The False Promise of Financial Liberalization

But financial decentralization extends beyond interest rate liberalization.

Financial markets did well through capital market liberalization.

E. The international environment Financial liberalization and capital flows

Indeed, equating financial liberalization with privileges for cities designated as financial centers undermines the very goals of liberalization namely, to reduce government control and to accelerate the development of financial markets.

Financial reforms should top the agenda, beginning with interest rate liberalization.

Failing this, China must postpone full liberalization of its financial markets.

Financial liberalization was sold as a commitment to follow market friendly policies.

Financial liberalization is not about foreign firms drilling holes in China s economy.

Then financial liberalization could proceed with market interest rates remaining at normal levels.

On the contrary, policymakers should tread carefully in their pursuit of financial liberalization.

First, countries should be cautious about external financial liberalization when financial sector development and institutional quality are below key thresholds.

History is littered with financial crises occurring in the wake of precipitous capital account liberalization.

This process is determined by rules of supply and demand, price, investment and financial transaction liberalization.

Indeed, the need to pursue financial liberalization to maintain growth is a central reason why middle income countries are so prone to financial crises.

A significant contributory factor underlying the financial crises was the premature liberalization of capital accounts in many countries.

With the liberalization of global financial markets that began in the 1970 s, foreign sources of credit became available.

And there is now a common understanding in China that meeting this objective requires that the government safeguard financial liberalization.

But it is time to go further and begin to lobby aggressively for faster financial liberalization in the developing world.

International financial liberalization, for example, has undermined the use of more inclusive and targeted developmental credit to promote desired economic activities.

Financial liberalization would attract foreign capital seeking high returns in capital scarce countries, allowing them to invest more than they saved.

With liberalization in the mid 1990s, OFDI began to take off, only to be stymied again by the 1997 financial crisis.

The first is that capital market liberalization opening up developing countries financial markets to surges in short term hot money is dangerous.

But, while it does sometimes appear that the current crisis is due, at least in part, to financial innovation, financial market liberalization has been shown to be a good thing overall.

Given all the effort that the world s emerging markets have devoted to shielding themselves from financial volatility, they have reason to ask where in the world is the upside of financial liberalization?

Are these skeptics right? Should we halt financial liberalization and innovation in order to prevent crises like the sub prime disaster from recurring?

Interest rate liberalization together with other financial reforms would help to improve the efficiency of capital allocation and to optimize the economic structure.

These were off the agenda in earlier trade rounds, as the US pushed for liberalization of financial services thus serving its own comparative advantage.

What China needs most is a financial sector capable of harnessing the forces of liberalization and globalization to drive economic growth in the decades ahead.

The latter, in turn, provides strong incentives for countries to address institutional shortcomings so that they can reap the potential benefits of external financial liberalization.

With increasing recognition of the causal relationship between finance and growth, in all regions, liberalization of the domestic financial sector has proceeded, in varying degrees.

Financial deregulation in the United States was a prime cause of the global crisis that erupted in 2008, and financial and capital market liberalization elsewhere helped spread that made in the USA trauma around the world.

But greater political liberalization is unlikely in the short or medium term. Cuba s government argues that America s financial and political support for the opposition impedes that.

But China slowed capital account liberalization after the Asian financial crisis ten years ago, so it is possible that America s troubles could make China more cautious.

As in other episodes of financial crisis and currency turmoil, the crisis in East Asia was preceded by financial liberalization and deregulation which, in some cases, constituted a major break with past practice (UNCTAD, 1998 53 77).

SMEs and households with net savings stand to gain the most from interest rate liberalization. But financial repression s winners commercial banks and SOEs will face new challenges.

When capital flight forced François Mitterrand to abort his program in 1983, France s Socialists performed an abrupt volte face and embraced financial liberalization on a global scale.

Only fire breathing free market advocates, seemingly oblivious to the fact that China s shaky financial system cannot survive liberalization overnight, are calling for an extreme version of floating.

So what is to be done? It will be hard to reverse financial liberalization, but its negative side effects including greater systemic risk require a series of reforms.

Both had resisted capital market liberalization.

Those policies should include trade liberalization.

C. Trade liberalization and poverty reduction

Instead of stable guidelines with a well defined monetary (exchange rate) anchor and a firm mandate to complete financial liberalization, China s macroeconomic and financial decision making will be ad hoc and anybody s guess as was true, and still is, for Japan.

This challenges the Washington Consensus, with its one size fits all formula of privatization, deregulated labor markets, financial liberalization, international economic integration, and macroeconomic stability based on low inflation.

Does the sequencing of trade liberalization matter?