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Meeting the Challenges for the Chinese Financial Sector: What Have We Learned from Other Countries? -- Speech by Stefan Ingves, Director, Monetary and Exchange Affairs Department, IMF
May 15, 2002
Thank you, Mr. Chairman, ladies and gentlemen, for inviting me to this conference. It is an honor for me to discuss this important topic among such distinguished speakers and such an eminent audience. Securing financial sector soundness is among China's most important structural reform challenges. The country's long-term growth prospects and macroeconomic sustainability are affected by it. At the same time, the financial sector has the potential to serve as an agent of economic change and transformation in the more immediate term—a point I will return to later in the discussion.
Today, I going to first take stock of financial sector reforms in China and identify some of the challenges that lie ahead. Then, I shall to turn to lessons learned from other countries on macroeconomic and financial stability and bank restructuring. Finally, drawing upon those lessons, I shall try to offer some thoughts on the medium-term reform agenda in China.
Financial Sector Reforms and Key Challenges
Over the past decade, much has been achieved in building the institutions, markets, and legal infrastructure for a market economy in China, although a large unfinished reform agenda remains.
The Asian financial crisis of 1997 underscored the importance of developing a credit culture and strengthening market discipline, heightening the priority accorded to financial sector reform, including:
Perhaps most importantly, the economic leadership in China is cognizant of the challenges ahead and has a credible strategy for reform. Thus, the basic elements for bank restructuring—leadership, institutions, regulations, and strategy—are largely in place or in progress.
Despite progress made, important weaknesses in the financial sector remain. Non-commercial lending to SOEs has continued, albeit on a diminishing scale; prudential regulation and enforcement still lag behind international best practice; banks are undercapitalized and their risk management, lending practices, and internal controls remain inadequate; and the stock of problem loans is very large.
Against this background, what are some of the key challenges that lie ahead?
One of the most central economic policy challenges is to strike a balance between stability and reform in the financial sector. Clearly, there is no single "right" place on this continuum. Ultimately, the issue is about balancing the economic, financial, and social costs in the short term with potential gains in the long term. Allowing problems in the financial sector to fester may preserve stability in the short run, but could lead to pronounced distress, and higher costs later on. At a minimum, sufficient progress has to be made to avoid deepening existing vulnerabilities, while building the capacity to manage financial distress when and if it occurs in the future.
A key challenge will be to develop a credit culture and contain the flow of new NPLs. With the stock of problem loans already high, it is crucial to avoid a further build-up. This goal is interdependent with developing a credit culture and with improvements in corporate governance, state enterprise reforms, and sustaining economic growth. Fostering a credit culture and better governance, in turn, hinge on a reliable legal framework supportive of private sector activity.
A closely related task is to resolve the stock of distressed debt in the economy. In essence, distressed debt is the counterpart to a portion of the capital stock and enterprises that need to be restructured or written off and closed. Once these restructurings and write-offs take place, resources—currently tied up in NPLs—will be freed up to finance new investment and consumption opportunities.
In the longer term, the financial sector needs to adapt to a new economic environment. The Chinese economy is becoming increasingly market-oriented and opening up to foreign competition, including in financial services. The financial sector in particular may have to compete for creditworthy borrowers and skilled banking personnel. As flexibility is introduced into the exchange rate and interest rates over time, financial institutions will have to become adept at pricing credit risks and managing market risks.
Another long term challenge is to deepen capital markets in order to diversify the sources of investment financing. Greater equity financing can help transform the ownership structure of the economy, attract strategic investors capable of restructuring their firms, and bolster market discipline. As with bank lending, the efficiency of equity financing will be a function of the quality of investment decisions made by investors and their ability to monitor and manage firms under their ownership through effective accounting, disclosure, and governance standards. Capital markets would also provide opportunities for risk diversification by investors, whose savings are still primarily invested in low-yielding bank deposits or in shares on the relatively undeveloped stock market.
What Have We Learned About Macroeconomic and Financial Stability?
