international balance sheets, with an emphasis on highlighting the broader impact on the international financial system.

The rest of the paper is organized as follows. In Section II, we document the basic stylized facts of the international financial integration of China and India. Section III briefly links these facts to the developments in the countries’ domestic financial sectors. (A more detailed account of the development in each financial sector is provided in Appendices I and II.) Section IV analyzes the impact of their international integration on the global financial system. In particular, we discuss: (i) China and India as a destination for external capital; (ii) China and India as international investors; (iii) the contribution of China and India to global imbalances; (iv) whether China and India pose additional global risks. Section V offers some concluding remarks.

# **II. The International Financial Integration of China and India: Basic Stylized Facts**

To document the major trends in China’s and India’s international financial integration, we study the international balance sheets of each country.<sup>8</sup> As mentioned above, we analyze: net foreign asset positions; gross holdings of foreign assets and foreign liabilities; and the equity-debt mix in their international balance sheets. Our focus on the international balance sheets has an advantage over capital flows, since the accumulated holdings of external assets and liabilities is the most informative indicator of the extent of international financial integration (Lane and Milesi-Ferretti 2006).<sup>9</sup> Moreover, they provide a reasonable measure of international portfolios, where they stand and how they might shift, and help to compare stock positions with the evolution of capital flows (with flows responding to stock adjustments). In some places we also discuss recent patterns in capital flows, especially where these patterns signal that the current accumulated positions are undergoing some structural changes toward new portfolio balances.

We start with Figure 1, which plots the evolution of the net foreign asset positions of China and India from 1985 to 2004. The figure shows that both countries have followed a similar path – accumulating net liabilities until the mid 1990s but subsequently experiencing a sustained improvement in net foreign asset position. By 2004, China was a net creditor at 8 percent of GDP, whereas Indian net external liabilities had declined from a peak of 35 percent of GDP in 1992 to 10 percent of GDP in 2004. Figure 1 also shows that the net foreign asset positions of other East Asian countries also have improved in the wake of the 1997-98 financial crisis, while the net positions of the G7, Eastern Europe, and Latin America have deteriorated. According to the IMF’s World Economic Outlook database, since 2004, China’s current account surplus has continued to increase, reaching 7.2 percent in 2005 and projected at 7.2 percent for 2006-07,

> 8 Lane (2006) provides more details concerning the historical evolution of the international balance sheets of China and India.

> 9 The international balance sheets cumulates capital inflows and outflows and, at the same time, takes into account the impact of valuation changes driven by capital gains and losses on asset and liability positions. The size of cross-border holdings highlights the relative importance of China and India in global crossborder portfolios. The level of foreign assets also determines the level of their exposure to external financial shocks, while the level of foreign liabilities measures the vulnerability of foreign investors to domestic shocks.

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