- Unwelcome capital outflows forced China to take a break in its very gradual financial liberalization. New leadership have decided to accelerate efforts to modernize the financial sector
- Because of systemic importance, China must manage the trifecta of sustainable and balanced growth promotion, financial liberalization and financial stability
- Successful financial liberalization must include: Stronger institutions and Financial Literacy; A modern, integrated and innovative financial system; and State-of-the-art Asset and Liability Management
Backwardness:’ advantages Step-by-step Financial Liberalization
Financial liberalization, or the deregulation of domestic financial markets and the liberalization of the capital account, is an engine of growth, for middle income countries. It also comes with risks that must, and can be minimized. Policy- and business-related lessons may be of relevance to successful financial liberalization in China.
Financial liberalization can lead to productive credit expansion and a better allocation of capital, both serving as growth boosters. But it can also aggravate boom and bust cycles and worsen inequality. This duality has played out in previous recent episodes of financial liberalization in East Asia, Latin America and the Nordic countries, thereby providing insights for other countries, including China, to seize the opportunities of financial liberalization while minimizing key risks.
Firstly, financial literacy plays an important role in getting the balance right. Secondly, holistic regulation and supervision mechanisms are essential to success. Thirdly, relevant reform sequencing and a flexible approach to crisis management are needed.
China has adopted a gradual approach towards financial liberalization and this strategy has proven right so far. The economy has to manage the trifecta of sustainable growth promotion, financial stability strengthening and financial liberalization development.
Firstly, economic growth must be sustainable in order to move the country up from the middle-income category and keep social stability in check. A more balanced growth, based on private consumption will help achieve this goal. Secondly, maintaining financial stability will be essential to avoiding boom-bust cycles. Note that The Bank for International Settlements (BIS) data, points to a high leverage of 257% of GDP in Q3-2017 (compared to 146% of GDP in Q1 2006). Thirdly, financial liberalization has already begun and had results. Progress has been made, with policy makers showing considerable agility and willingness to learn from experience, theirs and others. Interest rate liberalization is formally completed and monetary policy is modernizing.
The authorities have been gradually moving towards the liberalization of the capital account, though efforts have slowed in 2015-17: risk-off mode led to strong capital outflows (USD647bn and USD646bn in 2015 and 2016 respectively) and authorities stepped up capital flow management measures (e.g. additional documentation for outward investment; caps on annual overseas withdrawal).
2018: A turning point?
At the end of 2017, China took steps to encourage capital inflows and its authorities announced plans that would ease limits on foreign ownership of banks and securities companies (November 2017).
The China Banking Regulatory Commission followed up on the promise with a revised regulation, facilitating administrative procedures for foreign banks conducting business and investing in China, beginning of this year.
In March 2018, financial markets welcomed some good news including the launch of oil crude oil futures in Shanghai Futures Exchange and the internationalization of China’s iron ore futures market. In June 2018, 233 A-shares has been added in MSCI’s global benchmark. Concerning outflows, there has been little change; however, more favorable economic conditions (e.g. solid growth in private consumption, producer reflation) and a more stable RMB provide a window of opportunity for renewed progress and greater reform.
On the political and policy fronts, the nomination of Mr. Liu He as Vice Premier in charge of Economic Affairs, Mr. Yi Gang as a the new People’s Bank of China governor points to further pro-liberalization efforts. Early this year, Liu He provided a keynote speech at the World Economic Forum about China’s Economic Policy for the next years. Key messages resonate with a cautious, holistic but gradual financial liberalization process:
The necessity to transition the Chinese economy from a phase of rapid growth to one of high-quality development; The necessity to prevent and resolve major financial risks, especially through decreasing shadow banking and hidden debts for local government. The main goal is to effectively decrease overall leverage ratio in the next 3 years; and
The necessity to reform and open up at a faster pace. China will further integrate with international trade rules and ease market access, and will also substantially open up the services sector, the financial sector in particular, and create a more attractive investment environment.
Mr. Yi Gang in his first public speech as central bank governor also highlighted the importance of a gradual financial opening. The latter must continue as it leads to progress but should be associated with measures to reduce financial risks. He identified three critical tasks for his institutions: (i) the implementation of a prudent monetary policy; (ii) the opening of the financial sector; and (iii) the reduction of financial risks. These announcements were followed by a more detailed plan during the Boao forum. He announced six measures which should be implemented by June 2018, five others should be enacted by the end of this year (see table 1).
Table 1 Key measures announced in the Boao Forum (April 8-11, 2018)
China must succeed
Success is of critical importance, for China and for the world, given the country’s contribution to global demand; financing, liquidity and financial stability are unprecedented.
China accounts for one third of global economic growth, and is an important systemic influence on global trade in goods and services. More importantly, it aims at becoming a strong consumer market. For now, the US has the advantage, accounting for nearly 30% of global consumption. Yet, China is rising at a fast pace. While Chinese aggregate final consumption accounted for one tenth of that of the US in 2005, it rose to one third in 2016. Extrapolating this trend and assuming a gradual opening of the Chinese market for consumer goods, China’s private consumption could match that of the US in 2040. This trend should go hand in hand with a liberalization of the currency. On top of higher incomes, the Chinese consumer will need to have a fully convertible and strong currency, in order to buy and borrow from abroad with reduced transaction risk.