Let me now turn to some of the key lessons learned over the past decade. The financial crises in the 1990s, starting with the Mexican crisis in 1994-95, followed by the Asian financial crisis in 1997-98 and the crises in Russia and Brazil, have provided a wealth of experience from which to draw lessons. The IMF's intensified financial sector surveillance activities—primarily through the Financial Sector Assessment Program, jointly with the World Bank—have also helped to assess member countries' financial stability.
Much of the experience over the past decade highlights the critical importance of establishing fiscal and monetary control as the bedrock of macroeconomic stability. Fiscal and monetary control, in turn, ultimately rest on containing public sector financial imbalances, including quasi-fiscal lending through the financial system. Although a discussion of the principles of sound fiscal management are beyond the scope of this presentation, quasi-fiscal activities can become major threats to securing and maintaining monetary control.
This is why I mention the elimination of quasi-fiscal lending as the first pillar of fiscal and monetary control. Using the banking system to subsidize real activities undermines the development of a credit culture and has long been established as a key source of banking unsoundness. Soft loans to the agricultural sector in Turkey and to large state enterprises in Russia, for example, were major sources of financial fragility in both countries in the run-up to their recent financial crises. Moreover, quasi-fiscal lending undermines the integrity of public financial flows and stocks, which may be burdened by contingent liabilities from the financial system that are difficult to quantify. Similarly, the difficulty of distinguishing between commercial and soft loans impairs the quality of banking indicators, which may consequently underestimate the depth of asset quality problems. Therefore, support for loss-making enterprises or special public investment programs, if unavoidable, should be extended directly through the budget to improve transparency and avoid impairing banking soundness.
A second pillar of fiscal and monetary control is to clearly define the state's role in the financial system. The state plays a vital role in preserving financial stability by containing moral hazard through prudential regulation and supervision and by protecting depositors through a safety net, including deposit insurance and central bank emergency lending. In doing so, however, it is critical to draw a line in the sand. The potential scale, scope, and duration of the state's financial guarantees—for example, on the types of financial institutions and classes of liabilities that will be protected—ought to be spelled out in advance. Making explicit the extent of the state's support for the financial system can reduce moral hazard in the economy, so long as it is credible. Credibility will be established or lost ultimately by demonstration. Moreover, over time, the state guarantee should be replaced, for example, by an adequately funded risk-based deposit insurance scheme, once the financial system is placed on a sound footing.
A third pillar—and an essential prerequisite—of fiscal and monetary control is reliable and timely information on the financial and nonfinancial sectors. Decision-makers in central banks, supervisory agencies, and finance ministries need adequate financial information to monitor and diagnose financial sector problems and to distinguish between illiquidity and insolvency of individual institutions. Similarly, banks and investors need good financial information to assess and monitor the creditworthiness of borrowers and issuers of shares.
Admittedly, even with the best possible data, distinguishing between liquidity and solvency pressures may not be possible in crisis situations. Still, without good information on the financial and corporate sectors, fiscal and monetary control become much more difficult to secure, as the cases of Indonesia and Thailand demonstrate. Like most of their regional peers, most Indonesian and Thai firms did not adhere to international accounting standards. The absence of reliable data on financial sector asset quality and corporate sector indebtedness prevented the timely detection of growing corporate leverage and financial system fragility in both countries. Hence, by the time investor confidence was shaken in 1997, it was impossible to distinguish between insolvency and illiquidity among banks; a problem which was compounded by deposit runs.
Steps that can be taken to improve the quality of information include (1) strengthening accounting and disclosure standards; (2) making use of external audits by reputable international accounting firms; and (3) requiring disclosure of more detailed financial statements, including on asset quality. Indeed, the failure of Enron in the United States demonstrates the type of colossal failures that can occur in the absence of reliable and transparent financial statements and that no country can take the quality of information for granted. Given the length of time and amount of effort required to develop the infrastructure for reliable financial information, these reforms should start early on.
A fourth pillar is the specific rules on accessing central bank credit facilities that are well-defined, clearly articulated and publicized, and consistently applied. This principle applies to all types of central bank credit provided in the course of regular monetary operations or extended to the government, other public authorities or private companies, either on a regular or emergency basis. Although there is a tradition among central banks to maintain secrecy in emergency lending, there is a growing consensus in support of a rules-based approach. Under this approach, the central bank specifies the preconditions for providing support, but its lending decisions are still made on a case-by-case basis. This way, the central bank maintains a degree of constructive ambiguity.
