1a.Introduction to China's Growth Engine

China's phenomenal average annual growth rate of 9.8 percent for the last three decades can rightfully be described as a “seismic outer space observable event worth noting” (Davies & Quah, 2008). This unprecedented growth has improved the living standards of millions of Chinese people whilst maintaining inflation at an average of 2 percent and achieving per capita GDP of 8.5 percent for the period 1978-2005 (Li, 2009). The Chinese economy has transformed from a centrally planned system whereby it was largely closed to international trade, to a more market-oriented economy with a rapidly growing private sector and progressive moves to becoming the world's leading economic powerhouse.

The country has shown incredible resilience towards the global financial crisis, churning out an economic growth rate of 9.6 percent whilst Western economies continued to brawl an economic downturn (Statistics, 2009). Chinese bankers argued that the strict regulations on capital movements “meant that the contagion spreading across the rest of the world's financial markets had little impact on the world's most populous country” (Koenig P, 2007). However, in due course, the global financial crisis engulfed emerging markets through trade channels as the recession tremendously lowered demand for emerging market exports. The crisis manifested China through a 25.7 percent year-on-year fall in exports, seven months of consecutive lapse in FDI inflows which plummeted 22.5 percent and an estimated 3 percent cut in GDP growth (Roubini, Bilodeau, & Steinberg, 2009). These are alarming statistics for a country who claims its continued double-digit growth to have come from private sector expansion and huge state investment in infrastructure and heavy industry.

Since the 1970's China has adopted an export-led growth strategy such that today its export dependency is the highest amongst major world economies. Fixed asset investment (FAI) and exports are the predominate engines of China's growth which have attributed to staggering overcapacity and inefficiency. During the period 2002-2007 the average annual growth rate of exports was 29 percent

and 24 percent for FAI whereby their combined contributions to GDP growth was above 60 percent, thus emphasising their importance to China's growth (Yongding, 2009).

The persistently rising investment rate has meant that the growth of the Chinese economy is not in steady state as the investment rate cannot increase forever and exports cannot remain constantly higher than that of the global economy. The collapse of external demand threatens China's economy as the overheating that has resulted from strong investment and export demand could turn into overcapacity followed by sudden chances in inflation to deflation, as already witnessed in China during September to October 2008 (Stratfor, 2008).

This unbalanced growth has been achieved through China's exchange rate regime and monetary policy management which have been geared towards maintaining international competiveness' in the areas of manufactured goods and attracting foreign direct investment. These policy measures to foster exogenous economic growth have led to financial repression through their conflicting relationship with other macroeconomic objectives. The resulting government control in the banking sector has meant that non-performing loans are mushrooming, market forces are unable to prevail and corruption fills the air. Sustainable growth will only be achieved if essential reform strategies are implemented to enforce endogenous growth whereby economic policy is orientated towards the domestic market. Furthermore, the most fundamental dynamic suffocating domestic consumption is the principle structure of the Chinese financial system that threatens future growth and stability.

China is treading on thin ice whereby investment-driven and export-led growth is not sustainable; it is a shame that it has taken the global financial crisis to expose the vulnerability of China's growth strategy as well as highlight the fatal and detrimental effects it has had on the development of China's financial systems (Yongding, 2009).

The remainder of this essay is organised as follows. Section 1 introduces China's domestic financial system, which, upon analysis is found to be financially repressed due to export-led growth and political control. Section 2 suggests an alternative growth strategy by analysing endogenous growth theories, whereby, we find financial development and financial liberalization to have a positive correlation with economic growth. Section 3 proposes a liberalization framework for China which is based upon cross-country analysis of financially liberalized economies. The main areas of proposition include: banking and regulation, exchange rate, long term capital flows and the derivatives market. Section 4 analyses the future impact the global financial crisis will have on China's economy. This section concludes that China's capital controls and communist market structures stand as double- edged swords. As although China's was able to shield itself from the immediate effects of the crisis, these very walls will be the reason China suffers from a self-inflicted crisis if it fails to reform its economic structures in light of increasing global pressure. Section 5 concludes the findings and suggestions.

1b.The Current State of China's Domestic Financial System

Since the introduction of financial sector reform in 1979, China has made eye-catching progress in developing its financial markets. Key outcomes include the full convertibility of the renminbi (RMB) on the current account and the removal of quantitative and regulatory restrictions on the use of foreign exchange for current account transactions. Market-orientated transformations have taken place whereby its foreign exchange controls have been relaxed, the unification of the dual exchange rates has occurred and the implementation of a managed floating exchange rate regime (Xiaopu, 2003). Despite continued efforts to liberalize its financial sector, China still maintains restrictions on the capital account which include quantitative and regulatory controls on exchange between the RMB and foreign currencies as well as cross-border capital flows (Xiaopu, 2003).

China's financial system is dominated by its banking sector to an unusual and unhealthy extent, which itself is dominated by four major state owned banks, namely Bank Of China, Agricultural Bank of China, the Industrial and Commercial Bank of China and China Construction Bank. Consequently, China's banking system is one of the largest in the world whereby bank loans account for almost 75 percent of all sources of domestic finance and the remainder made up by government bonds, corporate bonds and equity. These banks account for over half of banking assets and an astounding amount of bad loans, which is estimated to be in the region of 40 percent of total outstanding loans (Chen, 2006). There are many fundamental and institutional problems within China's financial sector, with a bulk of them stemming from this framework.

The banking system has a complicated relationship with state owned enterprises (SOEs) whereby biased lending practises have created a large number of non-performing loans (NPLs). Recent studies revealed that NPLs have been growing at a rate of $150 billion per year since 2000, whereby the current value of NPLs ranges widely from $410 to $815 billion (due to incomplete and unreliable official statistics) (Chen, 2006). The continuous growth of NPLs, despite much effort from Chinese

authorities to sterilise bad loans, is an illustration of the poor governance structures, rent-seeking inclination, irrational lending behaviours and overall corruption in Chinese banks.

China's banking system has not developed as much as expected in spite of World Trade Organisation commitments to opening the Chinese financial sectors (Kwon, 2007). Foreign banks still find it quite difficult to make much of an impact on Chinese markets, in particular the RMB market in overseas currency lending where foreign banks are insignificant, currently there are 24 foreign bank subsidiaries in China with 190 branches (Davies & Quah, 2008).

