Haverford College Economics of Development: China vs. India Prof. Saleha Jilani The trilemma as a framework for understanding China and India’s recent monetary policy choices By: Hiram Ruiz Abstract: The remarkable growth that has characterized China & India in recent years has been the subject of much literature. China’s trade surplus, one of the largest in the world, has endowed it with extensive foreign exchange reserves. This has allowed China to become a net lender. The development of the Asian Infrastructure Investment Bank and moves towards full Yuan convertibility signal that China seems to be departing from its previous policies of strict capital controls. India, to a lesser extent, has also been changing its approach towards financial markets. How exactly has this change in policy been unwrapping in both nations and what are its effects both internally, in the surrounding region and the world? This paper will seek to answer this question using both a quantitative and historical approach. First, I will discuss some of the existing literature on the subject. Then I will give a brief historical summary of the financial market policies followed by each government since the 1990s. Once the reader has a grasp of the structure and functioning of financial markets, I will introduce the trilemma as a framework which demonstrates the different policy mixes a government can undertake. Finally, I will demonstrate where the countries started within the framework, where they are heading, and possible prospects for the future using quantitative data.
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Haverford College
Economics of Development: China vs. India
Prof. Saleha Jilani
The trilemma as a framework for understanding China and India’s recent
monetary policy choices
By: Hiram Ruiz
Abstract:
The remarkable growth that has characterized China & India in recent years has been the subject
of much literature. China’s trade surplus, one of the largest in the world, has endowed it with extensive
foreign exchange reserves. This has allowed China to become a net lender. The development of the Asian
Infrastructure Investment Bank and moves towards full Yuan convertibility signal that China seems to be
departing from its previous policies of strict capital controls. India, to a lesser extent, has also been
changing its approach towards financial markets. How exactly has this change in policy been unwrapping
in both nations and what are its effects both internally, in the surrounding region and the world? This paper
will seek to answer this question using both a quantitative and historical approach. First, I will discuss
some of the existing literature on the subject. Then I will give a brief historical summary of the financial
market policies followed by each government since the 1990s. Once the reader has a grasp of the structure
and functioning of financial markets, I will introduce the trilemma as a framework which demonstrates the
different policy mixes a government can undertake. Finally, I will demonstrate where the countries started
within the framework, where they are heading, and possible prospects for the future using quantitative data.
2
Introduction
The remarkable economic growth recently experienced by China and India, together with the fact
they comprise a large portion of the world’s population has turned them into important players in the world
economy. This has, in turn, motivated a vast amount of literature on a wide array of economic topics
pertinent to both the nations themselves, and the rest of the world. This paper will take advantage of the
abundance of literature on macroeconomic policy and financial markets regarding these countries in an
attempt to frame recent developments as breaks from previous policy stances, within the context of the
impossible trinity of international finance.
One of the most controversial topics within the trilemma is the usefulness of capital controls. IMF
publications such as: (Tseng W. et Al, 2005) and (Ostry, D et Al, 2011) tend to criticize the adaptation of
such policies. They generally cite the distortionary effects on the local economy, international implications
and the lack of credit such measures can induce as the main reasons for opposing the adoption of capital
controls. They do however, make exceptions for temporary controls meant to deal with short periods of
high volatility that arise purely from financial markets and not from fundamentals of the economy, such as
speculative attacks. Others, such as (Lane P. and Schmukler S. 2007) and more especially (Sen P. 2010)
acknowledge the role that capital controls have played in allowing these developing nations to retain
domestic macroeconomic control and exchange rate stability. This paper will examine the role capital
controls have played in China and India’s development strategy.
The exchange rate regime, a much contended topic within macroeconomics, will also be examined
closely in this paper. Currency interventions have enabled China and India to pursue, to lesser degrees of
course, export-led growth. Patnaik I. and Shah A. (2009) describe very insightful methods that attempt to
differentiate the de jure exchange rate regimes from the de facto exchange rate regimes followed by India
and China. They find that both central authorities have de facto pegged their currencies to the USD until
very recently. The choice of exchange rate regime becomes very important when combined with free capital
flows. Essentially, a peg cannot be maintained indefinitely without sacrificing monetary policy sovereignty.
Hence, nations such as China and India have used capital controls in order to maintain both a stable
exchange rate and monetary sovereignty. This basic tradeoff, known as the “trilemma” will be the main
focus of this paper. Before we delve into the mechanisms that create this phenomenon, it is first important
to explore the recent state of financial markets in both countries since they play a central role in the
trilemma.
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Domestic Financial Markets
Chinese financial markets are considered far less developed than their Indian counterparts. Dobson
W. (2006) undertakes the task of comparing the state of both domestic financial systems side by side. She
finds that the most significant problems plaguing them at the time were the prevalence of government
ownership of banks and the underdeveloped state of corporate stock markets. Lane P. and Schmukler S.
