China's International Financial Integration - Impact on Financial Development and Stability

One of the most important macroeconomic developments in the coming decades will be China's rapid financial integration into the world economy. Together as a group, emerging economies' GDP has risen from 20% to over 80% of advanced economies' GDP in the last two decades, and constitute 50% of world GDP. Global dynamics will increasingly be characterized by an advanced bloc and an emerging bloc, in which China plays a central role. There are important economic differences between the two sets of countries that can be crucial for determining the global equilibrium - perhaps most notably in financial development. In China's case its financial markets and macroeconomic conditions differ significantly from those of other emerging economies, suggesting caution when drawing historical parallels or lessons for globalization.

As the world's second largest economy, China's full integration into global financial markets will invariably impact the world economy. At the same time, the ramifications on the Chinese economy - given the particular characteristics of its financial development - are still largely unknown, as a result of the dearth of frameworks to analyze heterogeneous economies in a global setting. Our aim is to study the impact of its financial liberalization for China and the rest of the world-from a positive and a normative perspective.

Our research agenda focuses on developing hitherto non-existing frameworks for integrating China's particular financial market conditions in an open-economy macroeconomic setting. Typically, the existing literature focuses on the effects associated with particular financial frictions - such as collateral constraints, and limited enforcement in repayment. While these frictions may also be important for China, they are unlikely to be the most prominent. China's financial market distortions have certain distinct features: 1) financial repression; 2) a two-sector economy where the state sector is significantly less credit-constrained than the private sector; and 3) the prominence of banks in financial markets, among others.

The research projects intend to explore the impact of a country with these financial frictions and the process of financial integration. Important questions that deserve a thorough investigation include: given the described frictions, what is the impact of financial globalization on capital flows, exchange rate dynamics, and growth? Under what conditions would financial crises occur, and are they more or less costly than the crises that would have occurred in a closed-economy? From a normative perspective, should financial development and financial liberalization happen sequentially or simultaneously? Would liberalization induce faster financial development? Are these policy goals potentially conflicting and/or self-defeating? How are global financial shocks transmitted to China, and conversely how are China's shocks transmitted to the rest of the world?

China also differs from other emerging economies in its macroeconomic conditions. It is a net saver, and runs a significant current account surplus. Traditionally, emerging market financial crises have come from within: financial dollarisation, excessive deregulation, allocation inefficiencies due to high level of state ownership, etc. In the global financial crisis a negative shock from advanced economies was transmitted to emerging economies heavily financed through foreign investment, with domestic credit constraints amplifying these shocks. This research aims to fill a gap in the literature and directly address China's particular problems.

This project addresses what is perhaps the most critical question for the integration of China into the world economy, ensuring that the Chinese economy benefits from foreign investment whilst maintaining the stability of the financial system. The strategy for impact in this project, and the wider initiative of which it is an important part, is to engage with key policy institutions and top centres of excellence. As emphasised in the Impact Summary, our policy counterpart the PBoC has been part of the design of the project and will participate in the generation (through Deputy Governor Zhang Tao) and dissemination of research results (through the PBoC Research Department).

Most importantly, by tying the research closely to the agenda G20 Working Group on International Financial Architecture, a work stream resurrected by the Chinese G20 Chair, we want to ensure that the research output get sufficient attention in Chinese policy circles. But the results can also benefit a wider set of emerging economies facing similar issues as they integrate into the international financial system. We have secured that one out of six parallel streams of parallel sessions at the Berlin policy conference hosted by the incoming German chair of the G20 will be devoted to the International Financial Architecture agenda and will have representatives from most or all G20 emerging economies as well as from the international financial institutions.

While the emphasis in the project is on the engagement of key policy institutions, particularly the PBoC, and top academics, there are other important pathways to impact. In particular, the business press (first Caijing Magazine, and more recently, Caixin Media) has played an important role in promoting transparency and uncovering corruption, starting in the financial sector. The researcher will work closely with these outlets, now also playing a major role in social media, both in China and internationally. We envision both closed-door events with key financial industry participants and representatives from the government and participation in Caixin's annual summit which is attended by most senior policymakers and senior management of financial institutions.

In addition, we will engage with the Chinese financial sector. Given its heavy dependence on the state, the financial sectors' independence and influence is likely to be less than in advanced economies, but it is nevertheless very important to engage with these institutions. We will ask the PBoC to help convene a reference group of representatives of domestic as well as international financial institutions active in China. We also intend to convene Chinese policymakers and business representatives in events in Russia and India, including at least one event co-organised with the Reinventing Bretton Woods Committee.