Rumor has it that China is set to accelerate the deregulation of its financial system.

For years, China has restricted the ability of its residents and foreign investors to pull and push their money in and out of the country. While that may be illiberal, there was a sound reason for this restriction: Every emerging market that has scrapped these regulations has had a major financial crisis and subsequent trouble with growth.

The world can’t afford for that to happen in China. China is too big to fail.

This issue came to the fore last year when the People’s Bank of China (PBOC) announced that it might “liberalize” its financial system in five to 10 years. This move stood in stark contrast to a Chinese National Development and Reform Commission (NDRC)-World Bank report that put such a plan much further into the future. That study cited the overwhelming evidence that shows, first, that dismantling cross-border financial regulations is not associated with growth and, second, that it tends to cause banking crises in economies with fledgling financial systems.

But now, Guan Tao, a director general in the State Administration of Foreign Exchange has announced that “capital account convertibility” — as wonks call financial globalization — should happen in just a few years’ time. Indeed, last week China started raising the ceiling on the amount of foreign speculation in China.

Why the rush? Guan Tao says it’s about making the yuan a global currency. No doubt, in the long run it sure would be good to have more than the U.S. dollar on offer in the world economy. The dollar is increasingly a risky bet. Trading in yuan would reduce exchange-rate risk for one of the world’s largest trading nations (and its trading partners) and global risk by alleviating the over-reliance on the dollar.

That said, China should not put the cart before the horse. To get where it wants to be and deserves to be, China will need to carefully reform its interest rate, exchange rate and financial regulatory regimes first. Managing these reforms successfully will be close to impossible to achieve with a deregulated capital account. Financial stability is essential for China to move on with necessary reforms and maintain growth — let alone political stability.

Interest rates in China have been kept low to provide cheaper loans for industry. This has been very beneficial, playing a key role in a Chinese industrial policy that spawned the world’s manufacturing export powerhouse. However, at this point China’s investment rates are too high and China needs to consume more.

Low rates moved households to over-invest in real estate and have caused a real estate bubble in the country. If China deregulated cross-border financial regulations before reforming its interest rate policy, there could be enormous capital flight out of China. Low interest rates in China, juxtaposed with higher rates available abroad, would provide an attractive rate of return for wealthy Chinese. While China has taken small steps in interest rate reform, it has a long way to go.

Capital flight would also jeopardize China’s exchange rate reform, which has made great strides over the past two years. Exchange rate reform has made the yuan appreciate significantly, with estimates of yuan appreciation now at 35 to 50 percent.

Capital flight could cause a major depreciation of the currency that could hurt consumers by further weakening their purchasing power, and stall reform.

China will also need to continue financial regulatory reform. China’s big banks are still indirectly responsible for large amounts of nonperforming loans and are increasingly intertwined with a shadow banking system that is not properly regulated. These banks need serious reform — or they will not be able to compete with international financial firms upon liberalization.

The global record is clear: When Latin America prematurely opened its doors to foreign finance in the 1990s, domestic banks got wiped out. The new dominant players — foreign banks — didn’t lend to domestic firms with innovative new ideas. That undermined growth and economic transformation, resulting in anemic investment rates, de-industrialization and very little inclusive growth.

The International Monetary Fund’s own (and other) research shows that capital flows are susceptible to massive surges and sudden stops. These trends have only intensified since the global financial crisis.

For a while, there was a surge in capital flows to emerging markets due to low interest rates in the industrialized world, which made things look good. Now that the U.S. Federal Reserve has hinted its bond buying programs will slow, capital is fleeing from emerging market countries. But even before that trend occurred, things were more bubbly than rosy. During the 2009-2013 period, when capital flowed in, exchange rates appreciated. That hurt export prospects and caused asset bubbles.

Now that exchange rates are depreciating, all those loans from the credit bubble are more expensive because they are denominated in dollars.

China’s ambitions aside, the fundamental economic lesson is clear: Regulating capital flows is essential for the exchange rate to fluctuate relative to economic fundamentals — rather than the irrational whims of speculative finance. Indeed, there is now a consensus among economists and international financial institutions that capital account liberalization is not associated with economic growth in emerging markets, and that it causes banking crises (especially in nations with fixed exchange rates).

Such evidence has even prompted the IMF — the very institution that once saw rapid capital account liberalization as a No. 1 — to change its tune. The IMF now officially recommends the cautious sequencing of capital account liberalization.

China should remember with pride that it was not as severely affected by the financial crises of the 1980s and 1990s in Latin America and East Asia. These were crises where capital account liberalization played a big role. Large countries such as Indonesia were set back by as much as a decade. Why did China not experience the same disaster? Because it prudently regulated cross-border capital flows.

If China does not now proceed with great caution, few countries will weather a financial crisis when it hits China. All around the globe, we are reliant on China for trade, investment and finance.

China is too big too fail. Thus, it is in the interests of the United States and the rest of the world to urge China not to deregulate its financial system. But most of all, it’s in China’s very own interest.

Kevin P. Gallagher is a professor of international relations at Boston University and a regular contributor to The Globalist, where this article initially appeared. © 2013 The Globalist

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