To add, banks are subjected to many administrated controls which have had perverse consequences for the financial system and the economy in general. Nicholas Lardy has argued that, the way in which the Peoples Bank has administered interest rates has majorly impacted the distribution of income and wealth in China in terms of the household/banking/government sectors. Chinese households are burdened with the hefty cost of China's investment-led boom whereby they are essentially forced to subsidise low cost capital for producers and SOEs as well as protecting banks from the effects of economically non-viable policy loans (Pettis, 2009). In 2002 Peoples Bank fixed the ceiling interest payments it could pay on site deposits at 0.72 percent, a rate that remained unchanged until 2008, which at the time didn't seem a problem as inflation measured by CPI was negative. However inflation crept up to almost 8 percent in early 2008 which meant that the real rate of return on demand deposits went from a positive 1 percent to a negative 7 percent during the period. One can argue this as an implicit tax on households as they are the largest net depositors in the banking system. Despite such negative returns, Chinese citizens continue to deposit in these banks due to an underdeveloped and unbalanced financial system. The capital account restrictions have limited investment alternatives such that the opportunity to invest in safe havens and other financial assets are non-existent. The daunting reality of the situation is that as households have been

receiving the 2002 interest rate for the past 6 years; their income this year would have been higher by an estimated 4 percent of GDP which is a substantial amount. Furthermore this implicit tax is more than 3 times the proceeds of the personal income tax imposed on households in China (Davies & Quah, 2008).

Restrictions on foreign investor ownership of Chinese banks and state control dominating the banking sector, interest rate regulation and credit policy has lead to the substandard performance of the banking sector (Lynn, 2009). Consequently market forces are unable to prevail as banks are run by politicians and bureaucrats rather than banking professionals and credit is allocated according to political considerations. Such high barriers of entry and exit have limited new ideas and capabilities to arise regarding bank management, product and market reach. “China's banks are badly organised, and under government directions; human capital, operational precedes and information systems are all outdated” (Bai C. E., 2006). The fundamental problem lies with the fact that China's financial sector has been geared towards supporting international economic policies as opposed to the domestic economy. Ultimately taut restrictions over the banking system have prevented capital flows such that the government maintains full control over fluctuations in the RMB.

1c. The Analysis - A Financially Repressed Economy:

The Rational and Future Growth

The analysis of China's financial structures suggests that Chinese authorities have once again ignited the flame of a domestic financial repression.

Financial repression defined in this essay as: the low and now negative real return on deposits as evident from the households' point of view.

The root cause of this problem extends from China's export led growth strategy coupled with its exchange rate mechanism. Initially China maintained a fixed nominal exchange rate to the US dollar and thereafter in 2005 it decided to control the pace of the RMB appreciation which has lead to extensive government intervention in the areas of monetary policy, exchange rate and capital account management.

As exports led to massive sales of domestic currency due to outsized increases in domestic money demand, government intervention, to sustain China's undervalued exchange rate, has taken place in the form of PBCs - China's central bank - decision to increase the bank required reserve ratio 22 times since 2002, which has taken the rate from 6 to 16.5 percent (Poon & Batson, 2010). This has compelled banks to deposit an addition of RMB 5.2 trillion to the central bank and has led to the acceleration of official foreign exchange reserves which stood at $2.399 trillion at the beginning of 2010 (Yaguang, 2010). Clearly financial underdevelopment in China has led to global imbalances which to a large extent has been a major contributor to the 2008 global financial turmoil.

This key instrument coupled with the sale of large quantities of central bank bills to banks is essentially a sterilisation mechanism to curb increases in the value of the RMB, domestic money supply and thus inflation.

According to extensions of the McKinnon-Shaw framework , this has imposed a tax on Chinese banks as the nominal rate of return “banks receive on both reserves and central bank bills in China are below the nominal interest rate that banks would have received if they loaned these funds to consumers” (Lardy, 2008). It also hinders long term growth as these funds can no longer be channelled into increased bank lending to finance productive private sector investment and for any given loan rate it reduces the competitive deposit rate of interest, thereby reducing money demand, in addition to undermining the incentive of bank managers to improve the performance of their institution (Fry, 1993). Consequently the resulting smaller real size of the banking system implies less bank lending in real terms.

The economic rationale behind this repression can be explained using theories of financial development before 1973 which still apply today. James Tobin (1965) linked financial conditions and economic growth to Robert Solow's (1956) neoclassical growth model, whereby the classical assumptions of Solow's model remain of considerable importance, such that this enabled the analysis to “focus on the effects of financial conditions on the level of income and the short run growth rate” (Fry, 1993). In this model, households assign their wealth amongst money and productive capital assets. When the rate of return to capital is higher relative to money, household portfolios are dominated by capital investments whereby this results in a higher capital/labour ratio, higher labour productivity and thus greater income per capita. Consequently the transition from a low to high capital/labour ratio induces an acceleration of the real rate of economic growth and hence, according to this model, reducing the rate of return on money increases welfare. This model is a mirror representation of China's manipulated repressed financial system as reflected by the PBCs decision of fixed interest ceilings on demand deposits at 0.72 percent. At the same time returns to investment capital in China stood at approximately 21 percent in 2007 and more recently the

Chinese Government has urged private citizens to invest in huge programs to develop its infrastructure and domestic mining industry (Bai, Hsieh, & Qian, 2008) (Badiali, 2009). Its strategy is further aided by China's current account openness and fully liberalized FDI inflows.

These repressed interest rates on demand deposits have essentially allowed Chinese banks to offer loans at artificially low rates to inefficient SOEs as these SOEs play a crucial role in linking Chinese banks to the market and generating employment opportunities. However, due to the lack of competitive pressures and poor regulations these loans continue to sour which has led to surges in NPLs and threats of followed up surges as a result of the $586 billion stimulus package in response to the 2008 financial crisis and rapid bank leading; these being the more compelling reasons for the need for China's banks to raise equity capital this year (Pettis, 2009).

Fry (1973), Giovannini and de Melo (1993) and Nichols (1974) all put forward the economic rationale of imposing loan rate ceilings in order to finance debt. They argue that public sector deficits can be financed at a lower cost the more the private sector is crowded out from competing for available finance. This coincides with China's expected debt of as much as 40 percent of GDP for 2010 after taking into account of provincial dept, NPLs and last year's high public spending and low tax revenue (Orlik, 2009). Once again this undermines innovation and creative thinking as small/medium sized private enterprises are hindered from obtaining funds, such that investment is taking place in projects that might be unprofitable at the competitive free market equilibrium rate.

The implications of such policies are analysed in Robert King and Levine's (1993) general equilibrium model. They illustrate that increases in taxes on financial intermediaries lowers the equilibrium growth rate as this reduces the services provided by the financial system to savers, entrepreneurs, and producers which is also lowered by the imposition of credit ceilings whereby these distortions reduce the incentive individuals have to invest in innovative activity, thus impeding economic growth (King and Levine 1993b, 517).