In the same vein, the modalities and lines of accountability for central bank lending need to be established. Central bank lending, unless well-managed, can pose serious risks to macroeconomic and financial stability. Therefore, the precise modalities of lending, including its size, maturity, purposes, and eligible institutions and collateral need to be spelled out ex ante, as well as the trigger points for when and in whom lending decisions are vested. The role of collateral can be particularly important when liquidity and solvency pressures are difficult to distinguish. Moreover, decisions to lend to systemically important institutions at risk of insolvency or without sufficient collateral should be made jointly with the fiscal authorities.
In times of systemic crisis, the usual preconditions for liquidity support, such as solvency and collateral requirements, may have to be suspended. In an environment of panic and instability, the emergency lender's resolve should not be doubted by market participants. Emergency lending decisions in a systemic crisis, however, should involve all relevant authorities and be an integral part of a comprehensive crisis-management strategy designed to restore confidence. Regular training exercises involving senior officials on crisis management can enhance the capacity of policymakers to effectively respond to potential financial distress.
In the absence of clear lines of accountability and rules on access and ex post disclosure, central banks can be subjected to undue political pressure, leading to the exercise of excessive forbearance and to the abuse of the lender of last resort (LOLR) facility. In Hong Kong, SAR, for example, the Hong Kong Monetary Authority (HKMA) has a policy statement on LOLR outlining in detail the preconditions and instruments for support, as well as the procedures for exceptions. Where exceptions are concerned, decisions to grant or deny support should be made at predetermined levels of authority to ensure a clear demarcation of responsibility, and that any discretion is matched by adequate checks and balances. Again in Hong Kong, if the potential borrower is unable to comply with the preconditions, then the prior approval of the Financial Secretary is required. HKMA's long-standing institutional credibility, built in part on the transparency and stringency of central bank lending, was an important factor in Hong Kong SAR's resilience during the Asian financial crisis.
A fifth pillar is central bank autonomy, without which clear lines of responsibility and accountability are difficult to establish. There is now considerable evidence that suggests that central bank operational autonomy plays an important role in financial stability. Clearly, central bank autonomy needs to be accompanied by accountability to ensure central bank objectives are met.
Developing instruments and markets for effective control of money supply is an important complement to central bank autonomy and lending operations. For example, central banks often need to withdraw liquidity injected into the economy through the LOLR facility to ensure money supply growth is consistent with low inflation. Effective intervention and sterilization, in turn, depend on the availability of indirect monetary instruments and deep money and securities markets.
The experience of Indonesia once again highlights what can go wrong when the institutional prerequisites for monetary control are missing. By the time financial sector problems grew into a full scale crisis, the central bank had little choice but to provide liquidity support, but lending was not adequately controlled, for example, by ensuring that central bank credits were commensurate to the loss of deposits. Indonesia was not alone in providing large amounts of liquidity support to problem banks; but unlike Korea and Thailand, it lacked the monetary instruments and deep markets needed to sterilize central bank liquidity injections. Its loss of monetary control led to high inflation and a collapse of the rupiah.
Macroeconomic stability also depends on policy credibility, founded upon a reliable judicial system, transparency, and well-defined institutional responsibilities.
Strong and reliable legal and regulatory frameworks are the foundations upon which policy credibility and financial stability rest. In their absence, economic and financial policies can not be implemented. Legal and regulatory enforcement is needed to ensure action is taken against those that violate their prudential and financial obligations, and to act as a credible deterrent for all market participants.
