China, India Should Liberalise Cautiously

THE ASIAN Development Bank today said that China, India, Vietnam and Pakistan were vulnerable to a financial crisis of the kind that swept other parts of Asia in 1997 and 1998, if they opened up their economies too hastily.

In a study of financial markets in the region, the ADB said these four countries exhibited fundamental macroeconomic weaknesses or a fragile financial sector or both and needed to be careful about how they liberalised their economies.

"One lesson for these countries from the East Asian crisis is that capital account liberalisation should strictly follow the proper sequencing of financial and then capital account liberalisation," the ADB report said.

"Another lesson is it would not be wise for these countries complete financial liberalisation... Without creating the necessary institutions for prudential regulation and supervision and a desirable price and economic incentive system in the real sector," the report added.

A crisis of confidence, the report said had caused the 1997 battering of financial markets in the five most-affected countries -- Indonesia, Thailand, Malaysia, South Korea and The Philippines -- came from a crisis of confidence traced to structural weaknesses.

The report said the root causes of the crisis of confidence were not weak macroeconomic fundamentals but structural problems including liberalisation of financial markets without adequate supervision and regulation, crony capitalism and policy mistakes in managing private capital inflows. "The crisis involved private-to-private capital flows, not fiscal profligacy or monetary expansion. It was a liquidity crisis, not a solvency crisis."

While restructuring and reform were medium to long-term goals for these countries, in the short term they must reflate, the report said.

It added the reflation should come through accommodative fiscal and monetary policies, but the financing of these policies should be designed to avoid undue inflation, crowding out of private investments and foreign exchange outflows.

Reform efforts should target both the banking sector and capital markets. Countries should find a balance between the developmental role and commercial orientation of banks, resolve non-performing loans, enhance prudential regulation and supervision and strengthen financial sector infrastructure, the report said.

Economies should also develop domestic bond markets to broaden the investor base and prevent companies from relying on potentially volatile external finance, it added. This should be accompanied by improvement of corporate governance, reinforcement of capital market supervisory arrangements, improvement of equity market infrastructure and re-evaluation of market volatility controls, it said.

Regional, international efforts also needed to prevent the recurrence of region-wide currency crises, Asian nations must set up regional funding and guarantee mechanisms and move toward a full currency union, the ADB report said.

It also favoured the setting up of an Asian Monetary Fund. The suggestion, which has been previously mooted, has been viewed with some suspicion by the IMF.

But the report said: "Since the battered economies need financial and moral support from the regional and international communities and the assurance they will not allow financial and currency instabilities to rule in international financial markets, (setting up) an Asian Monetary Fund will promote self-help within the region, address regional developmental issues and boost confidence in the affected countries.