China's financial repression has ultimately reduced the cost to the government of sterilised intervention to sustain China's undervalued exchange rate compared to the cost if interest rates were liberalized. But this repression, relaying back to the underlying reason that caused it, has in fact imposed substantial cost on China's economy. Artificial low interest rates have resulted in excess demand for money and increased use of quantitative targets to control credit growth, which in turn has led to inefficient allocation of capital and thus the creation of underground financial markets, which in itself adds substantial risk to the Chinese economy (Lardy, 2008). This brings our attention to question the contribution financial innovation can have on economic development as an integral component of economic activity and as an incentive to adopt an endogenous growth strategy.

2a.Future Growth: Endogenous Growth Theory and Financial Development

The adverse impact of unsuitable export-led growth aided by an undervalued exchange rate has not gone without notice by Chinese officials. In a press conference following the National People's Congress in March 2007 the Chinese Premier Wen Jiabao raised his concern about China's economic growth, describing it as “unsteady, unbalanced, uncoordinated and unsustainable” (Lardy, 2008). His critique focused on the fact that growth has become disproportionally dependent on investment spending and external surplus. Consumption as a proportion of GDP continues to fall due to insufficient pension provision, negative returns on bank deposits and the binding of borrowing and intertemporal budget constraints, as postulated by Irving Fisher, thus suppressing current and future income and therefore consumption. Collectively these propose a threat to China's increasing exposure to macroeconomic shocks, both internal and external, as a result of pure contagion spreading throughout global markets regardless of the level of economic integration. Although this contagion is hard to predict or quantify, it can be stopped easily by decisive policies so long as macroeconomic fundamentals are not permanently damaged, a problem that China already faces as a result of increasing income inequality, government controls and ill domestic citizen rights (Reisen, 2008).

Subsequently China needs to adopt an endogenous growth model whereby the theoretical underpinnings of this model try to overcome the savings rate and rate of technological progress that remain unexplained by the neo-classical exogenous growth models, namely the Harrod-Domar and Solow model. Endogenous growth theory surmounts these shortcomings by building macroeconomic models out of microeconomic foundations such that growth originates from the domestic economy. The birth of endogenous growth theories dates back to the mid-1980's but more recent developments have linked sophisticated financial intermediaries and developments in the financial sector to accelerated economic growth.

At present, economic literature on finance and economic growth can be classified into two main streams of research. The first of these is the more general approach which examines the effect of financial development and economic growth and the second being the more specific one; the impact of financial liberalization on economic growth. Much focus will be given to the latter whereby further disintegration will allow for a more accurate analysis (Ozdemir & Erbil, 2008). A summary of these findings are presented in table 1 below; detailed theoretical analysis can be found in appendix 1.

2aI . Table 1 - Summary of the key findings of endogenous financial growth theories

Author, Date and Study



Bagehot, Walter (1873): A Description of The Money Market

One of the earliest studies that focused on the banking sector and its effect on the economy using Lombard Street as the main example. He brought to our attention the significance of financial markets on economic growth.


Schumpeter, Joseph (1934): Theory of Economic Development

He expressed that the services provision by financial intermediaries are necessary for technological improvement and economic growth.


Kose, Prasad, Terrones (2008): Does Openness to International Financial Flows Raise Productivity Growth?

At a 5% significant level - capital account openness has a significant effect on total factor productivity growth. FE measure = 0.07373 [0.03545]

GMM measure = 0.15476 [0.06056]

Fixed Effect and System General Method of Movement Regressions

Aghion, Howitt & Mayer-Foulkes (2005): The Effect of Financial Developement on Convergence: Theory and Evidence

Study on financial development and economic convergence shows that financial development interacted with initial relative output significantly negatively (-0.0061) proving that convergence depends positively on financial development.

IV Estimation

Bekaert, Harvey & Lundblad (2003): Does Financial Liberalization Spur Growth?

Data from 95 countries from 1980-1997 is used to explore 3,5 and 7 year averages of the growth rate of real per capita gross domestic product. They find that the annual GDP growth rate is more than 1 percent higher in the post-liberalization period and a sharp difference in growth between fully liberalized countries and those not liberalized of approximately 2.2%

General Method of Movement Regression

Ranciere, Tornell & Westermann (2006): Decomposing the Effects of Financial Liberalization: Crises vs. Growth

Annual data shows the direct growth effect from financial liberalization using the de-jure index to be +1 percent and +1.1 percent for the de-facto index. Five year average growth data shows a +1.2 percent for the de-jure index and + 1.22 percent for the de-facto index.

Regression modelled according to the Aikaike Criterion

Bonfiglioli & Mendicino (2004): Financial Liberalization, Bank Crises and Growth: Assessing the Links

Using data for 95 countries from 1980 the study shows that equity market liberalization significantly affects growth positively. At 5 % significant GMM = 0.015 [0.002]

General Method of Movement Regression

Caporale, Peter & Soliman (2003): Endogenous Growth Modles and Stock Market Development: Evidence from Four Countries

Empirical evidence that supports the hypothesis that stock market development spurs economic growth through its impact on productivity investment

VAR estimations in line with Akaike and Schwartz information criteria

Levine Ross (2001): International Financial Liberalization and Economic Growth

Levine shows liberalising restrictions on foreign banks to spur economic growth through increased bank efficient as a direct result of foreign bank entry. At a 1% significant level - domestic bank efficiency was -0.034 [0.008] (measured by overhead cost/total assets) and after foreign bank entry this increased to -0.015 [0.005]

Weighted least Squares Pooling bank level data across 80 countries for the period 1988-955

On broad-bases, there is no shortage of econometric modelling and theoretical analysis from which a sound conclusion can be made about the importance of financial markets to economic growth. From the above analysis, contemporary evidence has shown financial liberalization to spur economic growth via financial sector development, improvements in institutions and better macroeconomic policies that primarily boost productivity growth. The biggest growth effect from financial systems is believed to come from efficient capital allocation. This is due to the removal of informational asymmetries, reductions in transaction costs, facilitated contracting and the mitigation of free-rider problems that arise from the establishment of competitive financial intermediaries. Thus, financial repression stands as a serious obstacle to the development of China's capital market; financial stability is a prerequisite for financial development if China is to foster endogenous growth through financial deepening and financial sector reform.

Subsequently, to foster financial stability China's financial architecture will need desperate upgrading. The principle concern for China lies with its weak domestic financial structures. A gradual approach to financial liberalization, coupled with stable macroeconomic growth and opening up to foreign competition and cross-border flows, will in the long term contribute to confidence in the banking system. Much progress is needed in overcoming the legacy of state ownership and bias credit allocation to SOE alongside the establishment of a robust legal and supervisory framework. “China needs a dose of market liberalism, not more financial morphine in the form of government bailouts of insolvent state-owned banks (SOBs)...trying to re-capitalize SOB is like trying to put out a fire with kerosene” (James, 2007). Maintaining macroeconomic stability and growth whilst at the same time improving allocative efficiency throughout the liberalization process will be the overarching reform objectives. Not only will financial liberalization rebalance China's growth, it will also allow for the reduction in global imbalances whereby better access for households to credit and savings instruments should enhance consumption and lower the high savings rate. The direction of the financial liberalization process must be a move towards establishing a real private competitive capital market—one in which profit-seeking entrepreneurs are the driving force.

