesia were set back by as much as a decade. Why did China not suffer as much? Because it prudently regulated cross-border capital flows.

If China does not proceed with great caution now, few countries can weather a financial crisis that hits China. Across the world, we are reliant on China for trade, investment and finance. Simply put, China is too big to fail.

Thus, it is in the interests of the US and the rest of the world to urge China not to deregulate its financial system - but most of all, it is in China's own interest.

The author is a professor of international relations at Boston University and a regular contributor to The Globalist.

The Globalist

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