Capital Market Liberalization in China: Opportunities and Dangers

Capital market liberalization4, or financial globalization, is one of the most controversial aspects of globalization. On one hand, financial globalization makes it easier for funds to flow in and out of a country’s borders, allows transfers of technological and managerial expertise, and lowers the cost of capital. Capital account liberalization also provides an opportunity for a country’s currency to be accepted outside its borders, making trade transactions easier and less costly. On the other hand, however, capital market liberalization, especially that of short-term capital flows, can add to instability within the financial system. Historically, capital market liberalization has been associated with crises in industrial as well as emerging economies. According to the Bank of International Settlement, in many countries in Scandinavia, Latin America, and Asia over the past few decades,, financial globalization has given rise to capital inflows that were too large for the countries ’ financial systems to absorb safely (Icard, 2002). When these capital inflows stopped or reversed, the result was an impaired financial system. However, when studying capital market liberalization, one should distinguish between the two types of capital flows, foreign direct investments (FDI) and short-term speculative capital flows. While FDI has proved to be largely beneficial to emerging markets, short-term capital flows have posed somewhat of a challenge to many economies. In liberalizing its capital markets, China should continue to reap the benefits of FDI while paying close attention to the risks associated with short-term capital flows, and should minimize these risks throug