3a.Capital Account Liberalization: Analytical Sequencing for China

I.Cross-country experience

From the analysis of the experience of a broad range of countries that have liberalized their capital account, we are able to find trends in common features that led to successful and unsuccessful financial liberalization. Success defined here is in the context of countries that avoided financial crisis which is the main risk associated with immature financial liberalization. This analysis is the foundation which the suggested sequencing of China's financial liberalization will be based upon. One must note that each of the countries were at different levels of economic development such that they took various approaches to the pace and sequencing of capital account liberalization. Thus, illustrating that there is no such rule or set procedure for the sequencing and co-ordination of capital account liberalization with other economic policies.

The general consensus reached is that no financial system, advanced or developing, will be entirely risk free. Market and credit risk are the major threats that reoccur throughout, therefore taking centre to which the sequencing of China's financial liberalization will be based around. Other areas of importance deemed to avoid financial crisis and consequently to be addressed are: the need for a robust prudential framework, macroeconomic balances, liberalization of long-term capital flows before short-term flows, an appropriate exchange rate regime in light of high capital mobility, the need for adequate international reserve requirements, foreign bank influence and currency hedging.

Ultimately we are trying to create a financial environment whereby China's financial institutions can intermediate without government interference, maintain threshold liquidity requirements and provide stable mechanisms for payments and settlements. The environment needs to reflect a market based economy such that price stability and confidence prevails over short periods.

II.China's Sequencing

The immediate removal of capital controls would be a disastrous strategy given the fact that in China household bank deposits are almost 60 percent of GDP. Given the opportunity, diversifying domestic savings-portfolios into advanced financial instruments, with greater rates of return, will led to massive capital flight. Speculative hot money inflows, driven by expectations of RMB appreciation, also pose significant risk from the immediate removal of capital controls as it could lead to substantial buying of RMB assets and further currency appreciation. This in turn will cast doubt on the benefits of a liberalized financial system as monetary authorities would be faced with conflicting policy stance between maintaining a peg, such that monetary policy is targeted away from the needs of the domestic economy, and letting the RMB float. Consequently, when addressing adjustments to China's exchange rate regime, it is critical that existing capital controls are maintained until the domestic banking and regulatory systems are strengthened. China's suggested sequencing has been broken down into sections to address the following key areas: Banks and Regulation, Exchange Rate, Long term Capital flows, and the Derivatives Market.

III.Banks and Regulation

Privatisation of the banking sector (including the central bank) is fundamental to increase Chinese bank profitability, allocative efficiency, remove moral hazard and bring down the mushrooming NPL. The central bank should not pursue the responsibility of a public safety net by acting as the lender of last resort (LOLR) given the fact that it would give rise to moral hazard by encouraging excessive risk taking by banks. Although some argue the need for a LOLR as they believe that small liquidly problems may lead to financial crisis and thus severe social consequences, a better policy response would be the implementation of the Tobin tax on banks (Boot, 2006). The Tobin tax should be a risk based levy on banks such that it eradicates the burden on taxpayers should banks face future liquidity problems. More effort needs to be made to alleviate restrictions on foreign bank ownership as this encourages competition, brings about risk management techniques and efficient

profit driven lending practises. Although China has a well functioning bond market the development of a yield curve would allow investors to better forecast interest rate changes and help monetary policy to improve the management of the effects of capital flows. Market orientated interest rates on demand deposits will further reduce the incentive of capital flight by depositors and ease the resent boom in equity and property prices that heightens financial risk (Goldstein & Lardy, 2007).

The privatisation of the banking sector needs to go hand-in-hand with the development of a prudential regulatory framework. As cross-country experience has shown, the lack of regulations in light of greater capital mobility and a privatised banking system, formulates the incentive to take excessive risk in the form of inappropriate highly volatile investments. Effective management of cross-border transactions will prove critical due to liquidity, market and credit risk associated with international capital flows. Adequate bank capitalisation will be needed to withstand risks from creditworthiness, liquidity conditions and volatile prices. Capital adequacy standards should follow the framework of the New Accord setup by the Basel Committee on Banking Supervision. The New Accord constitutes a three pillar approach that covers against a wide variety of risk to capital by addressing minimum capital requirements designed to take account of operational, market and credit risk; supervisory reviews and market discipline. It also sets out the minimum standards of effective supervisory practices ranging from suggesting a suitable legal framework to clearly outlining the responsibilities and aims of all agencies involved in the supervision of banks (Basel II: Revised international capital framework, 2010). Prudential regulation across all financial markets and institutions will increase the resilience of the financial sector towards internal and external macroeconomic shocks as well as encourage discipline. Although China has made efforts to encourage transparency between banks by moving regulation control from the PBC to the CBRC, the regulatory system remains underdeveloped. The responsibility of regulation should be handed over to a private body such that it is independent from government interference. The structure of

regulation should follow the Core Basel Principles set by the Basel Committee on Banking Supervision, the IAIS Core Principles and IASB accounting standards. All three principles comply with international standards covering banking, insurance and accounting institutes. The establishment of these robust institutions will help ease excessive credit expansion, exposure of bank assets to market speculation and disparities between asset and liabilities on bank balance sheets.

IV.Exchange Rate

The criticality of adopting the correct exchange rate regime cannot be emphasised enough. Turkey, Mexico and Sweden highlighted the dangers of inappropriate exchange rate regimes under liberalized financial markets. Although we can learn from the mistakes of other countries, when it comes to suggesting a suitable exchange rate regime, China proposes a unique and complicated example whereby straightforward liberalization is unfeasible. The question that lies ahead of us is that of: Which currency regime will best serve China today and in the future, how can we formulate a strategy that appreciates the RMB without causing massive capital inflows whilst at the same time remove global imbalances?

In 2005 the PBC announced that the exchange rate regime would no longer be pegged against the dollar - but a move towards a managed floating exchange regime based on money supply and demand with reference to a basket of currencies. However, much evidence suggests that China's exchange rate regime is actually following a discretionary crawling peg against the US dollar such that, excessive government intervention in the form of sterilization, coupled with tight capital controls, has accelerated China's global current account surpluses from 3 to 13 percent of GDP during the period of 2003-2008 (Moosa, 2008). China's careless attitude and relaxed approach towards rectifying global imbalances has meant that today the RMB is undervalued by 20-30 percent, no longer enabling the exchange rate disequilibrium to be eliminated easily without having a large adverse impact on the domestic economy.

