China’s admission to the World Trade Organization (WTO) in December 2001 increased foreign participation in and advanced the reform of China’s financial sector, but critical issues, not covered by the terms of accession, are still outstanding. 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.
(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 .
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 . 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.
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 . 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.
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.