Working Paper 2018-10
China maintains tight controls over its capital account. Its prevailing regime also features financial repression, under which banks are often required to extend a fraction of funds to state-owned enterprises (SOEs) at below-market interest rates. We incorporate these features into a general equilibrium model. We find that capital account liberalization under financial repression incurs a tradeoff between aggregate productivity and intertemporal allocative efficiency. Along a transition path with a declining SOE share, the second-best policy calls for a rapid removal of financial repression, but gradual liberalization of the capital account.