The degree of undervaluation is so large that China has no choice but for a one-off RMB appreciation of 20-25 percent. A sequence of small adjustments will prove disastrous as it would provoke speculative attack each time an adjustment is made, which consequently will lead to larger sterilization problems. Currently China has a currency band of ±0.5%, which will need to be widened to 5 to 6 percent on either side of the new parity (Goldstein & Lardy, 2006). Not only will this illustrate China's commitment towards controlling its external balances, stop the acrimonious trade disputes between China and the U.S., but also allow for a comfortable transition to a free floating exchange rate regime. Consequently this would allow monetary policy greater flexibility in setting domestic interest rates, move towards establishing an equilibrium exchange rate, reduce excess capacity and dampen macroeconomic cycles fuelled by investment booms. Thus, ultimately, slowly but surely reducing China's dependency on exports and foreign direct investment as an engine of economic growth.

Although the RMB appreciation will reduce China's external surplus through the reduced growth of exports and increased growth of imports, there is worry of slowing growth, unemployment and increasing social instability. However, a large proportion of China's exports are made up of imported factors of production such that an appreciation of the RMB will not prove detrimental to the manufacturing sector. Fiscal expansion in healthcare, education and pensions would be needed to offset any other abbreviating effects of RMB appreciation (Cappiello & Ferrucci, March 2008).

V.Long Term Capital Flows

Since 1979 China has been successful in attracting foreign direct investment whereby no restrictions are imposed in this area except the requirement to follow industrial policy guidelines set by the Chinese government (Xiaopu, 2003). Moreover, since 2000 when China initiated its “go global” strategy, the focus has shifted on outward FDI whereby relaxed controls on outward capital flows and simplified administrative requirements has made China's “OFDI flow and stock stand as the 4th and 6th largest, respectively, among developing countries” (Committee, 2008).

China has largely benefited from its cautions approach to capital account liberalization whereby economic reform and the opening up to global markets have increasingly diversified foreign investment both into and out of China. These investments have made up for shortfalls in financial requirements, it has introduced advanced technology and management know-how from abroad and supported much needed industrial upgrading.

VI.Derivatives Market

The establishment of a well-functioning derivatives market is much needed as a fundamental risk management and price discovery instrument to help mature China's market economy. The addition of a wide variety of derivatives instruments to a traditional portfolio of investments will provide China with global diversification in financial instruments; breed returns not associated with traditional investments and most importantly hedge against inflation and deflation risk.

As China meets the objective rules of a market economy, under a free-floating exchange rate regime, China will face exchange rate risk to the profitability of international trade. In the extreme, volatility in the exchange rate will cause instability in the balance of payments and in the value of debts in the capital items of the balance of payments, which will suppress economic growth. The establishment of a derivatives market will allow for the hedging of these risks, (i.e. commodity and foreign exchange), such that long term stability in prices and thus inflation is achieved (Tian, 2005).

The derivatives market will improve the effectiveness of monetary policies as decisions will be based on ample accurate information through its scientific pricing mechanism and thus rational market expectations. Just as theory and experience has shown, the more profuse financial instruments are, the more effective monetary policy becomes which strengthens the macro economy.

Irrational capital structures and sky-scraping NPLs have impeded the profit-making ability of banks through the state ownership of financial institutions. The derivatives market will promote bound

instruments and trade patterns through the effects of securitisation, evidently allowing for capital structure optimisation and the healthy development of commercial banks.

In contrast, Warren Buffet once described derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal” (Buffet, 2002). His postulation and understanding of these instruments has proven to be 100 percent accurate as reflected by the credit crunch of 2008, the worst financial crisis since the Great Depression of 1929.

The problem arose when derivative trades in the shadow banking system crossed the line of a risk management instrument into speculation. The creation of complicated deals such as credit default swaps, which were valued at $62 trillion in 2007, and collateralised debt obligations (CDOs) which combined “prime” and “subprime” mortgages along with various other assets, led to the formation of packaged debt (Obyrne, 2008). This debt was sold to a special purpose vehicle who then repacked these CDOs into other CDOs, carving the debt into different tranches with incorrect credit ratings, consequently hazing the risk and ownership of the underlying asset. This interlinked complexity of derivatives fed though as volatility in the market when U.S. interest rates started to rise and house prices began to fall (Ruiz, 2008).

This predicament extended from the fact that derivatives are not treated like all other financial instruments whereby the derivatives market is unregulated - defended by Alan Greenspan in 1997 such that the US Congress allowed for the self-regulation of the over-the-counter derivatives market (Business, 1997). The danger of unregulated financial markets, as discussed previously, makes the supervision of these markets compulsory. To counteract the complexity and lack of controls in derivatives trades, Frank Partnoy, a former derivatives trader turned lawyer “recommends treating derivatives like other financial instruments, increasing prosecution of financial fraud, improving disclosure by moving from a rule-based to a standards-based reporting framework, and ensuring that regulations do not confer

oligopoly power on gatekeepers such as ratings agencies or auditors” (Ruiz, 2008). However, one must not conclude that derivatives are a financial bad, if implemented correctly and closely regulated they have shown to increase economic welfare and financial deepening. These two objectives are the underlying goals of any economy, as increased availability of liquid money allows low income groups better access to education and health services which directly impacts poverty reduction and expands opportunities for continued growth. Henceforth, despite the financial catastrophe of 2008, it is recommended that China goes ahead with the establishment of a derivatives market so long as derivatives are only used as a risk management instrument under direct supervision.

China's recommended liberalization framework has been summed up and displayed in the 3-stage fundamental framework below. Stage 1 sets the groundwork that the liberalization needs to follow covering macroeconomic stability, regulatory and institutional development. Stage 2 entails a consolidation and deepening of stage 1 and stage 3 entails the fundamental reassessment of the liberalization process and the removal of any remaining capital controls. By this stage China should have fully adopted a legal framework in line with international regulatory standards. Each stage covers capital account liberalization, financial sector reform and other policies of importance.

Only after the completion of stage 3, where stable macroeconomic conditions prevail coupled with sound privatized financial systems with robust supervisory regulation, should the RMB be re-valued by the recommended 20-25 percent one-off appreciation. The above policy measures should be more than sufficient to prevent a currency crisis via speculative attack and surges in capital flight. The timing of the sequencing cannot be estimated as the various elements to the sequencing strategy will take different times to complete. The only recommendation I suggested is that China should only proceed to the next stage when all the steps within each stage have been met.

