Financial openness will play a far more important role in the country's economic growth and stability in the next decade

One of the most contentious issues between China and Western countries, especially the United States, is the opening up of China's financial sector and revaluation of the renminbi. Western countries have urged China to open up its financial sector further, while China is cautious about the effects of financial liberalization.

China has enough reasons to be cautious. Even people very optimistic about financial openness cannot deny that, despite increasing national wealth in the long run, it could cause instability or even economic and political crises and thus harm economic growth in the short term. There is as yet no empirical evidence to support a robust relationship between financial openness and economic growth.

Financial openness is widely believed to lead to increased national wealth, and financially open countries have reaped many benefits. Financial openness has helped countries to promote free flow of international capital and thus allocate their resources more efficiently and with a higher degree of risk diversification. This has led some scholars to suggest that government policies aimed at further liberalizing the international financial market and making the financial system more efficient have a positive impact on economic growth.

Financial openness, however, poses a risk to national income. The effects of financial openness really depend on local conditions and institutions, and the results are not always positive. Large amounts of capital inflow and outflow in a very short term usually cause sharp changes in a currency's value and, therefore, create a high degree of uncertainty about returns on investment, which would harm investments and trade.

But financial openness seems to be an inevitable trend of globalization, no matter it is welcomed or not. Developed countries, such as the US, Canada, Germany and Japan, opened up their financial sectors in the 1950s, while many developing countries, including some in East Asia and South America, have gradually embarked on the path of financial openness since the 1970s.

Some countries have benefited from financial liberalization while some others have not. The problems many Southeast Asian economies encountered during the Asian financial crisis in the late 1990s are often attributed to capital market openness.

Then what about financial openness in China? China introduced financial openness policies in 1979. Before the introduction of market-oriented reforms, China's capital account had been tightly controlled. In fact, China had almost no cross-border capital flow. During the reform period, the Chinese government carefully and gradually liberalized capital controls, and achieved remarkable economic growth.

After entering the World Trade Organization on Dec 11, 2001, China agreed to take a series of measures to open up and liberalize its financial sector. Since then, it has made substantial progress in financial openness, further liberalizing its financial sector after a five-year transition period in 2006. After the global financial crisis broke out, China expedited the process of the renminbi's internationalization, which requires it to open its financial sector further.

Nevertheless, the process of financial openness is far from complete. In some capital account items, such as inward foreign direct investment, capital flows are rather free. In most of them, however, the control over capital account is still rather tight, particularly in three areas.

First, securities markets are divided among domestic and international investors. Foreign investors are allowed only to buy foreign currency denominated shares and debt instruments, such as B shares, H shares and red-chip stocks. But they cannot buy A shares, bonds or other money market instruments, unless they have Qualified Foreign Institutional Investor quotas. (B shares are US- or HK-dollar-denominated shares issued by Chinese companies in Shanghai and Shenzhen, H shares are Chinese companies' shares listed on Hong Kong Stock Exchange, and A shares are renminbi-denominated Chinese companies' shares listed on Shanghai and Shenzhen stock exchanges.)

Besides, Chinese residents are largely prohibited from buying, selling or issuing capital or money market instruments in overseas markets that are not part of the Qualified Domestic Institutional Investor scheme.

Second, while foreign-funded enterprises are free from restrictions to raise short- or long-term debts in overseas markets, other domestic entities need to qualify as main borrowers and have their proposed borrowing quotas and terms approved by the authorities before doing so. Also, domestic financial institutions can issue only external loans in line with certain provisions of foreign exchange liability/asset ratio management, and domestic non-financial enterprises are debarred from extending any external loans.

Third, no restrictions, except industrial policies, are imposed on direct investment by foreign entities in China, while for outward direct investment, domestic entities need to get the approval of the State Administration of Foreign Exchange, the Ministry of Finance and the National Development and Reform Commission.

Compared with many developing countries, China's gradual process of financial openness has been relatively slow. In fact, the problems that have emerged because of the gradual progress have led to several economic consequences both at the macro and micro levels.

First, although the relatively closed financial system didn't seriously jeopardize China's growth in the early years, it increasingly became a burden in later years. Second, the relatively closed financial system discourages the development of financial institutions and instruments, and thus impedes the efficiency of the financial system. And third, the lack of effective and efficient investment channels has prevented Chinese people's high savings from being utilized efficiently. This has fuelled prices in the real estate, while most private companies face high financing cost and strong financial constraints, which has hurt business innovation to some extent.

In conclusion, China's financial system and financial institutions are facing an increasing number of challenges. So it is fair to say that in the next decade, financial openness will be critical to China's economic growth and stability.

The author is assistant professor of finance, Nottingham University Business School, China.

(China Daily 04/20/2013 page11)