Good afternoon, ladies and gentlemen:
China’s financial system and financial markets have undergone profound changes since the Reform and Opening initiated in 1979. Currently, the main elements and structure have been established as well as a relevantly complete layout for the financial system. Its peculiar structure is a reflection of the transition from financial repression in a planned economy to a fully functional financial market in a market economy. The financial sector has developed slowly, lagging behind the real sector. For example, banks are predominant in the financial system, the bond market is relatively less developed, and Interest rates have yet to be fully liberalized.
Recent events in the financial sector have drawn attention from around the world, such as local debt problems, shadow banking, corporate bond defaults; in rush, depositors withdrew their money from the banks. The pessimistic climate has been reinforced by the economy’s slowdown since the beginning of the year. Many people believe that China is on the verge of financial crisis. In my view, it is not yet, but we have to address the roots of the problem and find solutions as soon as possible before a systematic crisis takes place.
Below, I specify the institutional issues that, in my opinion, underlie the peculiar financial structure as well as the financial problems as they appeared to us (they are phenomena, but people tend to talk about phenomena rather than their substance).
1. Interest rates have yet to be liberalized
Until recently, interest rates have been regulated. In the late 2000s, China’s central bank allowed the loan rate to float within a range, and then to float fully in the first half of 2013. Deposit rates were still regulated.
The low and regulated interest rate policy has been rooted in China’s development strategy since 1950s, even after reforms were enacted to support state-owned enterprises (SOE). This practice, also called financial repression, was widely seen in emerging Asian countries. The policy can be justified because it really helped the country to concentrate financial resources needed to survive difficult periods of time and achieve rapid economic development.
This policy is not only meant to support SOEs but also to protect state owned banks. Until now, banks have enjoyed 2-3 percent spread and therefore have little incentive to establish a fee-based business and develop other financial services.
This is due to the fact that government policies have heavily favored SOEs and state owned banks for a long time.
As a result, depositors (consumers) tried to shift their money toward alternative investments. In the 1990s, money was transferred to the recently established stock market, government securities futures market. In 2000, money started moving into the real estate market. In 2008, the government crackdown overheated the real estate market, and money started to migrate to wealth management. These unexpected money shifts from traditional banking sectors to other financial sectors have triggered one market boom after another, overheating, as well as government interventions.
Government interventions turned out to be less effective due to the institutionalized nature of the issues. In the mid 1990s, the government intervened in the overheating stock market. In 1995, the State Council closed the government securities futures market. In the late 1990s, the government rectified the corporate bond market. In 2008, the government intervened in the real estate market. In 2012, they tried to rectify shadow-banking problems.
2.The hunger for investments is reflected in both banks’ and local governments’ initiatives
Major state-owned banks have been transformed into corporations, and most of them have been listed. Their corporate governance is less restricted by bank operations. The presidents of banks were not nominated by boards of directors, but by the government.
Banks have been regulated by administrative measures such as credit ceilings and deposit loan ratios since the 1990s and especially in 2000s. Due to their peculiar corporate governance, they are incentivized to boost assets rather than maximize shareholders’ returns. This strict regulation stimulates financial institutions circumvent regulations, develop new products, and find new business opportunities. As a result, their off balance sheet business has developed. These dealings are made mainly through less regulated trust companies and money market funds.
SOEs have incentives to borrow from banks due to soft budget constraints and money tends to be cheap because banks feel safer giving money to SOEs rather than to SMEs and private companies in consideration of responsibility.
The money that moved away from the banking sector has boosted investments through other channels. Money that moved to the corporate bond market, money market funds, and trust companies has been less regulated. This is due to the fact that bank loans have been controlled through quotas, and the cost and return of money tends to be close to the market outside of the banking sector.
The investment initiative is not only coming from the banking sector, but also from local governments hunger for capital due to the central government’s performance evaluation that focused on GDP growth. Local governments establish platforms to serve as borrowers on their behalf. In addition, local governments have also established offices under their jurisdictions to coordinate finances from different sources.
3. Real sector vs. financial sector
It is obvious that regulated interest rates, the banking sector’s administrative framework, the underdeveloped corporate bond market, and money market funds are the roots of many of the financial issues.
