China: Economic Transformation and Financial ReformJohn Lipsky, First Deputy Managing Director, International Monetary Fund
at the International Forum of Sovereign Wealth Funds, Beijing, China
May 13, 2011
Good Morning. It is a great pleasure and honor to have the opportunity to address such an eminent gathering of officials, finance experts, and distinguished guests. I am particularly grateful for the chance to discuss the path ahead for China’s economy in the context of the broad issues that are being explored during this historic Forum.
In my remarks today, I would like to address one aspect of China's economic transformation that has important implications for investors and policy-makers here and around the world, including for sovereign wealth funds. That is: the role of China's financial sector reform in promoting more balanced and sustainable growth. This is an area that has received prominent attention in the 12th Five Year Plan, reflecting a clear recognition that a reformed financial system will provide an important boost to the the desired transformation of China's economic growth model. In fact, this goal was featured prominently in Vice Premier Li Keqiang's important address yesterday to this Forum.
Of course, China was on a firm trajectory toward a more modern and reformed financial system prior to the global financial crisis. Tremendous progress had been made to commercialize the large state-owned banks and to increase their efficiency and profitability. In particular:
- The banks' internal risk management and accounting practices were improved, and they acquired foreign strategic partners to help implement industry best practices. Moreover, the main banks were listed on foreign markets in order to strengthen investor oversight and control — and to ensure compliance with international accounting standards. The large volume of bad loans that were being carried on these banks' books — amounting to over 15 percent of GDP in bad loans just in 1999 —were carved out as the banks were recapitalized with government support.
- At the same time, the regulatory infrastructure was improved greatly with the establishment of individual regulators for insurance, banking and securities markets. Within these agencies, capacities for supervision were strengthened, and a regulatory infrastructure was put in place that meets international standards,
- 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, lessening their dependency on the banking system for credit.
- Finally, Shanghai became a critical part of the global financial infrastructure. Best practices and state of the art trading platforms were adopted in the key markets and equity market liquidity was increased by making a larger proportion of shares tradable. Shanghai’s market capitalization now amounts to around US$3 trillion, the sixth largest equity platform in the world.
And then came the global financial crisis, a product of excessive risk-taking, compounded by regulatory and supervisory failures that massively damaged financial systems in both the United States and Europe. The result was a deep recession -- while a much deeper downturn was averted only by the concerted action of policymakers around the globe, who provided unprecedented amounts of budgetary and monetary stimulus. China played a highly constructive role in this collective effort, reflecting its expanding role and responsibilities with regard to global economic governance.
While hit hard by the global downturn through trade channels, China emerged largely unscathed from direct contagion to its financial system. Nevertheless, the very rapid expansion in lending that formed part of China's anti-crisis effort may prove to have costs that will become evident only over time, if credit quality problems surface later.
However, I would argue that the global financial crisis had another, more subtle impact in China. As financial systems across the globe suffered severe strains, Chinese policymakers paused in their plans for financial reform. After witnessing the dramatic crisis in major, well-established financial markets, this was a natural response. But it is not the appropriate response for China over the longer term. Thus, it was particularly encouraging to note the important role assigned to financial sector reforms in the 12th Five Year Plan.
Not only will successful financial reforms support China's domestic economic development, but this issue also has a bearing on the outlook for China's external imbalances. This is because there are three broad aspects of China's current financial system that tend to dampen consumption, boost corporate savings, and distort economic decision-making.
- First, monetary control is still exercised in part through direct administrative limits on bank lending. This tends to underprice capital and depress interest rates Thus, China's inflation-adjusted deposit rate has averaged only one quarter of one percent over the past decade. As a result, households — whose savings predominantly are held in bank deposits — are being charged an inflation tax, while making both corporate investment and sterilized currency intervention cheaper than it would be otherwise. As a result, such a system suppresses household income and holds back consumption. At the same time, it boosts the returns enjoyed by the corporate sector through extra-low interest payments, raising their profitability and, ultimately, adding to corporate saving which today accounts for over one-third of China's national savings.
- Second, while there has been substantial progress in ensuring that interest rates on many instruments are market determined, deposit and loan rates nevertheless are still regulated. International experience indicates the entire term structure of interest rates is distorted when key interest rates are not market-determined. An ultra-low cost of funds creates a strong motivation for banks to expand lending and even to circumvent credit limits set by the central bank. As is well-understood, excessive credit growth tends to boost inflation for goods and services, while raising asset prices.
