In the following report Murtaza Syed, Deputy Resident Representative of the International Monetary Fund in China, examines the myriad challenges to China’s programme for economic reform.Syed proposes a clear roadmap that will allow China to achieve a stable, modern financial system. He says that the necessary financial reforms can be implemented over a five-year period and, if done right, will spur the next wave of productivity in China.

Recent concerns surrounding wealth-management products and the build up in local government debt have focused attention on the dangers of the rapid expansion of China’s informal financial system. The Chinese authorities have responded with measures aimed at containing the near-term risks.

There is also greater recognition that while financial innovation is in some ways welcome,  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 realise the China dream, which hinges on sustaining healthy economic growth and rebalancing the economy towards consumption.

Let us begin with a stylised description of China’s current financial system. 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 fuelling 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 subsidise the sterilisation of foreign exchange intervention.

So why should we worry about this status quo? There are two main reasons.

First, as we are already witnessing in the rapid expansion of ‘social financing’, 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 instead relies 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, the financial system perpetuates China’s unbalanced growth model by under-pricing capital and depressing interest rates. China’s inflation-adjusted deposit rate has averaged only one quarter of one per cent over the past decade. As a result, households — whose savings are mainly 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 state-owned 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.

By depressing household incomes and boosting savings in this way, China’s financial system contributes to low consumption. By mispricing credit it also perpetuates excessive investment and excess capacity, putting pressure on the balance sheets of financial institutions. And by preventing capital from flowing to the most productive enterprises and sectors, the existing system limits the economy’s medium-term growth potential.

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 liberalise their financial sector have lost control over monetary aggregates. When badly handled, financial liberalisation can lead to the unintentional injection of an enormous amount of credit and monetary stimulus into the economy. Eventually, this can end in the 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 important things: 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 constraints were removed; and third, they upgraded regulatory and supervisory frameworks early and continuously.

Lou Jiwei, China’s Minister for Finance

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 the setting up of 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. Indeed, the new Chinese leadership has also stressed the need for the next generation of reforms to be anchored on a top-level design and strategy.

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 of a plan could usefully include:

• Allowing relative prices — including the exchange rate — 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, not quantity controls. This would 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.
• Adopting a new monetary policy approach, as the exchange rate becomes more flexible, quantity controls wane and monetary aggregates become less stable. 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.
• Explicitly withdrawing implicit public guarantees of financial institutions. Instead, such blanket backing should be replaced with an explicit scheme for deposit insurance. It could be complemented by continuing to reform and commercialise China’s state-owned banks. Ensuring banks face hard budget constraints would be an important prerequisite for a more commercially-oriented banking system that adequately prices risk and efficiently allocates credit. It also helps mitigate moral-hazard risks and prevents banks from taking undue risks as interest rates are liberalised, restrictions on bank activities eased, and new markets opened. Improving the resolution framework is also key to allowing an orderly exit of weak or failing financial institutions. It is also important to ensure that losses on assets backing non-deposit instruments are fully borne by investors. This will promote risk awareness and prevent the perception that investments are implicitly guaranteed.
• Continuously upgrading regulation and supervision to monitor and identify macro-financial vulnerabilities, particularly those that pose serious risks to credit quality.
• Liberalising interest rates. As the next step toward interest rate liberalisation, upward flexibility of deposit rates should increase. This will help reduce regulatory arbitrage that currently favours wealth-management products over bank deposits. Full liberalisation of deposit and lending rates could be completed over time and based on prevailing conditions, gradually widening the flexibility along the way. Fully liberalising interest rates too early in the process—particularly before a more nimble monetary policy and better regulation and supervision are in place (see below)—would risk ‘over-competition’ by banks that erodes margins or precipitates a lending binge that poses risks to financial stability. One should expect liberalisation to lead to higher interest rates, in large part to reflect the true risk premium which to date has been implicitly subsidised by the government.
• Developing capital markets to promote alternatives to the current bank-based intermediation system. This would help improve the pricing and allocation of capital, while also providing households and investors with a broader range of potential saving instruments. 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.
• Fully liberalising the capital account as the final step. As a more robust system of monetary control, market-determined interest rates, a strong prudential regulatory system and putting a more flexible exchange rate in place, will ensure China is well-positioned to gradually free-up the existing controls on capital flows. Such steps will also permit China to internationalise 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 modern financial system capable of addressing the challenges of a more mature and complex economy. Tremendous progress had been made to deal with problem loans and recapitalise and commercialise the large state-owned banks. At the same time, the regulatory infrastructure was improved with the establishment of individual regulators for insurance, banking and securities markets. Interest rates on a range of fixed-income instruments were modified to become determined by market forces, while an interbank bond market was established to allow corporations to raise funds from securities markets, reducing their dependence on the banking system for credit.

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 accelerate the pace of change. If financial reforms stall rebalancing the economy may well prove elusive and the risks to macroeconomic stability will escalate.

Thus, it is encouraging to note the prominent role assigned to financial sector reforms in the 12^th Five-Year Plan as well as in more recent announcements by the new Chinese leadership. Indeed, the roadmap laid out above can be completed over a five-year horizon. Done right, financial liberalisation would be the next big wave of reform that China needs to unleash another round of productivity gains. It could be as significant as the state-owned enterprise reform of the 1990s, laying the foundations for continued strong growth in the coming decades and for fulfilling the promise of the China Dream.

For more information on the IMF’s proposed economic roadmap for China, view the IMF (2011) People’s Republic of China: 2011 Article IV Consultation Staff Report (Washington DC)

Murtaza Syed can be contacted at msyed@imf.org.