China’s Antiquated Financial System: The Creaking Grows Louder

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Nelson Ching / Bloomberg via Getty Images

Pedestrians walk past the People's Bank of China in Beijing, China, Dec. 23, 2011.

To maintain a stable RMB-to-dollar exchange range so far, China has had to ensure that Chinese and U.S. interest rates do not diverge widely, to prevent higher Chinese interest rates from driving up the RMB’s value. Since that makes China unable to use interest rates as a monetary policy tool, the PBOC has relied primarily on administrative controls, such as bank reserve requirements and loan growth rate targets, to control inflation. Allowing greater exchange rate flexibility will open the way for more market-based interest rates in the domestic financial system — both for inflation control by the PBOC and for more efficient, market-driven capital allocation by the banks. “If China continues to be the world’s largest exporter and second-largest importer, and holds aspirations for RMB to be at least one of world’s reserve currencies, they have to make these changes to the financial system over the next five to 10 years,” says Wendy Dobson, a professor at the University of Toronto’s Joseph L. Rotman School of Management.

Yet, some experts say true liberalization cannot occur until banks stop performing the government’s fiscal functions. Yukon Huang, a former World Bank economist and now senior fellow at the Carnegie Endowment for International Peace in Washington, D.C., notes that government expenditure in Europe is 45% of GDP; in the U.S., 30% to 35%; and in China, only 28%. “How can a socialist economy have such a low share of government spending?” asks Huang. “Government spending is done through the banks.” While there is nothing wrong with government spending through the banks or the budget, “as long as the money is well spent,” he says, in the long run, “the broader question is how to reform the budget system. Are the country’s institutions strong enough” to be able raise and collect taxes, rather than relying on household bank deposits?

But, as Wharton management professor Marshall W. Meyer notes: “China rarely institutes sweeping reforms in one stroke. Maybe now is the time to experiment seriously in banking.” For now, to continue the path of financial liberalization, analysts are recommending that China take the following major steps:

(MORE: Why China Will Have an Economic Crisis)

Liberalize interest rates. A flexible exchange rate will bring pressures to liberalize bank interest rates. Wharton’s Allen anticipates China’s first step in bank reform is to lift controlson deposit and loan rates. That move could shrink the spread between the two from three to one percentage point, “challenging the business model of the big banks,” says Loechel. Today, about 80% of Chinese bank revenues come from lending, compared to an international average of 50%, he says. But Chinese banks can still thrive if they follow the example of the Bank of China, which already makes 30% of its revenues from asset management. If banks double their current commission business, even while their interest spreads decline and labor costs rise, the big Chinese banks will still have a greater return on assets than their Western counterparts, he says.

Promote private-sector lending. To address the pressing need to financeprivate SMEs, China should allow private investors to invest in the banking system, says Liu. The handful of privately owned Chinese banks, including China Minsheng Bank, Ping An Bank and Zhejiang Tailong Commercial Bank, are doing well, he notes. In March, Chinese officials named Wenzhou in Zhejiang province a “special financial zone,” to encourage the growth of private lending institutions. Separately, the Supreme Court overturned its earlier death penalty ruling for Wu Ying, a Zhejiang-based entrepreneur accused of illegally raising money from private investors, signaling government openness to private-sector financing.

Create other capital markets. To give banks more competition, companies an alternative source of funding and households potentially higher-yielding investment vehicles, China should set up a corporate bond market, says Dobson. In March, China Securities Regulatory Commission chief, Guo Shuqing, said China could open up a junk bond market soon to help finance private SMEs. If so, China needs to strengthen the rule of law, says Dobson. “Financial markets are transparent and run on trust and confidence, based on rules and laws that are enforced,” she notes.

Strengthen bank supervision and deposit insurance. As China liberalizes its banking system, it must concurrently build bank supervisory capabilities, notes a former Morgan Stanley banker who has worked in Greater China for two decades. Widening the RMB trading band and liberalizing bank interest rates can take place relatively quickly, butdeveloping strong supervision could take at least 10 years, including the training of competent personnel, he notes. Likewise, creating a deposit insurance system will help safeguard against potential banking crises.

As China faces its next leadership transition, these reforms are an economic imperative that even conservatives in power cannot overlook, say experts. “If China cannot reform its banks and financial sector, it will have a deep negative impact on economic development and for social stability,” says Loechel. But the magic elixir of these reforms may be the true test of leadership. Says Dobson: “The really hard part is you need the rule of law for a modern financial system, based on trust and transparency, to function. Whether it’s Bo Xilai or Chen Guangcheng, many roads can lead to political reform. That’s the great opportunity now and the great unknown.”

(MORE: Why China Should Slow Down – But Probably Won’t)

Republished with permission from Knowledge@Wharton, the online research and business analysis journal of the Wharton School of the University of Pennsylvania.

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