Lack of transparency was a significant contributor to the emerging market crises in 1990s—especially to those in Mexico and Thailand, prompting a great deal of change since then. The international community's efforts to prevent future financial crises—through reforms such as the development of international codes and standards—are built partly on a commitment to greater transparency. There is a consensus that openness in economic policymaking and in disseminating data on economic and financial developments is a key component of reform programs designed to strengthen economic fundamentals. Similarly, central banks are devoting sizable time and resources to developing a consistent monetary strategy—whether they are focused on a monetary or an inflation target—and are using their strategies to communicate their intentions and actions both to the public, local and regional governments, and the participants in the decision making processes over monetary policy. In Europe, historically the Bundesbank, and more recently the European Central Bank, used their clearly defined monetary strategies and targets—in both cases "monetary targeting"—to enhance their autonomy, accountability, and credibility. Central banks more generally are providing greater insight into monetary policy objectives and decisions, and the instruments and operations used to achieve them. Many central banks publish inflation and financial stability reports, and have deepened their contacts with a wide range of institutions—including companies, industry associations, labor unions, and universities—which help the public and markets understand monetary policy decisions and operations. To achieve transparency in monetary policies, central banks have had to reorganize themselves and allocate adequate resources to external relations and economic research to build transparency.
Policy credibility also requires clearly defined institutional responsibilities, and where necessary, their reallocation. For example, the central bank ought to have the mandate and operational autonomy to pursue price stability as its primary objective. Only then can it be held accountable for its performance. Similarly, the supervisory authority should have the authority to adopt prudential regulations and intervene in financial institutions. Otherwise, it cannot be held accountable for the soundness of the financial sector. Shared or divided responsibilities in these areas often create conflicts of interest and undermine systems of accountability.
What Have We Learned About Bank Restructuring?
Now I would like to turn to the lessons learned from other countries on bank restructuring. Since the late 1980s, the emergence of many transition economies in Central Europe and the former Soviet Union has provided fertile ground for learning in this area as have the numerous financial crises, including in my own country, Sweden.
In managing financial crises, bank restructuring is an essential prerequisite for, but also highly dependent on macroeconomic stabilization. Given their interdependence, restructuring and stabilization need to be pursued in parallel. The essential preconditions for fiscal and monetary control, including those outlined above, need to be met as soon as possible. The formulation and implementation of a credible and comprehensive stabilization and structural reform program are also needed for stable prices, interest rates, and exchange rates, which are prerequisites for market participants to value firms and assets, and execute transactions. Even where a full-blown financial crisis has not occurred, as was the case in many transition economies, relative price changes, including the transition to market-based interest rates, must be effected before bank restructuring can begin in earnest; otherwise firms and collateral become impossible to value. Similarly, enterprises must be subjected to hard budget constraints to avoid distortions in relative prices. In the absence of profit-maximizing behavior by firms, prices may not reflect the true cost and demand for goods and services, distorting relative prices in the economy.
The first step in launching a successful bank restructuring program is to undertake a diagnostic review of financial institutions to assess their true condition, separate viable versus nonviable institutions, and identify candidates for restructuring.
On the basis of the financial sector assessment, the authorities must then develop a comprehensive reform strategy that includes (1) a long-term vision for the financial sector, including its size, institutional composition, and ownership structure; (2) a commitment and timetable for privatization, including after banks have been taken over by the government following a crisis; and that (3) coordinates banking and state enterprise reforms. Pursuing state enterprise and financial sector reforms simultaneously is particularly important in transition economies, where the scale and scope of both corporate and bank restructuring are large and highly interdependent. On the basis of the reform strategy, the institutional framework and incentives need to be strengthened to achieve reform objectives. This involves several elements:
First, an out-of-court mechanism for corporate debt restructuring should be established to help restore debt-repayment capacity among viable firms and to recover NPLs. Recourse to informal mechanisms often becomes necessary during large-scale corporate restructuring because formal insolvency procedures are often too cumbersome and judicial systems have limited capacity to process a large number of cases. Moreover, the liquidation bias built into Western insolvency laws may result in the closure of companies whose value as going concerns are greater than their liquidation value, provided that they are given the right incentives and relieved from the burdens—including social welfare obligations—placed on them during the command economy era. Throughout the process of corporate restructuring, it is important to facilitate foreign investment in restructuring firms; both as a source of capital and as a source of management know-how and technology transfer to catalyze the transformation of companies into profitable competitors.