While we are focusing on the financial system and financial markets, it is important not to lose sight of fundamentals of economics and especially consumer behavior. Since the beginning of 2000, there has been a boom in domestic savings. Savings ratios went up to over 50%. Capital contribution to GDP growth moved up to 70%. Corporate savings increased more than private savings.
Perhaps the urbanization program and the demand for infrastructure have changed the investment behavior of banks and local governments, and the emerging middle class and IT revolution have changed consumer behavior. These are also factors that related to financial issues.
4. The segmentation of financial markets
The marketplaces are artificially divided into the interbank market and stock exchange market.
The interbank is a money market, and the interbank bond market is a capital market. The two functions have been mixed up and give rise to a malfunctioning of the so-called interbank market.
One defect is the homogeneous behavior of market participants, which is the main reason for liquidity squeezes.
As a result of the market segmentation, the stock exchange lacked liquidity, whereas the interbank market traded less frequently. There are two different prices for the same credit or product.
5. The overlapping jurisdiction and lack of supervision
Currently, there are three supervisory bodies within the regulatory framework: CBRC, CSRC, and CIRC, which regulate the banking sector, stock sector, and insurance sector, respectively.
The bond market is subject to overlapping jurisdictions: NDRC has the authority to examine and approve enterprise bonds, CSRC is in a position to regulate the stock exchange bond market, PBOC firmly controls the interbank bond market, MOF runs the government securities primary market.
There are vacancies with respect shadow banking related institutions, such as trust companies and money market funds.
As a result of the segmented regulatory framework, there is no individual institution to work out a financial development program in the long run.
6. Lack of investor services industry
In the 1990s, two rating agencies were established: there were the associations of dealers, such as the government securities dealers’ association in 1993, and traders association in 2003. However, investor education has attracted less attention from regulatory authorities. Depositor protection systems have been discussed, but have yet to be fully established.
7. Monetary policy has been less skillful
There has been little coordination between fiscal policy and monetary policy since 1994. For the most part, fiscal policy has been expansionary, but monetary policy has been ambiguous; the word used is “steady”. Which is to say that it sends ambiguous signals to the market, and leaves itself more room for policy changes. The MOF rarely issued short-term treasury bills, and pays little attention to the shape of the treasury yield curve.Because interest rates have been regulated, normally lower than market rates, the treasury yield cannot serve as a benchmark. This gives rise to interesting phenomena: banks use deposits they received to invest in government securities and CDB bonds to get risk free arbitrage revenue. It is important evidence of market malfunction and inefficiency.
The Central Bank is used to absorbing liquidity increases as a result of foreign exchange reserves by repurchasing Central Bank Papers, but is less sensitive to the shortfall of liquidity. In addition, the Central Bank had fewer instruments before it introduced SLF. Discount windows have been used less frequently.
Banks have no flexibility to increase multipliers as credit ceiling and quota and deposit loan ratios when there is shortfall of liquidity, and banks are incapable of increasing liquidity
In summary, the inefficiency of the financial market and the fragility of the financial system are more likely to incur financial risks. Debt crisis is a potential risk and could occur in areas of the corporate bond market, local government debt, and shadow banking. These reflect the transitory nature of the financial system and market, and the contradiction between going forward and going backwards.
However, China’s financial sector is more robust than it was 10 or 20 years ago. Banks had NPL ratios in the 1990s as high as 30 per cent; after writing off NPLs twice, banks have improved their financial strength and performance, their risk management, and IT systems. Current NPL ratios are only 3% or less.
Local government debt is RMB 18 trillion, about 60% of GDP, there is no imminent danger of systematic defaults and debt crisis.
(I want to clarify some of the concept: financial system vs. financial market, financial sector vs. real sector; and phenomena vs. essence, issues and problems vs. solutions.)
Financial issues have to be put in the context of real economic movements. The roots of financial problems have to do with the structure of financial markets, which has to do with the financial system, which has to do with the financial regulatory framework.
Financial restructure should focus on issues mentioned above, that is to establish a long-term financial development program, including the contents of fully liberalized interest rates, integrating regulatory authorities, integrating marketplaces, improving corporate governance of banks, SOEs, and local governments (it works like corporation).