Ocnus.Net
China’s Looming Financial Reform Challenges
By Pieter Bottelier, China Brief 13/12/07
Dec 15, 2007 - 11:12:18 AM
For example, how and
how fast should China liberalize domestic interest rates, open the capital
account, appreciate and flexibilize the exchange rate, develop domestic capital
markets, promote outward investment? Most foreign observers urge China to
reform the financial system faster, but there are also concerns that China may
try to complete the reform process too fast and lose control. The financial sector
is the nerve center of a market economy, and regulatory institutions need to
stay ahead of system manipulators and innovative swindlers. The pace of reform
has to be conditioned by the capacity of the government to stay ahead of the
game. China’s institutional framework, though much stronger than 10 years ago,
remains relatively weak, and, as recent experience shows, regulatory
institutions in the financial sector have yet to learn how to coordinate their
policies and decisions. Effective lateral cooperation between parallel agencies
remains a big challenge for China, and not just in the financial sector. The
purpose of this note is to discuss some of the most pressing financial reform
challenges in light of domestic and international circumstances.
Domestic challenges
(a) Consumer price inflation (CPI)
After a period of mild deflation (1998-2002) followed by years of remarkable
CPI stability (2003-early 2007), concern about rising consumer prices has
returned. The monthly CPI increased by 6.9% in November (over November 2006),
the highest rate increase in 12 years. Unlike the previous episode of high CPI
inflation (1992-1995), however, this time consumer prices are rising primarily
because of supply factors in the food sector (pork, eggs, vegetable oil,
noodles), not because of excess demand—but that could change. The government is
understandably concerned that inflationary expectations may set in and begin to
drive price increases in the non-food components of the CPI as well. This would
be possible because of the large monetary overhang in the form of an unusually
high M2/GDP ratio (165 in October).
As a precaution the central bank has tightened monetary policy in recent months
and especially in recent weeks. It should be remembered, however, that the
central bank only has direct control over base money supply, not liquidity in
the hands of the public (M2). Liquidity in the banking system is already tight
as is evidenced by sharp recent increases in short-term inter-bank rates.
Should the central bank tighten monetary policy too much, there is a risk of a
sharp output contraction without necessarily a matching reduction in CPI
inflation. That would be the worst possible outcome. With good management and a
bit of luck the supply factors that caused higher CPI inflation so far in 2007
in the first place, can be overcome before inflationary expectations change the
parameters. At this point in time the main concern is still asset price
inflation, not CPI inflation, and with regard to asset price inflation I am
more concerned about the stock market than urban real estate prices, which,
though rising rapidly in some areas, have on average lagged urban income
growth.
(b) The stock market bubble
The successful experimentation with market-based solutions for the conundrum of
non-tradable state-owned shares in 2005 and the adoption of those solutions for
all majority state-owned listed companies triggered a revival of China’s stock
markets in 2006. The A-share markets in Shanghai and Shenzhen became runaway bull
markets, outperforming all major stock exchanges in the world. At the end of
October 2007 the average PE ratio (on projected earnings) for Shanghai listed
A-shares was over 60, compared to about 20 for emerging East Asia (excluding
China) and India. The ratio was about 70 in Japan before that bubble burst in
1990. In spite of a substantial (20%) market correction in November 2007, the
government is understandably concerned about the risk of new bubbles and the
consequences of a possible market crash.
There is little doubt that China’s stock market, in spite of the November
correction, remains in bubble territory. This entails both political and
economic risks. The former is important in China, because of the very large
number of individual households that own shares—probably over 60 million. The
risk that a stock market crash might trigger a deep economic recession is hard
to assess, but is probably lower than in otherwise similar circumstances in
developed market economies. Since buying on margin is officially prohibited
(and believed to be rare) in China, the situation is different from that in
Japan in the late 1980s or in the U.S. in 1929; it entails less risk that a
downturn becomes irreversible once it has started. Moreover, most of the
non-tradable shares, still state-owned and accounting for some 65% of the total
market capitalization of listed companies, will not become tradable for some
time. They are usually carried on the books of their owner at original nominal
value. Yet, a sharp down turn could be dangerous for financial system stability
if a large proportion of share purchases is financed with borrowed
funds—information on this is not readily available. Generally, the higher the
proportion of “own funds” used to finance share purchases, the lower financial
system risks. It is probably fair to assume that a high percentage of share
purchases in China by households, corporations and public agencies alike is
financed from “own funds,” A-share purchases by foreign interests are
relatively small and strictly regulated under the Qualified Foreign
Institutional Investor (QFII) scheme. Therefore, the main risk of a sharp and
sustained market downturn lies probably in personal bankruptcies and the
inevitable depressing effects on consumer demand and the real estate market.
The government has been trying to cool the market; for example, the stamp duty
on share transactions was tripled in May 2007, the ceiling on QDII outflows was
lifted and large domestic IPOs by state banks and state energy companies were
promoted to increase the supply of tradable shares. Yet, except for the market
correction in November, the risk of bubble conditions has not been eliminated.