In this context, an important question arises as to who should lead the way in enterprise restructuring. There are two main candidates: the government, usually through a centralized AMC or bank restructuring agency; or creditor banks, including through bank-owned AMCs or work-out units. There are compelling reasons why banks and particularly their work-out units may be best suited to spearhead the restructuring of loss-making enterprises, especially in transition economies. Banks, more than anyone else except enterprise managers, are likely to have more access to inside information on a debtor company's prospects through their existing credit relationship. More importantly, it is easier to structure banks' incentives towards rapid restructuring, asset resolution, and privatization. After all, banks potentially have the most to gain from the success of restructuring debtor enterprises and recovering distressed assets, especially if their own privatization is in prospect. But if banks are charged with the task of leading enterprise restructuring and resolving distressed debts, these tasks should be carried-out by a separate unit or wholly-owned entity to relieve banks of the burden of managing bad loans and to allow them to conduct normal banking operations.
Some argue that banks in transition economies may not be well-equipped to take the lead in enterprise restructuring given their limited experience with operating commercially. While this may be true in varying degrees, the same holds true for the government as well. Moreover, banks ultimately must learn to live on a commercial basis. Although banks with the wrong incentives can take excessive risks, it is easier to provide commercial incentives to banks and their managers compatible with sound banking and eventual privatization than it is to provide such incentives to public officials. This does not rule out a role for the government. Quite the contrary, the government must develop a consensus behind the restructuring program, formulate the policies and laws needed to strengthen the institutional framework, and decide when and how to use public funds to support state enterprises and recapitalize banks.
Perhaps most important is that the AMC or work-out units—whether centralized under the government or decentralized under banks—are organized according to available professional and institutional expertise in the economy and in a way that maximizes incentives for asset resolution. For example, while the scarcity of skilled expertise may call for a centralized approach to debt restructuring, the information-content of borrower and lender relationships and the potentially large number of distressed borrowers may favor a decentralized approach. If a decentralized approach is chosen, skilled personnel shortages may be offset by making use of foreign expertise through sub-contracting, joint ventures, or technical cooperation agreements. Regardless of the particular approach adopted, AMC or work-out units should be managed by professionals whose primary objective is to maximize asset recoveries. Moreover, it is crucial that the accounting practices of the AMC or work-out units are transparent and reliable enough to provide a basis for measuring and monitoring their performance and for peer analysis when many AMCs or work-out units are in operation.
Second, in order for out-of-court mechanisms to work, they need to be backed up by a supporting legal framework, which clearly defines the rights and obligations of creditors and debtors. A credible framework for corporate insolvency and creditor rights also serves to deter uncooperative behavior in out-of-court restructuring negotiations.
A third and critical component of the institutional framework for bank restructuring is adequate prudential regulation and supervision consistent with international best practice. Particularly important is the implementation of a loan classification and general portfolio review system to allow regulators to detect trouble early on and take prompt corrective actions, where necessary. Prudential regulations also need to ensure an appropriate level of disclosure to protect depositors and investors and to enable the exercise of market discipline. Such reporting systems need to be supported by in-depth onsite examinations and external audits to ensure compliance with regulations.
A crucial complement to prudential regulation and supervision is regulatory enforcement. Without it, policy and institutional credibility weakens, moral hazard grows, and manageable systemic deficiencies fester unchecked, creating the conditions for a crisis. The main challenge in enforcement is to insulate it as much as possible from political interference. In some countries, vesting key enforcement issues in one institution is most effective, provided that it has the independence and stature to resist pressure. In others, there is a strong argument for vesting enforcement decisions in a banking commission, consisting, for example, of the finance minister, the governor of the central bank, and sometimes securities regulators. Such a commission is often more difficult to manipulate than an institution where authority ultimately rests with one person. Regardless of the mechanism chosen, achieving the outcome of strict regulatory enforcement is critical.