VII.Summary of the Suggested Liberalization Framework for China

Stage 1: Setting the Foundations

Capital Account Liberalization

Maintain limits on short-term foreign exchange borrowing and lending in order to develop greater depth in the interbank foreign exchange market.

Financial Sector Reform

Privatization of the banking sector and the provision of additional power to supervisors to foster bank restructuring and mergers.

The development of the derivatives market alongside prudential regulation and supervision

Improve bank's risk management with respect to corporate clients foreign exchange exposures

Begin designing the new legal framework for regulation by an independent body

Other Policies

Target fiscal policy towards medium term stability without mass withdrawal of government spending in the short-term.

The legal framework will take time to fully device. The establishment of a working group will be needed to start drafting new corporate laws, insolvency laws and judicial reform.

Accelerate the sterilization of NPL to reduce bank debt-equity ratios to allow for corporate restructuring.

Increase financial transparency of statics and reporting to allow for the early warning of potential financial problems.

Stage 2: Deepening Reform

Capital Account Liberalization

Build on improving prudential policies and remove restrictions on equity investment and other non-debt creating capital flows

Financial Sector Reform

Continuation of the development of risk management

Train and employ supervisors, increase the frequency of onsite bank supervision, fully implement supervision cooperation amongst the different supervisory agencies. Place strict laws against insider trading and address any differentials with international supervisory standards

Strengthening the development of the derivatives market

Continuation of bank privatization with all systematic problems addressed

Other Policies

Full transparency of banking statistics, monetary and fiscal policies to foster reduction in uncertainty over market fluctuations

The adoption of the new legislation governing insolvency and the new judicial system

Control over government finance and stable interest rates

Stage 3: The Completion of Liberalization and Financial Reform

Capital Account Liberalization

Eliminating all capital controls including short-term capital flows

Financial Sector Reform

The establishment of a fully fledged derivatives market with tight prudential regulation

Review possibilities of financial innovation to transform savings into productive investment

Continuation of improves in supervision with regular updates in line with international standards and encouraged improvements in risk management by financial institutions.

Completed financial sector restructuring with no threats to bank profitability, liquidity, asset quality and capital adequacy

Other Policies

Stable government finances and macroeconomic indicators.

Regular review of the legal arrangements

(Idea based on the suggested methodology for sequencing by Ishii and Habermeier, 2002)

4a. China and the Global Financial Crisis of 2008

In hindsight China's capital walls have insulated the country's banking sector from overseas crises such that the manufacturing industry was the only sector to be affected by the 2008 credit crunch. China's tight capital controls have proven to be a success as they allowed China to churn out an economic growth rate of 9.6 percent whilst Western economies continued to cushion a recession.

However, in light of managing recovery from the global financial crisis, America has brought the rigidity of the RMB to the attention of world economies. China's currency policies since 2008 have halted the RMBs gradual appreciation giving China an artificial competitive advantage in international trade at a time when other economies continue to struggle (Batson & Johnson, 2010).

With Obama's over-arching aim to double exports in five years, in face of 9.7 percent unemployment and mid-term elections, a much tougher approach has been ignited by the U.S. in dealing with unfair competition. If no action is taken by the Chinese authorities to address this issue, it is rumoured that the U.S. Treasury will brand China a currency “manipulator” in its next exchange-rate report and demand the Commerce Department to investigate China's currency regime as an unfair trade subsidy (Economist, 2010).

The Chinese premier has defended his actions by stating that China's currency issues are an internal matter of concern such that “countries should stop pointing fingers at each other or take strong measures to force other countries to appreciate their currencies” (Batson & Johnson, 2010). He further argues that America's over emphasis on the RMB exchange rate will not solve problems amongst what is arguably the most important bilateral relationship in the world. Chinese officials believe that “the RMBs exchange rate is not a magical potion for solving global economic imbalances” and China must not be treated as a scapegoat during this tabulate time (Wang & Rabinovitch, 2010).

However, the sooner China moves towards a market orientated exchange rate the better for both the U.S. and China. Nonetheless, one must bear in mind that rebalancing China's economy will require massive structural reform, from the banking to the corporate governance sectors, as well as sound macroeconomic structures. The revaluation of the RMB is no penicillin to bring back millions of jobs to America and eradicating its huge trade deficits, but, it is a step forward towards establishing a more market orientated Chinese economy.

China's double- digit growth figures are no miracle and China will pay a price as these very capital walls stand as double-edged swords. On the one hand China has immuned itself from this global contagion whilst on the other hand, it has brewed its own financial crisis through its communist economic structures. These market structures have allowed the central bank to print money in order to force banks to lend as well as corporations and consumers to spend. The artificial credit stimulus of $1.3 trillion by the Chinese government, in hope of buying time until global systems stabilise, will result in a huge pile of bad debt on top of those accumulated over the decades (Leung & Wong, 2009) (Katsenelson, 2009).

Tight capital outflow controls, low interest rates in the US, a weak dollar and capital inflows to emerging markets resulting from liquidly injections by world central banks have led to the formation of asset bubbles in China's real estate, commodities and equities market. The bursting of these bubbles will prove very dangerous whereby the trigger to this turnaround would arise from a sudden slowing down of the Chinese economy, weaker overseas demand and defaults by unprofitable enterprises. This in turn will lead to the deterioration in asset quality which will flow through the financial system as observed in the U.S.

China's commercial banks continued failure to eliminate financial risk for lenders and decades of rapid loan growth has made the Chinese NPL market the largest in the world (Amberger J, 2008). Its investment driven growth strategy has meant that the resulting overcapacity will become an area of serious concern in the future. China's stimulus package has seen the fail in investment efficiency whereby this will bear an adverse impact on China's long-term growth. Its loose monetary and fiscal policies pose the greatest risk to the Chinese market, whereby, unnecessary low interest rates have essentially crowded out small/medium sized private businesses from credit markets. (Yongdiing, 2010). Had China liberalized the financial sector and the workings of its economy then maybe today China wouldn't be threatened by a self-inflicted crisis as a consequence of its own capital structures. It's just a matter of time before we see the next credit crisis - but this time emerging from the world's fastest growing economy.

In sum, if the indispensible financial liberalization policies are not implemented and if the government fails to overcome the structural problems, then the adverse impact of the measures taken to manage this global crisis will be serious. Once these issues have been addressed, only then strong foundations will be in place for China's sustained future growth.

5a. Conclusion

China should be congratulated on its phenomenal double-digit growth rates and overall economic performance. Integrated analysis, however, has demonstrated that China's export -led growth and one way capital flows have caused financial repression, global imbalances and asset bubbles. This has been aided by its communist market structures such that government intervention in the exchange mechanism and the financial sector has led to weak financial intermediaries, soaring none-performing loans and the undervalued RMB.