Furthermore, on August 20, 2007 the State Administration of Foreign Exchange
(SAFE) announced that Chinese households would be permitted to invest
(unlimited amounts) directly on the Hong Kong stock exchange. This announcement
was undoubtedly inspired by the desire to slow the accumulation of foreign
exchange reserves and reduce pressure on the domestic stock market. In early
November, however, after the Hong Kong market had risen by some 40% following
the SAFE announcement, Premier Wen Jiabao indicated that final approval of the
scheme would be withheld until a number of conditions had been met, which could
take a long time. The episode illustrates the difficulty of managing liquidity
in the hands of the public and the embarrassing lack of policy coordination
between relevant agencies of the state. A sudden large outflow of private
savings from China to Hong Kong could indeed destabilize both domestic and Hong
Kong capital markets; total deposits in the banking system at the end of the
third quarter of 2007 amounted to some RMB37 million (about US$ 5 trillion
equivalent). More than half of that amount was owned by households and
increasingly held in liquid form as bank demand deposits.
Although China’s central bank is primarily concerned with the management of
liquidity in the banking system (narrow liquidity or the margin of loanable
funds, i.e. bank liabilities minus outstanding loans and reserve requirements),
it also plays a role in the control of asset price bubbles driven by excess
liquidity in the hands of the public. In spite of several rate increases during
the past 6 months, bank deposit rates have once again become negative with
respect to current CPI inflation. This has not only accelerated to shift from
time deposits to more liquid demand deposits and from demand deposits to share
purchases, but it has also driven more financial intermediation underground to
unregulated informal money and capital markets which reduces the effectiveness
of macroeconomic controls. As China knows well from earlier experience,
negative real deposit rates can undermine the health of the entire financial
system [1].
Controlling asset price bubbles fueled by excess liquidity in the hand of the
public is always much more difficult than controlling bank liquidity and bank
lending, but it should not be impossible. To tackle the problem, all relevant
government authorities have to cooperate, including PBC, CBRC, CSRC, the
State-owned Assets Supervision and Administration Commission (SASAC) and the
Ministry of Finance (MOF). Policy measures and administrative measures are both
needed. For example, MOF could introduce a ban on the use of cash flow
surpluses for share purchases by local governments and their agencies. The
government could even introduce a ban on share ownership by most public
agencies. SASAC could prohibit share speculation by companies under its control.
CBRC and CSRC together should try to avoid or eliminate the use of bank and
brokerage loans for share purchases and guard against the emergence of
leveraged share buying. PBC should raise deposit rates. This will not stop
bubbles, but it has to be done for other reasons anyway. CSRC should accelerate
the listing in Shanghai and Shenzhen of high quality companies and fully
integrate the domestic B- and A-share markets as soon as possible. In addition,
share transaction taxes could be further increased, a capital gains tax on
realized share profits could be introduced, the Qualified Domestic
Institutional Investor (QDII) ceiling further lifted and the corporate bond
market enlarged.
(c) Economic imbalances
China’s economic and social imbalances—over-reliance for GDP growth on
investment and net-exports, growing social inequality, environmental
degradation—have become very serious and need to be addressed by all available
tools, including further financial sector reform. One of the reasons for
over-investment, particularly in manufacturing, is the low ceiling on deposit
rates that renders them negative with respect to current CPI inflation. Low
deposit rates have tended to increase excess liquidity in the corporate sector
and depress the entire interest rate structure. Especially for large
corporations with ready access to the official sources of finance, capital
tends to be too cheap in China.
Other factors that have contributed to “over-investment” by corporate China in
recent years include: (1) a sharp improvement in corporate profitability since
the beginning of this century, combined with the virtual absence of dividend
payments, (2) the fact that privatization proceeds have typically accrued to
the enterprises being privatized (or their holding companies), thus increasing
resources available for investment, and (3) easy access (for surplus
production) to export markets where prices are reported to be better on average
than in China’s hyper-competitive domestic markets [2]. Even in cases where
export prices are lower than domestic prices, corporate profitability does not
necessarily fall due to scale economies and/or continued high productivity
growth. This explains how the combination of low interest rates, high
liquidity, high corporate profits and strong productivity growth has created a
kind of manufacturing investment “flywheel” effect that is contributing to
growing imbalances in China’s economy. Part of the cure for these imbalances
therefore lies in an upward adjustment of the entire interest rate structure
and other measures that will have the effect of suppressing unregulated
financial markets. Faster exchange rate appreciation would also help to redress
domestic economic imbalances.
Although short-term money market interest rates and rates on government and
corporate bonds are essentially market-driven, China maintains a ceiling on
bank deposit rates and a floor under bank lending rates (mainly to protect
gross margins in the state-controlled banking system). Liberalization of the
entire interest rate system would promote healthy competition in financial
intermediation, which will have adverse consequences for the profitability of
relatively inefficient financial institutions, as is normal in a market
economy. In the interest of completing market reforms and addressing economic
imbalances China should liberalize all deposit and lending rates as soon as
possible without risking stability of the financial system.