Once the institutional framework and incentive structures have been strengthened, the restructuring of banks should be pursued vigorously. Here the challenge is to provide credible and effective incentives to the management of viable institutions to change and restructure. Incentives for restructuring can be provided, for example, by developing time-bound restructuring agreements between the supervisory authority and banks, against which management is held accountable, and in which the conditions for recapitalization are delineated. These agreements should include specific financial performance and prudential compliance targets, and benchmarks for restoring solvency and capital adequacy, including through conditional injections of public funds. It is critical to maximize the government's leverage associated with the prospective injection of funds by conditioning bank recapitalization on specific achievements on operational restructuring by bank management. Restructuring agreements require well-defined benchmarks on progress in risk management, credit risk analysis and staff training and can be complemented by including financial incentives for management and employees to improve performance, especially for banks earmarked for privatization.
As with the corporate sector, once bank restructuring has progressed enough and solvency has been restored, selling selected financial institutions to strategic foreign investors can provide equity capital and catalyze operational restructuring through the transfer of technology and modern management to domestic financial institutions. Many transition economies, including Hungary, the Czech Republic and Poland have benefited greatly from foreign investment in their financial sectors.
Let me emphasize that piecemeal approaches do not work. Similarly, attempts to grow out of the problem are also likely to fail, as the case of Japan demonstrates. Countries have had to intervene in the financial sector repeatedly owing to the incomplete nature of previous restructuring efforts, costing the government much more than necessary if the real sources of fragility had been addressed early on. Recapitalizing banks before restructuring, for example, risks wasting more resources. On the other hand, restoring solvency and capital adequacy to financial institutions is necessary to ensure that bank managers have the incentive to improve the net worth of their banks. Hence the challenge is to pursue restructuring and recapitalization simultaneously in a manner that maximizes the government's leverage and gives bank management incentives to perform along the way.
Finally, it is important to adopt the overall reform strategy to the country circumstances. Each country faces the task of reform against the backdrop of various opportunities and constraints, including the pace of economic activity, fiscal flexibility or the lack thereof, and the social and political impact of economic dislocation. The challenge is to coordinate and sequence policies in a way that minimize the constraints and permit the implementation of reforms at the maximum sustainable speed.
Let me now turn to Poland, whose approach to financial sector restructuring was both novel and exemplary, and which helps illustrate some of the issues discussed earlier. While there is a wide range of lessons to be learned from the experiences of several transition economies, Poland, which has some similarities with China, is an interesting example to explore. Among transition economies in Central and Eastern Europe, Poland was among the largest, with an economy composed of a substantial industrial sector and a large, underdeveloped agricultural sector. Not unlike China, the Polish banking system was dominated by state commercial banks, and burdened by a high level of NPLs—with nearly one-third of total loans nonperforming, which were owed principally by state enterprises. Clearly, there are also important differences between China and Poland, including the scale of their economies and restructuring challenges, and the relationship between central and local governments.
The Polish program was comprehensive and sought to achieve bank and enterprise restructuring at once. The strategy rested mainly on an informal out-of-court settlement approach under which banks kept NPLs on their books and were charged with restructuring and recovering bad debts through negotiated work-out programs with debtors. Banks were not allowed to extend new loans to debtors in default unless a restructuring agreement was signed and an acceptable business plan was presented. The out-of-court restructuring framework was enshrined in the Law on Financial Restructuring of Enterprises and Banks, which was in force from March 1993 to March 1996. By design, the law had a built-in sunset provision to reinforce the one-off nature of the exercise and to maximize the incentive of all parties to cooperate and restructure with in the prespecified timeframe.
In effect, debt was used as control device for banks to play a major role in corporate governance. The law gave banks temporary powers to lead out-of-court restructuring agreements with distressed enterprises. Banks were equipped with three tools. Bank-led conciliation agreements (BCAs), the sale of bank debts in the secondary market, and the option to convert bad loans into equity in state enterprises. BCAs were the most original and far-reaching feature of the program. Banks assumed de facto leadership in administering the agreements—even though a creditor council comprising the bank, the Ministry of Finance, and other creditors had to be established—and a simple majority based on outstanding debts was sufficient to impose a solution on dissenting creditors and approve the BCA. While the BCA was in effect, the borrower was protected from formal insolvency proceedings; but if the borrower failed to fulfill its obligations, banks were empowered to terminate the agreement, paving the way to pursue debtors in court.