China's currency peg to the U.S. dollar has essentially been a monetary anchor for the stability of internal prices. However, as we have seen, monetary stability in China has undermined China's long run financial stability. Over time, China's pegged currency regime has contributed to the mass accumulation of foreign exchange reserves, which in turn has led to a liquidity overhanging in the financial system, credit and more recently an equity boom. This excessive credit provision to SOEs has fuelled overinvestment which threatens deflationary pressure and surges in non-performing loans with detrimental consequences to the stability of the domestic banking system. Chinese authorities cannot fend off these risks forever by sterilising foreign reserves and enforcing strict administrative controls on bank interest rates and lending practises.

The examination of endogenous growth theories has led us to the conclusion that in order for China to foster sustained economic growth, a series of financial liberalization polices need to be implemented. The recommended policies are based on the cross-country analysis of countries that have opened their capital accounts, such that the recommended liberalization strategy has accounted for the possibility of a currency crisis associated with financial liberalization. The liberalization process manages the transition from a pegged to a free- floating exchange regime such that a gradual approach to greater exchange rate flexibility and liberalization of capital account is achieved. The removal of administrative controls will allow for greater efficiency of capital allocation, give the central bank more control to guide market interest rates and dampen the volatility of investment cycles. A robust financial sector will prove critical to the strengthening of China's social safety net by

providing instruments such as health care insurance and retirement investment funds deemed necessary to cope with China's future demographic challenges.

Although there is high risk of initial financial instability the fact of the matter is that, ultimately, financial development will lead to long-term macroeconomic stability via endogenous growth. China has shown whether a country has a controlled or liberalized financial market, it is impossible to completely eliminate risk, but it can be squeezed and contained once we have a grounded understanding of the markets and instruments we are dealing with.

As of yet economic professionals have been unable to produce a blueprint that facilitates countries to move from a state of financial repression to financial liberalization. Hence, future area of research would be the formulation of an economic model that allows for such transition. The model should be universal in application such that countries with varying levels of development could implement it. With regards to China, how it will adapt to the suggested liberalization framework is unknown until it has been implemented, but the recommended framework has taken into account the major areas of concern.

Although Bagehot discussed the relationship between financial sector development and economic growth in the 19th century followed by Schumpeter (1934) who stressed the role of the banking sector as a financier of productive investments and thus an accelerator of economic growth, it was not until the development of the basic AK-model from the endogenous growth theory that found

....... “three ways by which the development of the financial sector can affect economic growth.........First, it can increase the productivity of investments. Secondly, more efficient financial sector reduces transaction cost and thus widens the share of savings channelled to productive investments. Thirdly, the financial sector development can affect saving rate, either upwards or downwards” (Koivu, 2002)...

This has been made possible by introducing finance into the endogenous growth model via commercial/investment banks, stock markets and mutual funds. Stock markets enable the sale of firm shares to investors without having to move physical resources and banks and mutual funds allow for the diversification of portfolios. In general, financial institutions reduce premature liquidation of firm capital, reduces liquidly and productivity risks and also pools resources to identify and exploit production externalities (Levine, Financial Strusture and Economic Development , 1990), this encourages individuals to invest more in firms which in turn raises the rate of economic growth (Fry, 1993).

Most finance-growth studies follow the Schumpeterian view of financial intermediaries (as stated above) and are based on the grounds of seminal contributions of Goldsmith-McKinnon-Shaw (Valverde, 2004). Greenwood and Jovanoic (1990) built a long run model whereby economic growth fosters the expansion of financial intermediaries in their early stages of development and further down the line, a mature and consolidated financial system enhances efficient investment decisions and stimulates faster economic growth. This causality effect has been evaluated within bisectoral models of growth such as Odedkun (1996) and Wang (1999); the first stage of the model assumes financial-lending positively affects economic growth and the second stage experiences real-fostering as the economic conditions stimulate financial development. Bencivenga and Smith (1991) demonstrate the contribution of banks to economic growth to result from their monitoring and screening functions that allow for easier, efficient and faster access to credit. (Valverde, 2004)

We shall now focus on the second line of research whereby the move from financial repression to financial liberalization allocates markets greater role in development, thus allowing empirical studies to assess the effectiveness and impact of such movement (Ozdemir & Erbil, 2008). The extensive research in this field can broadly be split up into two categories, the de-jure measure of financial liberalization.

Rose, Prasad and Terrones (2008) empirical analysis focused on the effects of financial liberalization on total factor productivity (TFP) using annual data from 67 counties for the period 1966-2005. They conclude that during the globalisation period, more financially open economies registered much faster productivity growth compared to less financially open economics who in fact registered a slight decline in productivity growth. Their empirical evidence also shows that de-jure capital account openness has a positive effect on TFP growth, while de-factor financial integration showed no correlation with TFP growth (Kose, Prasad, & Terrones, 2008). This partially contradicts Ranciere, Tornell and Westermann (2006) study which decomposed the effects of financial liberalization; they find that financial liberalization has a direct positive effect on per capital GDP growth, whereby the de-jure index measured a 1 percent increase in growth and 1.1 percent increase by de-facto index (Ranciere, Tornell, & Westermann, 2006).

Both studies emphasised the need for well-developed financial markets such that financial institutions can attenuate the negative effects of debt inflows on TFP growth and mitigate the effects of a banking crisis. Financial liberalization has the tendency to trigger instability in the banking sector and significant increases in the probability of a crisis; as credit markets thicken the importance of a well grounded legal and prudential framework heightens.

Bonfiglioli and Mendicino (2004) study of 90 countries show that although capital account openness has zero-effect on growth, equity market liberalization significantly affects growth. Using data provided by the IMF AREAER (a de-jure index) they showed financial liberalization to have a weak and fragile relationship with economic growth and the possibility of restrained growth via financial crisis. Bekaert, Harvey and Lundblad (2003) second this finding, who using the same data, find that equity market liberalization effects growth by 0.71-0.94 percent per year, a robust outcome . Levine and Zeros (1998) empirical evidence on 15 countries suggests that financial liberalization of the capital account has a positive effect on stock market liquidity. This is a significant finding as such policy would allow countries to boost stock market development and promote economic growth even if capital control liberalization does not represent a financial elixir for economic growth.

