By Yiping Huang – Peking University;
Ran Li – Peking University;
and Bijun Wang – CASS
In late 2013 the Chinese authorities put together a reform agenda for the financial sector, focusing on reducing entry barriers, liberalising market mechanisms and improving financial regulation. This could be the final frontier of China’s financial reform, which — according to the plan — should make critical progress by 2020.
So why did the leaders decide to accelerate reform efforts in this area?
China’s financial reform started in 1978. Reforms in the past, however, have exhibited a unique pattern of being strong in building a comprehensive framework and growing transaction volume but weak on liberalising market mechanisms and improving corporate governance. The Chinese financial system already resembles a modern financial sector in advanced economies. Quantitative indices show the size of Chinese financial assets is very large. However, China still lags significantly in freeing up key financial market prices, especially interest and exchange rates. Most commercial banks still behave more like SOEs than listed companies.
This unique pattern of financial reform is closely related to the overall asymmetric liberalisation approach adopted by the Chinese government. While most products have been fully liberalised, factor markets remain heavily distorted. These distortions are like subsidising the corporate sector while taxing households. This asymmetric approach is behind China’s peculiar economic model with both strong growth performance and serious structural imbalances.
Repressive financial policies — such as controls over interest rate, exchange rate, credit allocation and capital mobility — are important forms of factor market distortions. The degree of financial repression in China today is not only higher than the world average but is also higher than average for low-income countries.
Surprisingly, such policy distortions in the financial market did not prevent rapid economic growth. In fact, earlier empirical works confirm that financial repression actually played a positive role in supporting economic growth, at least during the early reform years.
So why is the status quo no longer an option? First, the growth impact of repressive financial policies has changed from positive to negative. Second, repressive financial policies already contribute increasingly to macro-economic and financial risks. Important examples include growing banking risks and property bubbles. And, third, many of the policy restrictions are no longer sustainable, giving rise to the major concerns of ‘hot money’ and the rapidly growing ‘shadow banking’ system.
All this suggests that the authorities have no alternative other than completing the transition to a market system in the financial sector. The official plan covers 11 specific areas, including reducing entry barriers, liberalising interest and exchange rates, developing multi-layer capital markets, achieving capital account convertibility, and strengthening financial regulation, among others. All of these pursuits are centred around two key tasks: interest rate liberalisation domestically and currency internationalisation externally.
Both of the above tasks have a large number of prerequisites. For instance, before fully liberalising interest rates, an effective reform of commercial banks is necessary in order to avoid reckless competition after reform, and a new monetary policy instrument is needed if the People’s Bank of China’s (PBoC) base interest rate regulation is to go ahead. For renminbi internationalisation it is necessary, but not sufficient, to have: sustainable growth of the Chinese economy; an open, large, efficient and liquid financial market; and the credibility of China’s economic, legal and political systems.
While financial liberalisation is critical, it can also raise financial volatility. One big issue is whether China will be able to avoid a financial crisis. This is possible but is dependent on how it implements reforms. In the near term, the Chinese government still has a sound fiscal system to contain financial risks in individual areas, but the system could become risky if the central government’s credibility is overdrawn. If this is not addressed quickly, it could amount to a big problem.
At the moment, policymakers are still building consensus on pace, extent and sequence of various reform measures. In particular, whether China should move rapidly toward full capital account convertibility is still a subject of major debate. Yet, in the meantime, financial reform is already picking up the pace. PBoC Governor Zhou Xiaochuan indicated that it would take one to two years to liberalise interest rates. Some officials also suggested that the central bank may withdraw from daily intervention in the foreign exchange market, allowing market forces to determine the exchange rate.
But there are still important hurdles for the authorities to overcome in the near term. Introducing the deposit insurance mechanism has been talked about for years. But it still hasn’t happened yet. Establishing market-based interest rates is also dependent on successful resolution of the moral hazard problem. How to allow default of some debt and trust products without causing systemic risk remains a tough challenge for policymakers in the coming year.
Yiping Huang is Professor of Economics at Peking University and the China Economy Program at the ANU.
Ran Li is a PhD Candidate at the National School of Development, Peking University, and currently visiting the Australian National University.
Bijun Wang is a senior research fellow at the Institute of World Economics and Politics, Chinese Academy of Social Sciences.