International challenges
The international dimensions of domestic financial liberalization are very
important. The last thing China needs under current circumstances is additional
“hot money” inflows in response to higher domestic deposit rates. To reduce
that risk, domestic interest rate liberalization should be combined with the
“flexibilization” of exchange rate management and further capital account
opening. There are, however, good reasons why China may wish to keep at least
some capital controls and to continue managing its exchange rate, though with
greater flexibly than in the past. The current international financial system
has become unstable, because, since the collapse of the Bretton Woods system in
1971, there are no built-in restrictions on international liquidity creation
through U.S. current account deficits. In any event, China may wish to protect
its economy against unwanted speculative capital inflows (or outflows) and
other potentially destabilizing cross-border financial transactions. In light
of the very serious international economic imbalances that plague the global economy,
the current U.S. dollar-based international financial system looks
unsustainable in its present form.
Since the beginning of this century, the world has seen an unprecedented
worsening of global trade imbalances, reserve accumulation in surplus economies
(such as China) and an accumulation of net external liabilities in the U.S.,
custodian of the international monetary system since the collapse of Bretton
Woods. Most international reserves are invested in U.S. dollar-denominated
financial instruments. The U.S. has become the world’s largest debtor nation.
The declining international value of the U.S. dollar since 2003 has reduced its
attractiveness as reserve currency and increased pressures for the development
of alternative ways to invest reserves and store wealth. If the custodian and
greatest beneficiary of the international monetary system (i.e. the U.S.), is
unable, for whatever reason, to reduce its unsustainable external deficit
without forcing major wealth losses on its creditors in the form of a declining
dollar, then the system itself is potentially at risk. Since return to a
Bretton Woods-type international financial system (which requires much greater
domestic policy discipline than the current system) is implausible, the
question arises what a large developing country like China can do to protect
its economy from the vagaries of the current system without contributing to
instability. When its domestic financial system is sufficiently mature some
years down the line, China faces a dilemma: join the international system fully
and play by its rules, or maintain at least some capital controls and influence
over the exchange rate. The first choice risks importing instability, the
second risks contributing to instability.
Some have argued that the main source of the current global economic imbalances
is the inability or unwillingness of the U.S. to avoid sustained large external
deficits through domestic policy adjustments. Others emphasize that a large
part of the weakness of the current international financial system is precisely
the fact that large surplus economies like China do not play by the same rules,
but instead link their currencies to the U.S. dollar and avoid market-based
exchange rate adjustments through market intervention. As China’s example
demonstrates, such intervention permits global imbalances to grow larger than
otherwise would have been the case. In addition, China’s efforts to prevent or
slow both nominal and real exchange rate appreciation (through domestic
sterilization) present huge challenges of domestic monetary management. Since
China’s trade and current account surpluses have become the largest in the
world in absolute terms (2006 and 2007) and are now also among the largest in
relative terms, it is hard to avoid the conclusion that China has become a
contributor to global imbalance. The solution, however, is not simple; China is
in a “catch-22” situation. Although China’s exchange rate is undervalued and
should be allowed to appreciate faster, the question remains: How can countries
like China be expected to fully play by current international rules if those
rules may be the source of international financial instability?
It is hard to avoid the conclusion that modifications of the current
international monetary system are needed. The internationally agreed, IMF-led
Special Drawing Right (SDR) scheme that was introduced in 1969 was by all
accounts a system innovation of monumental importance. It turned the IMF into a
kind of global central bank responsible for ensuring adequate international
liquidity to finance economic growth and trade. Perhaps the SRD scheme can be
modified to soften the effects of and ultimately redress the severe and
unsustainable current trade and financial imbalances [3]. In the absence of credible
western leadership on global monetary system reform, Asia, including China, may
have to take the lead in developing new schemes designed to ensure global
economic balance with enough new liquidity to finance growth.
China has to complete its domestic financial system reforms in the midst of
uncertainty over the future of the international monetary system. It has to
make its own assumptions about the merits of the U.S. dollar as reserve
currency, invest its mammoth reserves in ways that best serve the country’s
long-term economic interests, which include global stability and development. A
strategic economic dialogue between the U.S. and China on bilateral issues and
trade imbalances is important, but not sufficient to solve the conundrum of
unsustainable global economic imbalances. China should continue to open its
financial system to foreign participation, liberalize financial markets,
flexibilize exchange rate management and gradually open its capital account. It
may, however, wish to stop short of fully embracing all aspects of the current
international financial system. That should not prevent China from actively
participating in international efforts to improve the current international
financial system.
Notes
1. As part of the macro economic reforms of 1993, deposit rates were indexed to
inflation to encourage time deposits and suppress financial intermediation
outside formal channels.
2. Over-investment is in quotation marks because under current circumstances in
China we see little evidence of idle production capacity because producers are
usually able to increase export sales or substitute for imports, thus adding to
the country’s ballooning net-exports since 2005.
3. Fred Bergsten made an interesting suggestion in this regard in an op-ed piece
in the Financial Times of 11 December 2008.
Source: Ocnus.net 2007