China: Challenges and Impacts of Financial Sector Transformation
Delivered at the opening ceremony of the China Financial Summit 2014
Your Excellency, Mr. Zhu Guangyao,
Vice Minister of Finance
Representatives of the Private Sector,
Members of the Media,
Ladies and Gentlemen,
China is no stranger to positive and creative reforms. Known for its ownership of reforms, and their implementation, China has taken the bold step of announcing a broad-ranging set of new reforms which augur well for laying the foundations of a robust, stable and well-diversified financial system.
In my remarks today I will offer my take on what makes this round of reforms different, and what some of the critical elements of this reform package are. I will end with some perspectives on the likely impact of the reforms.
What’s Different about this Round of Chinese Reforms?
On domestic front, the reforms are:
- Comprehensive and far reaching;
- Being launched at a time when China is embarking on a rebalancing of its growth dynamics and redressing its structural imbalances;
- Extending to a number of sectors, and are likely to penetrate to the level of local government business and finances;
- Aimed to align incentive frameworks for the real sector, market liberalization, and strengthening of the financial system; and
- Being implemented whilst China is also contemplating internationalization of the Yuan and the timing and process of capital account convertibility.
Along with these domestic considerations, China is undertaking the reforms at time when a global transformation is underway, partly driven by structural changes as the dust settles on the global financial crisis, and partly by the global efforts to address long-standing concerns about stability and the structural impediments which have held back the growth potential of economies.
The G20 is moving to garner the support of both advanced and emerging markets to deepen competition, and rationalize product and labour markets etc. in order to raise global growth by two per cent -- if successful this will involve some interesting dynamics at global and country levels.
The international financial regulatory regime is also being overhauled. We can anticipate a shift from liquidity-driven to growth-driven markets, and changing regulatory environments which are resulting in changing strategies by global banks and capital movers.
This is all happening at a time, along with a normalization of U.S. monetary policy, that could introduce renewed vulnerabilities for emerging markets, and as such calls for enhanced vigilance, keeping the economic fundamentals strong and using strategically macro-prudential measures.
Multilateral Context of the Reforms
As a key member of the United Nations, China’s adoption of and support for the post-2015 sustainable development agenda will be critical. Such an agenda must be universal, requiring collective action on climate change, water, energy efficiency, and conservation – in addition to exploiting the potential of all countries to develop renewable energy sources.
Given China’s important role in multilateralism, it is also playing a key role in the development efforts of other regions, as evident from its announcement of the establishment of the Asia Infrastructure Investment Bank – a timely initiative given the trillions of dollars needed to meet growing infrastructure requirements. China is now also looking beyond Asia, to support the development requirements of Africa and Latin America, and this will change the dynamics of trade, finance and technology. China further needs to explore options to support the sustainable financing agenda, which calls for funding for climate finance including promotion of renewable energy and the “green financial system.”
Specific Aspects of the Reforms
Looking at the components, there are, among others, three key areas worth highlighting from the financial sector reform package:
- Foundations are being laid for modern monetary management, where over time indirect tools and instruments will be deployed to steer money supply and demand, while China has a fiscal and resource edge to manage more directly the liquidity of the financial system;
- Interest rate liberalization is already under way as the administered lending rate was replaced by a market-determined prime rate. Retail deposit rates are still controlled, but the rise of wealth management products and instruments floated by the shadow banking sector offer higher market-based returns. With the removal of restrictions on deposit rates, there will be more incentives for savers to remain within the formal financial system which, over time, will enjoy deposit protection. Attractive deposit mobilization system will reduce the risks of financing ventures and vehicles outside the purview of regulators; and
- Strengthening of financial regulatory oversight and the priorities identified by the major financial authorities will restore confidence in the financial system.
Likely Impact of the Reforms
There is a strong debate regarding the likely impact of reforms. Predominantly, it has to be reinforced that financial sector reforms will have broad-ranging positive impacts of reforms. For instance they will help:
- Diversify the sources of financing, which have been largely banks, and the beneficiaries which have been largely state owned enterprises and the corporate sector;
- Create improved efficiency of the financial markets and capital allocation and improve, among others, access to credit to SMEs, and those excluded from the formal financial system;
- Generate a win-win for both households and corporates, with the former having alternate opportunities to diversify their holdings and the latter access to alternate sources of financing and reducing their overdependence on banks;
- Reduce, and bring under the ambit of regulation the shadow banking system, will help to reduce financial system and investor risks;
- Strengthen the overall efficiency and stability of the financial system; and
- Level the playing field in the regulatory and supervisory system, which will help to reduce opportunities for regulatory arbitrage.
There are however genuine risks which cannot be ignored. Overhauling a system, of the size and magnitude of China’s, and one that has been driven by different ideological stances, is by no means an easy task. To take one example: historically, China’s financial controls have kept interest rates low, which have allowed banks to offer loanable funds at competitive rates. There are now concerns that the liberalization of interest rates would result in rising interest rates, with associated impacts on businesses. These pressures could be compounded if savings rates decline gradually over time, along with changing demographics, and reforms to social safety nets.
Besides the implication for the fixed income and foreign exchange markets, this could have an impact on China’s investment intensity, corporate margins, and debt sustainability. For instance, if there is a rise in interest rates above the levels of growth in coming years as a result of the reforms, debt dynamics will get visibly worse.
For years China’s financial system has enjoyed excess liquidity, given high savings rates, closed capital accounts, and large external inflows. While China is likely to remain a preferred destination for FDI given its potential and large market, properly sequenced capital market liberalization will be critical.
In conclusion, I believe that there are ample ways and approaches available to Chinese authorities to mitigate the risks to which the financial system will be exposed in the process of financial system reform.
The keys will be:
- Proper pace and sequencing of reforms: for instance it would be prudent to ensure that macroeconomic fundamentals are strong as the county pursues full interest rate liberalization and capital account convertibility (as announced at the Third Plenum) sequenced with strengthening of financial system;
- Better oversight and coordination of regulators, with supportive timely introduction of market-based financial resolution mechanisms and a deposit insurance system;
- Developing an early warning system, along with a scenario analysis for crisis management, with clarity on the countervailing measures needed;
- Fiscal and monetary policy maneuverability at hand; and
- Strengthening of corporate governance at financial institutions which ought to emphasize proper due diligence of credit and sector exposures, contained to prevent risks if interest rates rise or if there is a credit crunch.
What is quite evident is that the leadership of China is fully committed and the country has the capability and capacity to steer these reforms in a coordinated manner.
I thank you.