##ization of prices, financial reform, a revision of government ’ s role in the economy, urban and rural development, and additional areas opened to fdi. see sala - i - martin, x., ( 2006 ), “ the world distribution of income : falling poverty and … convergence, period ”, the quarterly journal of economics, cxxi ( 2 ). see kehoe, t. j. and ruhl, k. j. ( 2010 ), “ why have economic reforms in mexico not generated growth? ”, journal of economic literature, 48 ( 4 ). bis central bankers ’ speeches the potential for success is high in light of china ’ s proven ability to implement necessary and difficult reforms in the past. given china ’ s importance to the global economy, the world is following this process with fixed attention. the implications of financial development the incorporation of financial reform in china ’ s transformation plan is highly appropriate considering its potential benefits. china can take further advantage of common knowledge regarding financial development, such as the following points, which can be gleaned from years of world experience. first, functioning financial markets are a necessary condition for a prosperous economy. many studies based on cross - country, individual - country, and industry levels confirm that greater financial deepening tends to bring about higher rates of economic expansion. 3 second, the market is a cost - effective mechanism for channeling savings to financing. market functioning, in turn, requires competition, with the free entry and exit of for - profit players, as well as the possibility of the failure of institutions which are no longer viable, provided that the stability of the financial system is preserved. markets also require flexible prices, which of course, include interest and exchange rates. 4 third, productivity may be enhanced by opening an economy to foreign investment and the free movement of capital. it is better for financial institutions to be well - developed and adequately regulated and supervised before the capital account is fully freed. flexible exchange rates and currency convertibility allow for independent monetary policy. furthermore, economies with flexible interest and exchange rates are able to accommodate external shocks more easily than those under rigid price regimes, where adjustment relies heavily on quantity changes, including higher unemployment. fourth, financial markets frequently suffer from imperfections, such as asymmetric information, adverse selection, and moral hazard, which can translate into negative externalities to the rest of the economy. the financial system is based on trust and the management of risk. when risk is not appropriately priced,

contagion may arise and trust may be jeopardized. these limitations make adequate regulation and supervision absolutely necessary. while the rules of the game should provide the correct incentives to market participants, by reducing moral hazard for example, prudential policies should aim at preventing systemic crises. fifth, we are continually learning about how financial systems should best develop. specifically, successful financial liberalization depends greatly on how well and in what order it is implemented. neither can it be considered a panacea. history teaches us that financial crises have been recurrent, and that many of them have resulted from poor policies, a fact to which the recent global financial debacle bears witness. for a review of the literature on the relationship between growth and financial markets, see levine, r. ( 2005 ), “ finance and growth : theory and evidence ”, in aghion, p. and s. durlauf ( eds. ), handbook of economic growth, volume 1, part a. amsterdam, north - holland elsevier, pp. 865 – 934 ; and zhang, j., et al. ( 2012 ), “ financial development and economic growth : recent evidence from china ”, journal of comparative economics, 40 ( 3 ). the advantages and disadvantages of fixed vs. flexible exchange rates have fueled a long - standing debate. for a seminal reference on the benefits of flexible exchange rates, see friedman, m. ( 1953 ), “ the case for flexible exchange rates ”, in friedman m., essays in positive economics. chicago, university of chicago press, pp. 157 – 203. bis central bankers ’ speeches china ’ s financial challenges china has made significant progress in fostering its financial system. key advances include bank restructuring, increased foreign participation in financial institutions, the listing of banks on domestic and foreign stock markets, the development of debt, stock, and derivatives markets, the liberalization of lending interest rates, the initial opening of the capital account, and a stronger regulatory and supervisory framework. these measures have allowed china ’ s financial system to become one of the largest in the world. this is reflected by indicators such as the ratio of financial assets relative to gdp, the number of financial intermediaries, the capitalization value of the stock markets, and the fact that some of the major banks in the world in terms of market value are chinese. 5 this advancement is obviously impressive, especially given the daunting complexity of the system. the next step is