Capital Account Liberalization, Currency Float, and Twin Crises
After the collapse of the Bretton Woods system in early 1970s, a new breed of financial crisis emerged. Three quarters of the IMF’s member countries suffered some form of banking crisis between 1980 and 1996, and their study did not include the subsequent Asian financial crisis in 1997. In many of these crises, banking panics in the traditional sense were avoided either by central bank intervention or by explicit or implicit government guarantees. But the advent of financial liberalization in many economies in the 1980s, in which free capital in- and out-flows and the entrance and competition from foreign investors and financial institutions follow in the home country, has often led to “twin” banking and currency crises. A common precursor to these crises was financial liberalization and significant credit expansion and subsequent stock market crashes and banking crises. In emerging markets this is often then accompanied by an exchange rate crisis as governments choose between lowering interest rates to ease the banking crises or raising them to defend the home currency. Finally, a significant fall in output occurs and the economies enter recessions.
The entrance of China to the WTO (World Trade Organization) potentially introduces cheap foreign capital and technology, but large scale and sudden capital flows and foreign speculation significantly increase the likelihood of a twin crisis. The first key question is, when and to what extent should a country open its capital account and financial sector to foreign capital and foreign financial institutions? The prevailing view is that success or failure of this policy hinges on the efficiency of domestic financial institutions, while others have promoted reforming the financial sector as a precondition to liberalizing. This latter view assumes that financial liberalization does not alter the efficiency of domestic financial institutions. But this policy change affects both the supply and price of capital, two important determinants of lending contracts. A model of endogenous financial intermediation demonstrates that an efficient financial sector prior to liberalization is neither necessary nor sufficient for a successful financial liberalization. Read more
Financial Crises
Financial crises often accompany the development of a financial system. Conventional wisdom says that financial crises are bad. Often they are very bad, as they disrupt production and lower social welfare as in the Great Depression in the US. Hoggarth et al. (2002) carefully measure the costs of a wide range of recent financial crises and find that these costs are on average roughly 15-20 percent of GDP. It is these large costs that make policymakers so averse to financial crises.
It is important to point out, however, that financial crises may be welfare improving for an economy. One possible example is the late nineteenth century US, which experienced many crises but at the same time had a high long run growth rate. In fact, Ranciere et al. (2003) report an empirical observation that countries which have experienced occasional crises have grown on average faster than countries without crises. They develop an endogenous growth model and show theoretically that an economy may be able to attain higher growth when firms are encouraged by a limited bailout policy to take more credit risk in the form of currency mismatch, even though the country may experience occasional crises (see Allen and Oura (2004) for a review of the growth and crises literature and Allen and Gale (2004a) who show that crises can be optimal).
In this section, we consider financial crises in China. Given China’s current situation with limited currency mismatches any crisis that occurs is likely to be a classic banking, currency or twin crisis. It is perhaps more likely to be of the damaging type that disrupts the economy and social stability than of the more benign type that aids growth. The desirability of preventing crises thus needs to be taken into account when considering reforms of China’s financial system. First, we examine how China can prevent traditional financial crises, including a banking sector crisis and a stock market or real estate crisis/crash. We then discuss how China should be better prepared for new types of financial crises, such as the “twin crises” (simultaneous foreign exchange and banking/stock market crises) that occurred in many Asian economies in the late 1990s.
Stock Exchanges and Market Inefficiencies in China
Since the inception of China’s domestic stock exchanges, the SHSE and SZSE, in 1990, they have been growing very fast. At the end of 2005, HKSE was ranked 8th among the largest stock exchanges in the world, with the total capitalization reaching roughly half of GDP. Despite the fast growth of the markets, however, their efficiency still leaves much to be desired. The inefficiencies from the political decisions of protectionism, poor regulation and intermediation, result in problems of adverse selection among firms seeking an initial public offering (IPO), and a moral hazard problem among already listed firms.
Firstly, even though there has never been any explicit regulation or law against the listing of non-state owned firms, the going public process strongly favors former SOEs with connections with government officials. For example, each candidate firm must obtain listing quota/permission, disclose financial and accounting information, and is subject to a lengthy evaluation process; the whole process is inefficient due to bureaucracy, fraudulent disclosure, and lack of independent auditing. As a result, most of the listed firms are indeed former SOEs. Secondly, once listed, managers in firms with severe agency problems do not have an incentive to manage assets to grow, but rather to rely on the external capital market to raise funds (mainly through mergers and acquisitions, and seasoned offerings of securities) to pursue private benefits. These problems can nicely be seen in the following case study. Read more
Brief Overview of China’s Financial System
Prior to 1949, the financial system of China was very well developed. The earliest form of capitalism can be seen at the times of the late Ming Dynasty (17th century), when commerce was initiated in the Zhejiang-Jiangsu area and further developed during the Qing Dynasty (17th century to early 20th century). Late Qing China had a highly commercialized society with detailed regulations of guilds (merchant coalitions), where the key role was played by family traditions and customs. In Section IV below, it will be shown that modern equivalents of these mechanisms were behind the success of Hybrid Sector firms in the same areas in the 1980s and 1990s.
The development of China’s financial system from the late nineteenth century to the early twentieth century was highlighted by the emergence of Shanghai as the financial center of China and Asia. During this period, Shanghai transformed from an agricultural-based trading hub for surrounding areas into an industrialized center linked to international goods and financial markets. With thriving entrepreneurial and trading activities, various financial institutions were given life. For example, five of China’s first modern banks were founded between 1897 and 1908; and by 1936, there were 28 major foreign banks that had set up branches in Shanghai. Read more
