# **I. Introduction**

The goal of this paper is to assess how the increasing economic prominence of China and India is reshaping the international financial system. China and India have grown rapidly in the last decade, at average annual growth rates of 9.1 percent and 6.1 percent, respectively, and they are expected to continue their fast growth in the years to come. For example, Winters and Yusuf (2007) project that China and India are expected to grow at annual rates of 6.6 and 5.5 percent, respectively, between 2005 and 2020, while the world economy is expected to grow at 3.1 percent per year during the same period, resulting in projected shares of world GDP for China and India of 8.2 and 2.4 percent in 2020. Their exports and imports of merchandise and services have also grown substantially in recent years.<sup>1</sup> This economic performance, combined with the openness of their economies, makes China and India crucial players in the world economy.<sup>2</sup> China and India have also become increasingly prominent in the international financial system. Both countries have gradually adopted policies that are more market oriented and open to the flow of capital across their borders. Although their financial systems still remain restricted, China and India have received significant capital inflows in recent years. Moreover, both China and India have become key outward investors. In particular, China is the world’s largest holder of foreign reserves, reaching 853.7 billion U.S. dollars at the end of February 2006. India’s reserves are also very high, standing at 139.5 billion dollars in mid-January 2006. Although at a much smaller scale, China and India have also recently started to invest in the private sectors of other countries: the most well-known example is the purchase of the PC business unit of IBM by the Chinese company Lenovo.<sup>3</sup> To analyze the implications of the emergence of China and India for the global financial system, we consider several dimensions of their international financial integration: net foreign asset positions, gross holdings of foreign assets and foreign liabilities, and the equity-debt mix on international balance sheets. We also analyze the importance of domestic developments and policies related to their domestic financial systems for both the current configuration of their external assets and liabilities and the dynamics of the international financial integration of China and India.<sup>4</sup> We thus discuss the effects of three different interrelated domestic factors in each economy: (i) financial liberalization and exchange rate/monetary policies; (ii) the evolution of the financial sector; and (iii) the impact of financial reform on savings and investment rates. Finally, we assess the current international financial impact of these countries and probe how their increasing

> 1 Over 1985-2004, the trade/GDP ratio for China increased from 24.1 percent to 69.4 percent, while the ratio for India grew from 13.2 percent to 39.9 percent. By 2004, China accounted for 6.3 percent of global trade, with India taking a 0.9 percent share. (As is the case throughout this paper, these calculations do not take into account the revision to Chinese GDP data that was announced at the end of 2005.)

> 2 For instance, UNCTAD’s 2005 Trade and Development Report argues that strong demand, especially from China and India, is the main factor behind the increase in commodity prices (including oil) since 2002.

> 3 See Huang (2006) for an analysis of this transaction.

> 4 In the other direction, it is clear that international financial integration fundamentally influences the functioning of the domestic financial system. That relation, however, is not the focus of this paper.

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