In order for banks to act as an effective agent for monitoring, controlling and restructuring enterprises, banks too had to be subjected to effective control and discipline. This was achieved through improvements in prudential regulation and supervision and the discipline brought to bear by intensifying competition.
The program included two additional noteworthy features. First, nonviable enterprises whose immediate closure was considered too costly from a social welfare perspective were not included in the program. Instead, their delinquent loans were transferred from the originating bank to the government resolution agency, the so-called Industrial Development Agency (IDA). Then, these firms were restructured or liquidated with conditional support provided through the IDA, which itself was financed through the budget. Second, insolvent state banks were recapitalized based on thorough portfolio reviews early in the program, giving bank management strong incentives to maximize loan recoveries. These incentives were complemented with financial incentives, which included stock options in state banks, all nine of which were earmarked for privatization within 3-5 years.
The decentralized and comprehensive approach to dealing with the twin problems of bank and enterprise restructuring in Poland was effective in transforming the economy and establishing the foundation for a sustained economic growth. During the period of 1991-1997, bank NPLs declined and the number of creditworthy enterprises rose substantially.
Some Further Thoughts on the Medium-Term Reform Agenda in China
Based on what we have learned from other country experiences, let me offer some thoughts on the medium-term reform agenda in China. In doing so, I am mindful of the difficulty of transposing strategies or solutions from other countries to China. China's situation is clearly very unique. In particular, the scale of China's transformation surpasses that of all of Central and Eastern European economies combined. Hence there are both tremendous opportunities and challenges. While the size and diversity of the Chinese economy and its labor force magnify the challenge, they also present the opportunity to experiment locally with certain approaches to various problems, before they are adopted at the national level.
Against this background, the future reform agenda may include some of the following issues:
First, fiscal control could be consolidated by containing quasi-fiscal lending and the flow of bad loans. Achieving this objective, however, is complex and involves decisions on when and how to deal with loss-making enterprises and weak financial institutions. The simultaneous pursuit of bank and enterprise reforms may be the most effective route, but requires the design of a credible set of market-based incentives and rules of accountability, underpinned by strong legal, regulatory, and supervisory frameworks. Part of the solution lies in holding the management of banks accountable for internal bank restructuring in the short run, and transferring ownership to the private sector in the long run. Privatization, however, should be preceded by a strengthening of prudential regulation and supervision to preempt excessive risk taking by banks, and by a well-designed, risk-based deposit insurance scheme that protects small depositors.
Second, the framework for distressed debt resolution could be established, including through an out-of-court mechanism for debt restructuring. The role of the recently formed AMCs is part of this issue. The framework could potentially give banks a more active role in a coordinated effort to tackle bank and enterprise restructuring, given their interdependence.
Third, somewhat greater exchange and interest rate flexibility could enhance macroeconomic policy flexibility and allow banks to price risks more effectively. There are, however, a number of important sequencing issues to be considered in making such a move. For example, banks need to be prepared to assess and price credit risk before interest rate liberalization, yet they cannot be expected to acquire such skills without enough incentive and ability to actually price those risks. Similarly, greater exchange rate flexibility will require the development of an alternative anchor for monetary policy, and the markets and instruments for foreign exchange management, yet these markets and instruments can hardly develop without flexibility in interest and exchange rates in the first place. Hence, moving towards greater flexibility needs to be carefully sequenced and accompanied by supporting measures, including enhanced prudential regulation and supervision to minimize risks.
Finally, capital account liberalization and financial sector restructuring and market development should be managed in an integrated, coordinated, and well-sequenced fashion. Permitting and attracting foreign direct investment into the financial services industry could serve as a catalyst for bank restructuring through the transfer of know-how and technology and by intensifying competition. Similarly, liberalizing portfolio flows over time can help deepen capital markets and strengthen the role of market discipline in the economy, provided that supporting prudential measures are adopted to contain greater foreign exchange risks associated with a higher volume of capital flows.
It is easy to offer suggestions on how to go forward. To create change on the ground takes vision, a lot of hard work, and a willingness to execute policies at all decision-making levels in the economy. With these words I conclude my reflections. Thank you again for this opportunity to share some thoughts on these issues. I would be happy to take questions.
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