Financial liberalization and capital allocation in China

The aim of this paper is to quantitatively evaluate the consequences of capital account liberalization on China’s real economy and capital allocations when economic uncertainty surges. We construct a heterogeneous-agent open economy dynamic general equilibrium model featuring financially constrained households and multiple types of saving instruments, including housing assets and foreign assets. Capital account liberalization offers China’s domestic households more options for purchasing foreign assets as an alternative saving instrument, enhancing consumption-smoothing capacities and mitigating the crowding-out effect of the housing sector on the real economy. The quantitative analysis further indicates that in the short run, the reduced investment demand for housing assets caused by financial liberalization leads to more capital being allocated to the domestic real sector, and in the long run, a trade-off exists between smoothing consumption and promoting output. When uncertainty increases, capital account liberalization can improve social welfare and facilitate capital flows from the housing sector to the real sector.