Aurora Borealis
1 January 2014 CFA Institute Journal Review

Is China or India More Financially Open? (Digest Summary)

  1. Biharilal Deora, CFA, CIPM

Because of the current and potential sizes of China’s and India’s economies, the world has a huge stake in the integration of their financial systems into global markets. The authors use various measures to examine the absolute and relative openness of these two economies. They challenge the popular measures that suggest that China and India restrict capital flows to a similar extent and that rank China as a more open economy than India.

What’s Inside?

The authors examine the degree of capital account openness for both China and India. They consider eight dimensions of capital account openness, including several based on the law of one price, which examines the offshore–onshore gaps in foreign exchange forwards, short-term yields, bond yields, and equity prices. Other standard “openness” measures include analysis of saving and investment and external flows. The authors also propose two new measures: the openness of consolidated banking systems and the internationalization of currencies. Generally, the measures reveal that both economies are becoming more financially open. In six of the eight dimensions, India’s economy appears to be more open financially.

How Is This Research Useful to Practitioners?

The popular Chinn–Ito Index is based on the study of regulations. The authors do not believe it is the most appropriate index for analysis and question its suggestion that China and India restrict capital flows to a similar extent.

The authors also challenge Lane and Milesi-Ferretti’s (Journal of International Economics 2007) ranking of China as the more open economy. The authors’ analysis of six out of eight factors supports the argument that India is the more open economy, possibly because of India’s lack of willingness to enforce regulatory controls and its relatively high tolerance of outside capital inflows into its equity markets, reflecting the country’s need to finance its deficits. Other factors include India’s corporate laws, which allow intra-firm transactions that can lead to arbitrage between onshore and offshore markets. These factors, along with the heavier influence of global banks in India’s banking sector, contribute to the openness of its economy. The internalization of China’s currency—creating a pool of renminbi bank accounts and bonds outside of mainland China and allowing offshore delivery of the renminbi—is making capital controls ineffective and providing arbitrage opportunities.

The classic “openness” measures fail to reveal how fast the economies have opened up lately and what the future holds. The authors’ research allows practitioners to gain a clearer picture from their analysis of the various measures.

How Did the Authors Conduct This Research?

The authors question whether the existing openness measures appropriately track the progress and relative position of China and India in international financial integration.

They test two time-series hypotheses concerning the relative financial openness of India and China. They also test one cross-sectional question: Is India more open than China? To begin, they use four traditional price-based measures and analyze the average deviations from the law of one price, including deviation of onshore and offshore foreign exchange forwards, gaps in short-term yields, gaps in bond yields, and deviations in equity prices in offshore and onshore exchanges. All four price-based measures—covering currency, money, bond, and equity markets—generally suggest the greater integration of India in global finance. The authors use t-tests and ANOVA F-tests to confirm that the larger averages of China’s onshore–offshore price gaps are statistically different from those of their Indian counterparts.

The authors then test the effect of capital market openness by examining how closely changes in domestic saving are related to changes in investment using estimated Feldstein–Horioka coefficients (Economic Journal 1980). This test identifies China as the more open economy. Evaluating the gross external positions or cross-border flows relative to domestic outputs, however, they determine that neither country is financially open yet and that China has further to go than India.

The authors suggest three new measures to determine the absolute and relative degrees of capital market openness between China and India: (1) consolidated banking market integration (i.e., credit share of Bank for International Settlements–reporting banks in the respective countries), (2) a currency internationalization measure, and (3) the ratio of currency trading to the economy’s international trade. These measures identify India’s economy as more integrated.

Abstractor’s Viewpoint

A foreign fund, when looking at traditional measures of an economy’s openness, could end up making poor decisions. The authors show why such measures can be misleading and why it is important to track the progress and the relative position of a country.

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