TRANSFORMING CHINA’S GROWTH MODEL: THE URGENCY OF FINANCIAL REFORM

Author:Murtaza Syed and Xiaoling Shi  Time:2012-02-23   Hits:0

Recent news out of Wenzhou has focused attention on the dangers of the rapid expansion of China’s informal financial system. The Chinese authorities have responded with timely and forceful measures that should help contain the near-term risks. There is also greater recognition that  uncoordinated and disorderly growth of the nonbank sector—which tends to be less well regulated than banks and less affected by the tools China uses to exercise monetary policy—could pose a danger of financial instability and erosion of macroeconomic control in the coming years. To forestall this risk, China needs to reform its financial system. Without such reform, it will also be difficult to sustain rapid economic growth and rebalance the economy toward consumption.

 

Two words immediately come to mind when defining China’s financial system as it stands today: liquidity and control. The system is flush with liquidity, both because of a high stock of savings that is held domestically by China’s closed capital account, and large inflows associated with the country’s balance of payments surpluses and intervention to manage the exchange rate. To prevent this liquidity fueling dangerous lending booms, the People’s Bank of China relies on control—predominantly direct tools like quantitative limits on bank credit and increases in bank reserve requirements. These have proven quite effective in recent years. By contrast, interest rate hikes are used more sparingly as they conflict with other goals—both loan and deposit rates are kept artificially low to provide cheap credit to certain firms, protect bank margins, and subsidize the sterilization of foreign exchange intervention.

 

So why should we worry about this status quo? There are two main reasons. First, as we are already witnessing, quantitative controls on credit create enormous incentives for banks to find other ways to lend, including off-balance sheet and through informal means. By not actively using interest rates, China is unable to choke off the demand for credit and relies instead predominantly on attempting to stem its supply by banks. But the more intermediation occurs outside of banks, the less effective these supply controls become and the tougher it is to enforce the credit policy needed to manage the trajectory of the economy. This is clearly risky and could begin to compromise macroeconomic control over time.

 

Second, China’s financial system perpetuates its unbalanced growth model by under-pricing capital and depressing interest rates. China's inflation-adjusted deposit rate has averaged only one quarter of one percent over the past decade. As a result, households —whose savings are predominantly held in bank deposits—are charged an inflation tax, suppressing household income and holding back consumption. At the same time, it boosts the returns enjoyed by the corporate sector through extra-low interest payments, raising their profitability and investment and, ultimately, adding to corporate saving, which today accounts for over one-third of China’s national savings.

 

So the rationale for financial reform in China is powerful. However, there is a complication. Changing the system is not without risk. International experience cautions that many countries that have tried to liberalize their financial sector have lost control over monetary aggregates. When badly handled, financial liberalization can lead to the unintentional injection of an enormous amount of credit and monetary stimulus into the economy. Eventually, this can end in a heartache of over-heating, asset bubbles, bad loans and sometimes even a banking crisis. Countries that have been successful in containing these risks—such as Australia, Belgium, and Canada—did three things in common. First, they mopped up liquidity and tightened monetary conditions early on to drive up the real rate of interest. Second, monetary policy was nimble and independent enough to guard against an excess supply of credit as interest rate constrains were removed. And third, they upgraded regulatory and supervisory frameworks early and continuously.

 

So there is a way forward for China to reform its financial system, but it will need to be carefully sequenced. Unlike most reforms undertaken over the last three decades— such as those in agriculture and special economic zones for manufacturing exports—financial reform cannot be piloted or restricted to certain banks or geographical areas. The likelihood of arbitrage will not allow for such experimentation. So it is important to have a broad roadmap for financial reform, albeit one that is flexible enough to adjust to unforeseen events.

 

What could such a roadmap look like? There is no single, superior approach for use in all cases. But cross-country experience and China’s specific features suggest that the key elements and sequence of any plan could usefully include:

·             First, allowing relative prices to be more market-determined to stem the continuous inflow of liquidity. At the same time, the stock of excess liquidity would need to be absorbed by issuing central bank bills and moving to a point where interest rates clear the credit market, and not quantity controls. This would also facilitate a shift away from quantitative limits on credit and toward the use of conventional monetary tools. Significantly, it will also give the central bank increased ability to run a more activist, independent, and counter-cyclical monetary policy.

·             Second, as quantity controls wane and monetary aggregates become less stable, China will need an alternate monetary policy approach. It would appear sensible to shift to a framework that establishes clear objectives on growth, inflation, and financial stability, and deploys a combination of monetary and macroprudential tools.

·             Third, strengthening regulation and supervision to monitor and identify macro-financial vulnerabilities, particularly those that pose serious risks to credit quality.  

·             Fourth, promoting alternatives to the current bank-based intermediation system to improve the pricing and allocation of capital. This could include further efforts to encourage the development of mutual funds, corporate bonds, equities, annuities, and insurance, as well as building a stronger institutional investor base. It is important to ensure that financial market development is coordinated and does not advance too far ahead of banking reform, lest deposits start to flow out of the banking system in a disruptive manner.

·                    Fifth, dismantling the controls on loan and deposit rates to allow banks to price and distribute credit more efficiently. Liberalizing interest rates earlier on in the process—particularly before a more nimble monetary policy and better regulation and supervision are in place—would risk “over-competition” by banks that erodes margins or precipitates a lending binge that poses risks to financial stability

·                    Finally, as a more robust system of monetary control, market-determined interest rates, a strong prudential regulatory system, and more flexible exchange rate is put place, China will be well-positioned to gradually free-up the existing controls on capital flows. Such steps also will permit China to internationalize the renminbi at an appropriate pace, thus making its currency more freely usable for international trade and finance.

 

Prior to the global crisis, China was on a firm trajectory toward a more modern financial system capable of addressing the challenges of a more mature and complex economy. However, as financial systems across the globe suffered severe setbacks, Chinese policymakers paused. In some ways, this was natural. But over the medium term, China needs to maintain the pace of change. Thus, it is encouraging to note the prominent role assigned to financial reforms in the 12th Five- Year Plan. Indeed, the roadmap laid out above can be completed over a five-year horizon. Done right, financial liberalization would be the next big wave of reform that China needs. It could be as significant as the state owned- enterprise reform of the 1990s, laying the foundations for continued strong growth in China in the coming decades. 

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This paper was submitted for the 72nd International Forum on China Reform on the theme of "Surmounting Middle Income Trap -- China in the next decade". The authors are, respectively, Deputy Resident Representative and Economist in the IMF’s China Office. Their email addresses are msyed@imf.org and xshi@imf.org.

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