(2007) devote part of their chapter in “Dancing with Giants” to this same topic. This section will summarize
their findings more closely and provide an update on the state of both financial systems in order to gauge
the progress China and India have made since the time of writing of these papers nearly a decade ago.
One of the most criticized characteristics that both of these countries’ financial systems share is the
large portion of government ownership of banks. At the start of the 1990’s both nations had very primitive
domestic financial markets by western standards. The period from the 1970’s-1980’s brought a mass wave
of bank nationalization to India in an attempt to increase the savings rate by opening bank branches in
remote rural locations. After this, only 10% of banks in India remained under private or foreign ownership.
(Dobson W. 2006) At the start of the 1990’s however, India faced a balance of payments crisis which forced
it to undertake extensive liberalization as a condition for being bailed out by the IMF. This period saw a
freeing of FDI and most portfolio flows, with the capital account from abroad remaining heavily restricted.
In 1997 the Tarapore Committee issued a detailed framework and timeline for full capital account
convertibility, which it then had to be postponed due to the Asian Financial crisis of the late 90’s.
Nevertheless, liberalization has continued at a steady pace, and Indian financial institutions resemble their
western counterparts in many ways.
Chinese financial markets follow a similar pattern. The People’s Bank of China controlled both
monetary policy and collecting savings until 1984, when four state owned policy banks were given the
latter function. These banks primarily channeled savings into the country’s state owned enterprises (SOE’s).
1995 brought a series of institutional reforms which aimed to establish lending based on creditworthiness
by introducing prudential norms and a change of governing structure. However, these four big banks still
continue to dominate the financial sector to this day, and the other commercial banks are owned by local
governments. The pervasion of government ownership of the banking system is thus much deeper in China
than in India.
Table 1.1 shows government ownership of banks in India and the breakdown of China’s banks,
which are for the most part all government owned. In India one can notice a gradual entry of private
ownership into financial markets, where private institutions have gone from 20% of market share (% of
total assets) in 2005 to 25% in 2013. In China, although banks remain much more strictly controlled by the
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Table 1.1 Banking Sector Breakdown (% Total Assets)
government, some degree of de-centralization can be observed. The big four commercial banks, which are
owned and operated by the central government have been losing market share to smaller institutions which
are mostly owned by local governments. The market share of the big four commercial banks has dropped
an impressive 10% over the span of 9 years. Although the Indian government still owns the vast majority
of banks in India, it has made considerable progress in reducing its share of assets. In China, although some
de-centralization is seen, the government still owns a significant stake in every bank. Both countries have
reformed management structures, incentive schemes for managers and prudential standards. However, the
distortions government ownership creates with misdirected lending to poorly preforming sectors cannot be
completely corrected with oversight reform. (Dobson 2006)
China 2005 2014 Big Four Commercial Banks 52.5 43.23
Joint Stock Banks 15.5 17.9
City Commercial Banks 5.4 9.97
India 2013 Public Sector Banks 75 70.85
Private Banks 19 21.45
Foreign Banks 6 7.68 Sources: China Banking Regulatory Commission & Indian National Reserve
The lack of a strong stock market is another widely cited impediment in the development of Chinese
and Indian financial markets. Figure 1.1 shows stock market capitalization as % of GDP for both India and
China. It also includes Singapore and Korea, since they are liberalized Asian economies which will serve
as comparison. Unsurprisingly, China is at the bottom of the list, with a market capitalization of just under
50% of GDP. It worth noting that a large portion of this is made up of the stock of state owned enterprises,
so the private sector market capitalization will be somewhat lower than shown. India has a larger market
capitalization, around 65%, which is unsurprisingly larger than China’s. Its share of government owned
stock is only 30%. This means that India has both more market capitalization as % and GDP and a higher
portion of it comes from private sector firms. It is clear from the figure however that both countries have
much work to do. Although we can’t expect a country such as China or India to have the same market
cap/GDP ratio as a financial city-state such as Singapore, a percentage closer to Korea’s is likely to result
from further financial liberalization.
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Chinese and Indian financial markets are wildly different from those in more liberalized economies.
The penetration of governments in commercial banking and the undeveloped state of capital markets affects
the allocation of lending. Although India has more banks in private hands and a much more developed stock
market, significant distortions still remain which provide credit to loss making firms at the expense of profit
making ones which go under-funded. Financial markets play a key role in the trilemma, and their
development is required to be able to tap into international capital flows without excessive exposure to risk.
The Trilemma
The Trilemma is a hard choice policymaker’s face in international finance. Figure 1.2 summarizes
the “choose-two-of-three” problem graphically. Completely unrestricted capital flows should lead to the
no-arbitrage uncovered interest rate parity condition. This directly relates exchange rates to interest rates
and hence governments, when faced with currency inflows/outflows, must decide to either let their currency
appreciate/depreciate or to intervene forcedly by adjusting the money supply. This would of course lead to
movements in interest rates which could very well be undesirable. It is not hard to see why countries such
as China and India would be reluctant to give up these two important developmental tools. Until recently,
both countries decided to restrict capital flows in order to retain both exchange rate stability and monetary
sovereignty. In the following sections I will examine each component of the trilemma individually, and
each country’s experience with them. Because both countries utilized very strict capital controls until very
recently, it will be useful to begin with this topic.