Whilst the World Bank, the World Trade Organisation and the International Monetary Fund believe that policies that encourage international financial integration spur long-run economic growth in developing countries, Paul Krugman (1993) disagrees with such theory. He has argued that international financial integration is unlikely to be a major engine of economic development after noting that capital is relatively trivial for economic development and that large flows of capital from rich to poor countries have never occurred before (Levine, 2001). Ross Levine (2001) challenged this argument by considering other channels via which international financial integration can influence long-run growth. She put forward three building blocks which together form a coherent perspective linking financial integration to economic growth. The first of these suggest that “TFP accounts for the bulk of cross-country differences in the growth rate of GDP per worker, second that domestic

financial systems exert a large, causal impact on economic growth primarily by boosting TFP and third that liberalization of foreign capital and banks tends to enhance the function of the domestic financial system” (Levine, 2001). She furthers this argument by extending to theories and empirical evidence that suggest that the biggest growth effect from financial systems comes from capital allocation. This is due to the removal of informational asymmetries, reductions in transaction costs, facilitated contracting and the mitigation of free-rider problems that arise from the establishment of competitive financial intermediaries.

Aghion, Howitt and Mayer-Foulkes (2005) looked at the effect of financial development on growth convergence. Their cross-country growth regression supports the theory that countries with more than some threshold level of financial development “will converge to the growth rate of the world technology frontier, and that all other countries will have a strictly lower long-run growth rate” (Aghion, Howitt, & Mayer-Foulkes, 2005). They conclude that financial development is the most powerful force in elevating income inequality and thus growth differentials.

Countries that avoided a financial crisis

Hungary is a prime example that illustrates - whilst removing the sceptical view of many - the benefits attached to financial liberalization. The country shows that early implementation of financial reform combined with sound macroeconomic fundamentals can considerably increase the resilience to peripheral shocks. As financial crisis unfolded in Russia, structural reforms in Hungary were largely completed, banks and bank consolidations were privatised and a sound macroeconomic and prudential framework had been established. These achievements developed a robust financial system whereby Hungary was able to mitigate the contagion spreading from Russia's crisis. Hungary's experience also highlights the benefits of allowing foreign participation in the domestic financial market though the speeding up of financial modernization, the sharing of knowledge and ultimately increasing the resilience towards adverse economic shocks (Ishii & Habermeier, 2002).

Analysis of the past 20 years has shown South Africa to have been subjected to large swings in its capital account such that large capital inflows were followed by significant outflows. However financial sector reform and capital account liberalization saw the removal of the dual exchange rate system and the strengthening of the prudential framework in broad compliance with the Basel Core Principles. The resultant sound macroeconomic policies and a strong banking system allowed South Africa to withstand large volatility in capital flows and market prices. The driving force behind this success was the well capitalised banking system which held low corporate debt to equity ratios coupled with the authorities' gradual liberalization of the capital account for residents such that the central bank's reserve position was preserved (Ishii & Habermeier, 2002).

London's status as the “world's financial hub” came about after the UK exited the ERM in 1992 due to market turbulence and increasing conflict of policy stance between that suited for the domestic economy and that required to maintain the overvalued exchange peg. Since 1992 the UK has established a well-capitalised and diversified banking system, a sound prudential framework which is subject to regular audit and upgrading, strong market discipline and a highly developed money and capital market and monetary instruments to meet acute liquidity needs. These factors, coupled with an independent monetary policy have helped establish a stable financial sector such that large speculative capital flows no-longer prevail, essentially making the UK a safe haven. Although some may argue the above statement with regards to the global financial crisis of 2008 where the UK was one of the hardest hit economies; the above structures allowed for quick actions from the government to foster recovery though quantitative easing which is thought to have saved the economy from a credit-led depression. It is, however, interesting to point out that monetary conditions in the U.S. and Eurozone are substantially worse than those of the UK, whereby the difference may be somewhat down to quantitative easing (Flanders, 2010).

Countries that experienced a financial crisis

Korea demonstrated impressive macroeconomic performance from the 1960s through to 1997; however Korea's industrial development supported by directed lending and extensive government intervention proved not so successful. This was due to fundamental weaknesses in the financial sector and poor governance in the chaebol dominated corporate sector such that these factors become the destabilising force of the whole economy. Inappropriate sequencing of the financial liberalization process, investment in economically unviable projects, the continuum of government intervention after substantial liberalization and the large exposure of chaebol's to banks made Korea highly vulnerable to adverse shocks, especially due to the de facto of chaebol's high indebtedness and low profitability. Ultimately government intervention hindered the development of a prudential framework such that financial supervision had not adopted to facilitate the open capital account. The lack of market forces and the favoured liberalization of short-term financial flows as opposed to stable long-term capital flows made the financial sector unable to deal with the risk associated with capital account liberalization (Eichengreen, Mussa, Dell'Ariccia, & Detragiache, 1998).

Mexico's experience provides us with a primary example of the implications of a tightly managed exchange rate regime in the presence of macroeconomic imbalances and high capital mobility. Mexico's currency crisis was due to the combination of political disturbances coupled with domestic and external adverse shocks. The reassessment of Mexico's economy in light of the strong expansion of liquidity and current account deficits, led to the reversal of private capital inflows and pressure on the foreign exchange market which ultimately forced the peso no choice but to float. The experience emphasises the need for indispensable developments of a robust regulatory framework, supervision and homogeneous accounting standards to mitigate the expansion of risky loans and banks exposure to credit risks (Ishii & Habermeier, 2002).

The importance of achieving financial sector development to coincide with macroeconomic policies can be analysed though Sweden's experience. The weak prudential framework of the financial sector allowed for an irrational response to the boom of the 1980s such that it led to excessive domestic lending and foreign borrowing. Sweden warns us of the implications of greater freedom of capital movement within a weak regulatory framework. Given the opportunity, banks took excessive risk in international money markets and the new market based financially open economy. This heavy external borrowing and the issuance of foreign currency loans resulted in massive losses in the banking system as the inevitable bust that follows every boom saw the collapse of asset price bubbles, the breakdown of the tightly managed exchange rate regime and hence the deterioration in the value of loan portfolios. The lesson to be learnt here is the need for robust regulations across all subsidiaries and that lending in foreign currency will remain exposed to credit risk if the income stream of the borrowers is not dominated in foreign currency and if currency hedging is not enforced.

Turkey's double exposure to financial crisis was the result of weak macroeconomic foundations and a fragile financial structure under a crawling peg regime such that the high interest rates that prevailed from macroeconomic imbalances and a high risk premium gave banks the incentive to heighten their exposure to interest and exchange rate risks (Eichengreen, Mussa, Dell'Ariccia, & Detragiache, 1998).

Paraguay provides us with an interesting example whereby the financial sector crisis did not lead to a full-blown exchange crisis due to the presents of foreign banks and substantial levels of financial dollarization that alleviated large capital outflows. Further analysis shows that macroeconomic balances and high levels of official international reserves are also important factors that prevent a full-blown exchange rate crisis (Ishii & Habermeier, 2002).

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