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Financial Reforms Critical to Transforming Chinese Economy

Skyline of Shanghai, China’s financial capital. Country has made ‘remarkable progress’ toward financially sound system (photo: Yang Liu/Corbis)

ECONOMIC HEALTH CHECK

Financial Reforms Critical to Transforming Chinese Economy

IMF Survey online

July 20, 2011

  • China a bright spot in global growth
  • Inflation expected to start declining later this year
  • Financial liberalization will help rebalance China's economy

Financial liberalization will be essential in transforming China’s economic model to one of more inclusive growth, raising household incomes, boosting domestic consumption, and reducing the reliance on exports as an engine of growth, say IMF economists.

In their regular Article IV assessment of the country’s economy, IMF economists called for a revamp of China’s financial system with a comprehensive set of reforms that strengthen the conduct of monetary policy, improve the financial stability framework, develop financial markets and savings vehicles, and move toward more market-determined loan and deposit interest rates.

The assessment follows a visit by a team of economists led by Nigel Chalk, the IMF’s mission chief for China. This year, for the first time in China, the IMF, in collaboration with the World Bank, also conducted an assessment of the health of the Chinese financial system under the Fund’s Financial Sector Assessment Program (FSAP). The FSAP marked the culmination of more than a year of work by IMF, World Bank, and outside financial sector exports.

“In our surveillance work, we have taken up this financial theme and focused on laying out a clear, strategic roadmap to manage the process of financial liberalization in the coming years, in a way that both reduces the risks and delivers the full benefits of a more market-based financial system,” said Chalk.

“Financial reform will be of great help in rebalancing China’s economy,” he added.

Financial reforms beneficial to depositors

The report notes that China’s system currently leaves many depositors short changed, with deposit rates well below the rate of inflation. While this helps to sustain high levels of corporate investment and foreign currency intervention, it conflicts with many of the objectives of the government’s 12th Five Year Plan.

The IMF team visited Beijing, Shanghai, and Chengdu from May 23 to June 9 to conduct the annual review and presented their findings to the Executive Board of the IMF on July 15.

Both the FSAP and a separate report on the spillovers to the global economy from China’s policies were also discussed by the Executive Board.

At the conclusion of his visit to China in June the IMF’s then Acting Managing Director, John Lipsky, paid tribute to the authorities for their adept handling of the economy during the recent global crisis. He said the country’s economy was a “bright spot” of global growth.

Exchange rate an important complement

In moving ahead with financial liberalization, the staff team highlighted the importance of allowing the renminbi to appreciate to give greater monetary policy autonomy to the People’s Bank of China and to reduce the pace of foreign reserve accumulation.

“A stronger renminbi would increase household income, boost consumption, make China’s manufacturing products more affordable for the Chinese people, and help build a stronger service economy,” said Chalk.

The report also recognized that financial liberalization was likely to be a complex and lengthy process, which would need to be carefully sequenced.

“Continuing to delay could mean that the financial system, instead, evolves in an uncoordinated and disorderly fashion, outpacing supervisory capabilities, and revealing regulatory gaps,” says the report.

This would risk change “proceeding on a timetable driven not by careful, pre-emptive, and concerted policy planning, but rather by the pace of market disintermediation and innovation.”

The risks ahead

The report also discussed the main near-term risks to the Chinese economy, including the danger of rising inflation. IMF economists expect inflation to decline in the second half of this year—it rose above 6.4 percent June—as the impact of higher food prices eases.

“Barring further food price shocks, and assuming the ongoing tightening of monetary policy is maintained, there was general agreement that inflation should soon peak,” says the report. This monetary tightening should rely more on higher interest rates and an appreciation of the exchange rate, and less on credit controls, it suggests.

In recent years, many China watchers have also been concerned about the threat of a property price bubble in Asia’s largest economy, where the property sector directly makes up 12 percent of GDP.

In their report, IMF economists said they did not see imminent risks of a major downturn in the sector, but they warned that as long as the cost of financing continued to be low, and other investment options remained limited, “the propensity for property bubbles will remain.”

Assessing China’s financial sector

The FSAP report concluded that China had made “remarkable progress” in its transition to a more market-based and financially sound system. Consequently the banking sector had entered the global financial crisis from a position of relative strength.

But it also noted that the country’s financial sector was confronting several risks, not only from rising real estate prices and economic imbalances, but also from a likely worsening of credit quality following the enormous injection of stimulus in response to the global financial crisis.

IMF staff believe the potential risks in the financial system are manageable given the capitalization of banks, strong economic growth, and proactive approach being taken by the regulators in dealing with these credit risks. But they recommended improving supervision and regulation, and further enhancements to financial institutions’ risk management systems, as China moves toward a more commercially orientated financial system.