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Figure 1.1 Stock Market Capitalization (% of GDP)
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Capital Controls
Capital controls have played a key role in the developmental policies followed by China and India
in recent times. The IMF until very recently preached full capital account convertibility and openly opposed
any type of capital controls. However, international financial developments such as the Asian financial
crisis of the late 90’s and the 2008 sub-prime mortgage crisis in the US have changed the IMF’s stance on
the issue, albeit only minimally. This section will discuss the nature of capital flows and their effects on
developing economies; it will also summarize the experience of China and India with them.
First, some caveats are in order. Capital flows are a very broad term for describing the international
movement of myriads of different types of investment vehicles which vary in inherent risk and maturity.
Distinguishing between them becomes important when talking about financial system stability. Some
authors have undertaken the task of ranking different types of assets by order of riskiness, putting foreign
denominated debt as the most risky and Foreign Direct Investment inflows at the least. (Ostry et al. 2011)
In general, portfolio flows will always be more volatile than direct investment because while the first can
be sold instantly and its value moved out of the country, foreign direct investment cannot usually be
liquidated easily. Thus, FDI inflows are more stable and represent a bigger commitment to the recipient
country than fast moving portfolio flows. Maturity is also related in a similar manner, since short term
inflows can become outflows faster than vehicles with longer maturities. In addition to this, the degree of
controls can vary marginally in the context of different countries. No country has completely open or closed
capital accounts, but some mix of restrictions that can be marginally different from the restrictions of
another country. All of these complexities, in addition to others that will soon be explained, make measuring
Figure 1.2
Free Capital Flows
Monetary
Sovereignty
Exchange Rate
Stability
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the degree of capital controls of a country a difficult affair. However, many have undertaken the task of
measuring the level of capital controls of an economy. Exactly how to do this is a contentious debate within
the literature.
Although a thorough comparison of the different methods for measuring capital controls is beyond
the scope of this paper; due to the complexities detailed above one cannot simply use a single measure as
evidence of capital controls. For this reason, it is important to look at various different measures, keeping
in mind their limitations and what they are actually measuring. Measures can be grouped into two large
types: de jure measures and de facto measures. De jure measures utilize laws and policies officially followed
by the governments in order to create an index of “freeness”, while de facto measures try to gauge to the
extent to which the official laws are actually enforced on the ground. There are also hybrid measures which
include both de facto and de jure measures, but those will not be discussed.
Figure 1.3 shows an index of freedom of investment in India and China from 1995 to 2015. The
index is compiled from a vast number of de jure variables which try to capture the restrictive effects of
capital controls. It ranks countries from 0 to 100 based on such policies, with anything under 50 being
considered a very restricted capital account. As can be observed, both countries have liberalized their capital
accounts over time, albeit gradually, and only during 2000s. Quinn D. et al (2011) find this measure very
imprecise, due to the binary nature of the variables used, the fact that the index only captures de jure
variables and the observation that the US is ranked the same as Albania, Algeria and the Republic of
Mozambique, which are all considered much more closed to capital than the US. A much stronger de jure
measure of capital controls can be found in recent IMF publications.
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Figure 1.3 Hertitage Foundation's Investment Restrictivenes Index
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Fernandez, A. et al (2015) construct a data set that not only measures capital controls across time
and countries broadly, but also includes data on inflow and outflow restrictions separately. Figure 1.4 and
1.5 show the evolution of capital controls on inflows and outflows of China and India from 1995 to 2013.
The index ranks countries from 0 to 1, 0 being the most free and 1 the most restrictive. Note that both India
and China are located at the restrictive extreme of the spectrum, as the previous index also showed. Both
also exhibit rapid liberalization during 1997, the year of the Asian financial crisis. A reversal however, can
be observed in China during the year 1999 and in India during 2001. This reversal seems sustained until
the present day, and interestingly enough, China appears to be somewhat (.10 point) more liberalized in
2013. This is due to the heavy restrictions India keeps on outflows, but can also be attributed to the nature
of the index, which is measures de jure variables of liberalization. In order to completely grasp the
experience with capital controls fully, it is important to take a look at a de facto measure of capital openness.
Lane and Milesi-Ferretti’s (2006, 2007) de facto measure, which has been called the “industry
standard” of de facto measures for capital openness (Quinn D. et al, 2011) takes the sum of total assets and
liabilities in a nation’s financial market and divides it by GDP. Such a measure will reveal how well
integrated a financial market is to the rest of the world, and the division by GDP allows us to grasp the
magnitude relatively fairly by country. Figure 1.6 shows the evolution of this measure for China and India