Financial Sector Reform and Capital Account Liberalization, Address by Takatoshi Kato, Deputy Managing Director, IMF

May 19, 2004

Financial Sector Reform and Capital Account Liberalization
Address by Takatoshi Kato
Deputy Managing Director of the International Monetary Fund
To the Beijing International Finance Forum
Beijing, May 19, 2004

Your Excellencies, Ladies and Gentlemen:

1. I thank you very much for your warm welcome and the opportunity to address such an eminent gathering. It gives me great pleasure to visit China at this critical juncture, and it is an honor to be here in the presence of senior policymakers and distinguished international guests.

2. China has been one of the bright spots of the global economy over the last several years. Indeed, China's foresight in opening its markets to international trade and joining the WTO has resulted in an on-going dramatic and rapid integration of China into the world economy. In particular, this process is providing substantial benefits to China and to the Asian region.

3. To foster sustained strong economic growth in China, successful restructuring of the banking system is critically important. The overall size of the banking system relative to GDP, its high nonperforming loans stemming from support to state-owned enterprises, and the government's far-reaching commitment to fully open the sector to foreign competition by December 2006 as part of the WTO agreement increase the urgency of restructuring the major banks. In these circumstances, I fully agree with Premier Wen Jiabao who said at the close of the National People's Congress in March that on banking reform China is engaged in "a last ditch battle that we cannot afford to lose." Accordingly, and in the spirit of the frank and open discussions taking place during this forum, I would like to share with you today my views on several priorities related to the restructuring of the financial sector.

4. Important steps have already been taken to push forward financial sector reform, but much more remains to be done. Clearly, there has been progress in improving bank supervision and in the disposal of existing nonperforming loans. The announcement in December 2003 of the recapitalization of the Bank of China and China Construction Bank was one of the most recent and significant steps in moving bank restructuring forward. More importantly, the regulatory authorities have rightly put in place performance targets and guidelines for reforming corporate governance in these two banks. Efforts now need to focus on rapidly restructuring these banks, as well as the rest of the financial system, to ensure that balance sheets are further strengthened. In this regard, experience with bank restructuring around the world points to several important lessons that should be taken into account in formulating the next steps in the reform program.

5. First, time-bound restructuring programs are critical for success. Performance targets and governance guidelines for BOC and CCB need to be rigorously enforced. Moreover, these same types of time-bound programs need to be put in place for other banking institutions. The substantial progress made in strengthening supervision and introducing prudential requirements based on international standards has made it clear that banks in China will need to be substantially restructured to meet prudential requirements. Guidelines on capital adequacy require that these targets be met by 2007, and the banks need to be held accountable for making progress and meeting intermediate targets along the way. It is also important that any further recapitalization of the banking system be undertaken in such a way that secures improvements in the performance and operation of the banks.

6. Second, banks need to be run on a fully commercial basis. This would involve creating modern corporate governance structures. Key benchmarks for this could include establishing independent boards of directors, external audits, and implementation of proper risk control procedures. In this regard, foreign strategic investors can play a very useful role as a means to promoting sound governance. Any remaining government interference in banks' lending decisions also needs to be eliminated. Finally, ceilings on lending rates need to be removed. This would enhance the ability of banks to intermediate funds; allow banks to price risk appropriately, increasing their commercial orientation; and improve their financial performance. All of these steps put even more emphasis on the need to further strengthen supervision and regulation to ensure that financial institutions are fully compliant with all requirements.

7. Third, complementary reforms in other areas will also be required for bank restructuring to be successful. Enhancing the commercial orientation of China's banking system will also require fundamental reform of the operations of state-owned enterprises. These enterprises need to be consistently subject to hard budget constraints, and state-owned banks given clear instructions to lend to them only on a commercial basis. Legal reforms, especially those related to bankruptcy, will also be important. This would help strengthen collection and disposal efforts to deal with the stock of nonperforming assets inherited from the past and help mitigate collection problems in the future. Other supporting reforms would include legislation addressing financial transactions such as securitization, the creation of credit bureaus, and the enhancement of auditing and accounting standards. Finally, the taxation of banks needs to be modernized and brought in line with international practice. In particular, banks should be allowed to deduct specific loss provisions for income tax purposes, and the business tax on banks should be reduced further or eliminated.

8. Given the magnitude of the task that is required, it will be some time before the financial system is fully strengthened. Until then, maintaining China's steady and gradual approach to capital account liberalization is appropriate. A high savings rate, limited development of the domestic capital market, and extensive controls on capital outflows have led to a very high level of deposits in the domestic banking system. A relaxation of capital controls would likely lead to some diversification of assets by domestic residents and an outflow of funds from the banking system. At the same time, controls on capital inflows have prevented the build up of large external liabilities by financial institutions. Thus, on both accounts, the lessons from the 1997/98 Asian Financial Crisis show that a premature liberalization of capital controls would expose the financial system to substantial stress and risks.

9. Successful restructuring of the banking system will also require effective macroeconomic control to prevent overheating and the accumulation of new nonperforming loans. The current rate of credit expansion is excessive and may indeed be running a risk of creating another batch of NPLs in the future. But to rein in credit growth in the face of sustained capital inflows, the effectiveness of monetary policy needs to be improved. Increased flexibility in the exchange rate can help accomplish this.

10. The existence of capital controls should not be a reason to delay this movement toward greater exchange rate flexibility. In fact, their existence permits China to move ahead. More flexibility in the exchange rate is in China's best interest because it would help shield the money supply from international influences, moderate the impact on China of economic shocks, and facilitate adjustment to the major structural changes underway in the economy. Increased exchange rate flexibility can be pursued while capital controls are maintained and the banking system gradually strengthened before the capital account is opened. Many other countries have followed a path of introducing exchange rate flexibility first and removing capital controls only gradually over a number of years. For example, the United Kingdom only removed capital controls in 1979, Japan in 1980, and most European countries in the late 1980s or early 1990s, well after exchange rate flexibility had been introduced. Indeed, because of the capital controls, the financial system in China is not greatly exposed to exchange rate risk as banks' net foreign position in 2003 amounted to only about 5 percent of broad money, and foreign currency loans were only about 5 percent of domestic credit. Moreover, to provide the impetus for further development of the exchange market and hedging instruments, it would be advisable to have a period of "learning by doing" by introducing greater exchange rate flexibility well ahead of the liberalization of capital controls and the full convertibility of the renminbi.

11. All of the measures I have discussed here would develop the domestic financial sector, deepen integration with the global economy, and lay a solid foundation for a bright and prosperous future for China. There is much at stake for China, and for the entire global economy, in getting things right, and I have full confidence that China will continue to successfully make its way forward along the reform path.


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