Financial Reform and Economic Development in China
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Financial Reform and Economic Development in China

James Laurenceson and Joseph C.H. Chai

This book is a comprehensive, balanced and realistic assessment of China’s financial reform program and future direction. Covering not only the banking sector but also non-bank financial institutions, stock market development and external financial liberalization, the authors examine the impact of financial reform on economic development in China during the reform period. This volume will facilitate a more accurate assessment of the Chinese approach to financial reform, and will therefore, allow more informed future policy choices for both China and other developing and transitional countries.
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Chapter 7: External Financial Liberalization in China

James Laurenceson and Joseph C.H. Chai


7. External financial liberalization in China INTRODUCTION The previous chapters have dealt almost exclusively with issues relating to domestic financial reform in China. However, financial reform also has an external element. External financial liberalization (EFL), the topic of this chapter, can be defined as the removal of barriers to the free flow of capital between countries (Eichengreen et al., 1998, p. 2). At least in theory, economists have traditionally looked upon EFL as a means to promote economic development and maximize national wealth (Makin, 1994, p. 93). This is for two primary reasons. First, access to foreign capital can promote domestic growth by allowing a country to invest more than its saves, or import more than it exports. Second, it can increase the efficiency of investment by allowing funds to reach those projects that offer the highest rate of expected return on an international scale. However, the experience of numerous developing countries has shown that these benefits do not come automatically. As once again evidenced by the Asian crisis in 1997, far from being growth inducing, EFL has frequently coincided with an unsustainable increase in foreign debt and domestic consumption, a rash of unproductive investment and sharp fluctuations in exchange rates, equity indices and asset prices (Diaz-Alenjandro, 1985; McKinnon and Pill, 1996). A modeling exercise conducted by McKibbin and Tang (2000) sought to gauge the consequences of China undertaking rapid EFL. The model’s predictions depended crucially on the assumptions made regarding investor confidence. When EFL coincided...

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