1. FINANCIAL LIBERALIZATION, CRISIS, AND RESCUE: Lessons for China from Latin America and East Asia

2. Aims of Presentation Introduction Challenges facing China’s financial sector Financial liberalization trends: LA and EA Liberalization and crisis Rescue costs Lessons for China

3. Introduction Liberalization has transformed financial system in developing countries -- Strengthened role of private sector and market forces in decision making -- Resulted in crises and need for rescues -- Created new government role and increased foreign ownership

4. China’s Financial Sector People’s Bank of China Policy banks State-owned commercial banks (“Big 4”) Publicly-listed commercial banks Non-bank financial institutions Securities markets

5. China’s Successes Rapid growth over several decades Strong external accounts, including large volume of reserves Stability in face of Asian Crisis

6. China’s Challenges Clean up NPLs and raise capital ratios in banking sector Improve regulation and supervision, corporate governance Continue liberalization of financial sector (domestic and international) without crisis

7. Financial Liberalization Trends Definition of liberalization, WB Index Almost all countries have liberalized domestic financial sector LA has been eager, but volatile EA has moved more gradually

9. Policies Accompanying Liberalization Macroeconomic management Prudential regulation and supervision Capital account opening Institutional development

10. Liberalization and Crisis (1) Theoretical insights in recent literature -- New explanations for crises (internal oriented, external oriented) -- Twin crises -- Correlation between liberalization and twin crises

11. Liberalization and Crisis (2) Twin crises in LA and EA (Chile, Mexico, Argentina; Thailand, Korea, Malaysia, Indonesia) Typical “syndrome” -- Liberalization and privatization -- Lending boom, ignoring loan quality -- Macroeconomic policies leading to capital inflows, overvaluation, debt build-up -- Twin crisis

12. Liberalization and Crisis (3) Not all countries have suffered twin crises -- Governments took early measures (Brazil, Philippines) -- Countries received less private capital inflows (Peru, Philippines) -- Other types of crisis (Colombia, Venezuela, Taiwan)

13. Rescue (1) Four rescue mechanisms commonly used -- Assistance to increase liquidity -- Assistance to raise capital ratios -- Removal of bad loans -- Take-over or closing of banks Details matter for outcomes

14. Rescue (2) Crises and rescues are very costly -- Fiscal outlays are high -- GDP losses are steep -- Other costs add to burden

16. Rescue (3) Costs of crises linger for years -- Slower GDP growth -- Lower investment ratios -- Lack of credit availability

18. Lessons for China (1) Gradual domestic liberalization preferable -- Importance not clear in LA and EA, but Chinese banks lack experience -- Clean up NPLs, increase capital ratios -- Generally improve capacity of financial institutions to meet new challenges before full liberalization

19. Lessons for China (2) Policies accompanying liberalization must be selected with care -- Real macro stability before liberalization -- Strong prudential regulation and supervision before liberalization -- Partial capital account opening after liberalization and adjustment

20. Lessons for China (3) Institutions must be strengthened to support liberalized system -- Rule of law, judicial system -- Ministry of finance, central bank, regulatory agencies, credit bureaus Improving institutions takes time, furthering argument for gradual approach

21. Conclusions China has opted for a market economy Financial sector is a crucial component May be some role for public-sector banks But main component of financial sector must be autonomous banks that operate in stable, self-sustaining manner