The internationalization of the RMB has strong implications for the global financial system. Firstly, on global capital allocation, China accounts for 27% of global savings. Assuming that markets were to be liberalized, this would have an influence on asset prices, globally speaking. Gradual liberalization has already been associated in rising asset prices in high income markets such as Australia or Canada, including housing. Secondly, it effects global payment. For now, despite China’s large economic size, the RMB share as international payment currency is small at 1.61% in December 2017. Easier access to RMB would help corporates to diversify their means of payment. Lastly, global monetary policy is affected as well. Being a reserve currency, central banks could diversify their foreign exchange reserves with further holdings of RMB. The PBC said that more than 60 countries have included the RMB in their foreign reserves.
Six lessons learnt for China’s journey to financial liberalization
There are six building blocks (Figure 1) to support China’s efforts to modernize its financial sector:
- Stronger financial institutions that can assess, monitor, regulate and prevent financial risks in a predictable way.
China has already made important progress with tighter regulation to reduce financial risks, with the establishment of a Financial Stability and Development Committee that increases regulatory oversight. While there are few details on the operating framework, Mr Xu Zhong’s (Director General, Research Bureau of the PBC) research explained that the new body could oversee the PBC, the China Banking Regulatory Commission (CBRC), the China Securities Regulatory Commission (CSRC), the China Insurance Regulatory Commission (CIRC) and the State Administration of Foreign Exchange (SAFE).
Regarding monitoring and prevention, more transparent balance sheets and data will help financial institutions react proactively to risks. Overestimated GDP numbers (e.g. Liaoning) as examples are a key concern for policy-reaction.
Concerning predictability, clarification and stronger enforcement of the institution’s role will be crucial for improving policy efficiency, but, also for anchoring the market’s expectations, which are a vital element of financial stability. For example, clarifying the role of the PBC and transparent communication on monetary policy will be important in the long term.
Currently, the institution has multiple objectives such as stabilizing the level of the exchange rate and domestic prices, supporting growth and ensuring financial stability with no explicit target.
This contrasts with other central bank peers that have a simpler framework (e.g. price stability for the ECB) and a more explicit target (2% inflation over the medium term). This helps guide market expectations when there is a policy move.
2. Superior Financial literacy.
The ability to use knowledge and skills to manage financial resources effectively require investment in educational resources, but also on laws that promote transparency and awareness of financial corporations.
Financial corporations must ensure that their customers are aware of the risks of their financial products and services. China has already made strong efforts in terms of education investment.
Regarding transparency, financial institutions, such as, the PBC, CBRC, CIRC and CSRC are improving rules to create a more transparent system, even though diversification and the increasing complexity of Chinese financial products present a challenge. Strong moves include the new regulation on asset management issued in November last year.
3. A healthy and modern financial system.
The reduction in financing risk has already started and should be backed by stronger financial institutions. Meanwhile, healthy financial deepening will be pivotal to ensure safe transactions.
There are two key areas of improvement: stronger efforts to improve social security and the modernization of China’s financial markets with new institutional players.
The first, would help reduce inequality through efficient resource mobilization and help diminish precautionary saving (Feldstein, 1974) while the latter would allow for stronger mobilization of resources to finance growth and a stronger role given to market forces in order to avoid moral hazard.
While the interventions of China’s authorities in the last market turbulence (2015-2016) were probably necessary to avoid financial and social panic, they also contributed to distorting risk pricing and encouraged risky behavior with implicit guarantees.
Figure 1 An augmented framework for financial liberalization
4. Regional integration.
This includes merging on- and offshore currencies to eliminate opportunities for arbitrage and clarify RMB valuation, as well as the extension and the reinforcement of the free trade zones’ role as springboards for financial liberalization and regional development. Existing free trade zones (Shanghai, Shenzhen) have already emerged as key global players. Shanghai’s GDP accounts for USD469bn with a growth of +6.9%. Shenzhen rose to USD338bn, with a growth of 8.8% in 2017. This compares to a market size of USD340bn in Hong Kong. With no restrictions on the use of foreign currencies and favorable taxation, establishing free trade zones could help gradually move forward with financial liberalization, taking advantage of the lessons learned, but also creating regional driving forces.
5. Digital innovation.
The PBC decision to include big data and artificial intelligence in its monitoring process in order to detect and prevent financial risks is important. The recent announcement by Vice-Governor Fan Yifei from the PBC on the issuance of their own digital currency (digital cash) confirms China’s pioneering position.
New lending and payment methods offer opportunities but require a clear regulatory framework to avoid risks.
China’s financial authorities have generally been strong advocates of financial innovations, yet a loose regulatory framework was associated with a rise of risks.
One example is the fast rise of online micro-lending over the past years, which was fueled by a lack of regulation. Financial authorities issued new rules clarifying loan originators and conditions for loans in December 2017.
A cautious approach involving preliminary investigations and short-testing phases could be a key enabler for success.
6. State-of-the-art Asset and Liability Management (ALM).
With the introduction of the C-Ross capital regime and the new Asset and Liability Matching regulation in 2018, the Chinese regulators are moving in the right direction for establishing a more economic based steering framework for the insurance industry.
However, there is still a way to go for the whole industry to improve ALM capability, from mentality and corporate governance to processes and system infrastructure.