- Third, the financial system in China remains bank dominated, even though much has been done to develop alternative markets and financial instruments. Nonetheless, it is still the case that around 90 percent of all household financial assets are held in the form of bank deposits. Over the past five years, on average only around 11 percent of corporate financing has been sourced from bond and equity markets. With limited alternatives to bank deposits, — and with those deposits bearing low or negative inflation-adjusted rates of return — Chinese savers are driven by necessity toward other stores of value. This, in turn, causes strong demand for non-financial assets as investment vehicles—notably property.
So what is to be done?
A well- designed program of financial reform can make an important contribution in helping China to meet its goal of accelerating the transition to better balanced economic growth. While this process is recognized widely to be in China’s broad economic interests, it also is in the commercial interests of the banks themselves. This is of central importance to the China Investment Corporation (CIC), given that it owns substantial stakes in China’s banking system.
What’s wrong with the status quo, this raises the question? After all, China’s financial system has not stood in the way of a remarkable period of strong growth, while steering clear of serious financial sector volatility. In my view, however, the prospective value of reform is increasing as the economy matures and becomes more complex.
Implementing the reforms that are needed will require a clear roadmap and careful sequencing. There is no single superior approach for use in all cases. But experience suggests that the key elements of any plan could include:
- Shifting away from quantitative limits on credit and instead using conventional monetary tools more proactively This includes de-regulating loan and deposit rates to allow these and other key interest rates to be determined by market forces
- • In parallel, continuing to increase the commercial orientation of the banking system and strengthening supervision to monitor and identify macro-financial vulnerabilities, particularly those that pose serious risks to credit quality. New progress on strengthening regulatory agencies will be important, and work remains to be accomplished on modernizing smaller banks and the rural credit cooperatives.
- Equally important will be to continue promoting alternatives to the current bank-based intermediation system. This could include further efforts to encourage the development of mutual funds, corporate bonds, equities, annuities, insurance, and securitized assets, as well as building a stronger institutional investor base.
- Increasing exchange rate flexibility to give the central bank increased ability to run a more activist, independent, and counter-cyclical monetary policy.
As a more robust system is put in place of monetary control, market-determined asset prices, a strong prudential regulatory system, and more flexible exchange rate, 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.
Over time, China's currency no doubt will become a serious candidate for inclusion in the IMF’s SDR basket. Indeed, the SDR's future role is being examined as part of the efforts by the IMF and the G-20 to improve the international monetary system. The goal is to augment the supply of safe global assets, improve the provision of crisis-related liquidity, reduce the impact of exchange rate volatility among major currencies; and ultimately to reduce the perceived need for international reserve accumulation.
I'm sure it is recognized that many of the themes I have discussed today already are outlined, in broad terms, in the 12th Five Year Plan. In the coming years, the Chinese authorities intend to strengthen and improve financial oversight, to develop financial markets and encourage financial innovation, to have interest rates determined by market forces, and to make the renminbi more freely usable in international transactions. I should also note that the IMF has been working intensively with the Chinese authorities over the past year, as part of the Financial Sector Assessment Program — or FSAP — to identify and prioritize the principal tasks needed to further strengthen China’s financial system. I am confident that this collaborative effort is proving to be useful, by adding IMF experts' unique international experience to help support China's financial reform.
To sum up, I am highly confident that China's planned financial reforms will prove to be fundamentally positive for both China and its international partners. I see no reason why the bulk of the reform agenda won't be accomplished within the time frame laid out in the 12th Five Year Plan. The process will need to be handled skillfully and flexibly. Undoubtedly, there will be unexpected developments along the way that will require good judgment and innovation. I am also confident that with clarity of purpose, intellectual rigor and practical skills, China will achieve its goals.
As we all recognized following the 2008/2009 Great Recession, financial sector reform is a key global task, and it is as yet unfinished. Thus, through its participation in such international fora as the G20 and the Financial Stability Board, China will be able to draw on its partners' expertise, as well as offering its own perspective in this area. And in this — as in so many other areas — China will be stepping forward into a more prominent role. The expert and generous hosting by the CIC of this Forum is one example of this, and I know we all look forward to the future progress and contribution of the IFSWF under Chairman Jin's excellent leadership.
Thank you for your attention.