financial liberalization will widen opportunities for foreign investment and expand the international investment alternatives for domestic residents, with the accumulation of external assets and liabilities by the private sectors in these countries likely to grow. With these changes, we may expect to see a diminution in the compositional asymmetries of external liabilities, with a greater dispersion of inflows among the FDI, portfolio equity, and debt categories. On the asset side, there should be a marked increase in the scale of acquisition of non-reserve foreign assets. With the projected increase in their shares in world gross domestic product (GDP), China and India are set to become major international investing nations.

Although projections about net balances are subject to much uncertainty, institutional reforms and further domestic financial development would put pressure on the emergence of significant current account deficits in both countries in the medium or long term, all else being equal. Accordingly, if taken together with a possible deceleration in their rate of reserve accumulation, the roles of China and India in the global distribution of external imbalances could undergo a substantial shift in the coming years. These changes will have significant implications for other participants in the international financial system.

The analysis in this paper builds on several strands of the existing literature. A number of recent contributions have highlighted the importance of domestic financial reform for the evolution of these countries’ external positions.<sup>5</sup> The roles of China and India in the international financial system have been much debated, with opinions divided between those who consider the current role of these countries (together with other emerging Asian economies) as large-scale purchasers of reserve securities to be essentially stable in the medium to long run and those who believe that the current configuration is a more transitory phenomenon.<sup>6</sup> Relative to the existing literature, we make a number of contributions. First, we provide a side-by-side examination of China’s and India’s current degree of international financial integration, with a focus on the level and composition of their international balance sheets. Although we put these countries together in the analysis because of their size and growing economic importance, many differences remain and are highlighted in the paper. Second, we provide a comparative account of the development of their domestic financial sectors, and we show how distinct policies in the two countries help explain differences in their external capital structures.<sup>7</sup> Third, we conduct a forward-looking assessment of how future reforms in their domestic financial sectors will affect the evolution of

> 5 On China, see among others Blanchard and Giavazzi (2005), Chamon and Prasad (2005), Lim, Spence and Hausmann (2005), Goodfriend and Prasad (2006), Ju and Wei (2006), and Prasad and Rajan (2006). On India, see among others Kletzer (2005) and Patnaik and Shah (2006b).

> 6 Dooley, Folkerts-Landau, and Garber (2003) famously dubbed this configuration the “Bretton Woods II” system; Caballero, Farhi, and Gourinchas (2006) provide theoretical support. Although this hypothesis has a broad appeal in explaining the stylized facts of recent imbalances, it remains highly controversial. Other authors, such as Aizenman and Lee (2005), Eichengreen (2004), Goldstein and Lardy (2005), and Obstfeld and Rogoff (2005) provide broad-ranging critiques.

> 7 The analysis here is partly based on Bai (2006), Kuijs (2006), Li (2006), Mishra (2006), Patnaik and Shah (2006a), and Zhao (2006).

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