by Adrian Ineichen
Undoubtedly, China has made impressive economic progress in the last three decades and continues to outperform most economies with an annual growth rate above 8.2% for 2009, even in the current global economic crisis (Xinhua, 2009). But many challenges remain, particularly regarding financial markets, the capital account, and monetary policy. The 2009 lending boom, huge foreign exchange reserves, a re-pegged renminbi (RMB) exchange rate to the US dollar, and capital controls are elements of an imbalanced economy and could have negative implications for China’s long-term future. This article discusses some of the problems and examines options to address them.
The Current Financial Situation in China: Problems and Issues
China’s Financial Markets Are Underdeveloped
The banking sector is dominated by the five biggest state-owned commercial banks that hold 52.6% of all Chinese banks’ assets and are utilized to direct credit mostly to preferred state-owned enterprises (SOE; cf. EIU, 2009). This situation has led in the past to inefficient capital allocation and bad loans. As recently as 2009 the ratio of non-performing loans (NPL) of the Agricultural Bank of China for example was estimated to be at 23.5% (EIU, 2008), but this ratio has now declined on average for all Chinese commercial banks to 1.66% in October 2009 (People’s Daily, 2009). However, given the increase in 2009 in bank loans through November to RMB 9.21 trillion (compared to RMB 5.01tr in 2008; RTTNews, 2009), the NPL ratio could surge again.
It appears that most of China’s largest banks meet Basel standard’s tier 1 ratio of 4%, but China imposes stricter rules with 7% for tier 1 and 10% for tier 1 and 2 which are not met by all banks (e.g. the China Merchants Bank; cf. WSJ, 2009). Chinese banks are thus seen in need to raise additional capital of US$43bn soon to meet tougher standards; regulators have pushed for more caution due to the lending boom in 2009 (CNN, 2009).
Meanwhile, the separation between commercial banks, securities firms, and insurance companies seems to have softened as Chinese institutions face foreign competition. Credit rating/scoring systems are archaic and risk management is weak. Most credit card applications and credit scoring are processed manually and thus prone to errors. Even though policy initiatives aim to improve data collection and dissemination, information sharing among financial institutions appears to be limited (LA Times, 2008).
Capital markets are relatively small and weak (e.g. derivatives markets, cf. Kim, Lee & Shin, 2008; EIU, 2009). Corporate governance, accounting and auditing standards are inadequate and the rule of law is enforced arbitrarily. Financial repression and inefficient capital allocation generate large welfare costs (Prasad, 2008).
The Capital Account Is Gradually Opening Up and Capital Controls Become Less Effective
As the Asian Financial Crisis 1997/98 demonstrated, combining fixed exchange rates with financial liberalization could have disruptive effects. China’s capital inflows consist largely of FDI, which tends to be more long-term oriented and is associated with technology and managerial skill transfer. Interestingly, most of China’s (utilized) FDI inflows come from East Asia (not from the West), although the biggest chunk, 31.7% from Hong Kong (HK) involves probably a large share of round-tripping between mainland China and HK (figures for 2004, cf. Prasad & Wei, 2007).
China restricts foreign investment into RMB-denominated securities on the mainland. However, such capital controls have become leaky and are likely to be further undermined through gradual opening of cross-border capital flows. Even though China’s capital controls remain effective enough to allow the persistence of a gap between offshore (so-called non-deliverable forwards, NDF) and onshore forward rates of the RMB to the dollar (Ma & McCauley, 2008), politically unintended capital flows seem to increasingly occur both via the capital as well as the current account (due to e.g. remittances or investment income). Meanwhile, investment income flows out of China have stayed flat since 2000, which could imply that foreigners try to delay or cancel profit repatriation out of China to benefit from expected RMB appreciation and investment opportunities (Ma & McCauley, 2008).
The large and rising foreign exchange holdings of the central bank, the People’s Bank of China (PBOC), currently about US$ 2.3tr, provide some insurance against potential future financial shocks, but imply also large money inflows and impose costs (such as inefficient investment of foreign exchange reserves into low-yielding bonds abroad; cf. Wyplosz, 2008).
China’s Monetary Policy Has Insufficient Tools and Strives to Achieve Too Many Objectives Which Generates Trade-offs
The PBOC’s goals seems to include maintaining a GDP growth rate of at least 8%, inflation of about 3%, a stable exchange rate to the dollar and structural adjustment while pursuing money growth and interest rate targets (Yu, 2008). The PBOC incurs high costs in sterilizing capital inflows through the issuance (and roll-over) of low-yielding short-term bonds. Raising domestic interest rates would attract even more capital inflows (due to carry trades), which would put more appreciation pressure on the RMB. Reserve requirements were sometimes raised in the past as an alternative but they seem to become less effective as Chinese banks hold large excess surpluses, hence such regulatory adjustments may have not necessarily an impact on money supply (Yu, 2008). As China’s money markets are large but fragmented, they limit the influence of the PBOC’s interest rate policy on commercial bank lending. This situation has led to a “stop-and-go” monetary policy: Too much money growth is followed by too strong tightening and vice versa which reflects ineffective and clumsy tools and generates inefficiencies in the economy.
Financial Liberalization and Development: Policy Options
Despite mixed empirical evidence and short-term challenges, financial liberalization has many potential benefits, such as access to international capital markets, which could improve risk-sharing and the utilization of domestic savings for more efficient investments, lower costs of capital (as inefficient investments and cronyism will decrease), and improved intertemporal consumption smoothing opportunities. However, potential negative aspects include more exposure to international financial shocks which could lead to boom-and-bust cycles in the short run. In the longer term, financial liberalization may lead to strengthened institutions, which stabilize markets (Kaminsky & Schmuckler, 2007). To reap some of the benefits and avoid some of the pitfalls, China could implement the following options.
Further Gradually Internationalize the RMB and Make It More Flexible
If the RMB is fully convertible, the Chinese could trade in their own currency and incur fewer risks. A more flexible RMB could mitigate external shocks and reduce inflationary pressure arising from capital inflows compared to a peg. One step in this direction could be the expansion of the RMB trade settlement – which is currently restricted to ASEAN countries, HK and Macao – to all Asia and the rest of the world, after gaining some years of experience in the ASEAN region. Another option is the expansion of RMB bond issuance abroad and then allowing RMB deposit accounts abroad (likewise: first in Asia, then globally). If China’s growth rate picks up, the world economy recovers, capital flows (out of the dollar) into attractive investment opportunities increase, and the euro strengthens against the dollar, there might even be some room for putting the RMB back on an appreciation path linked to a currency basket (similar to 2005-2008; cf. the views of Prof. Keidel, Georgetown, in Batson, 2009).
To contain capital flow volatility and asset price bubbles, investment ceilings could be set for certain sectors. The creation of new investment opportunities (e.g. in China’s underdeveloped Central, Western and Northeastern provinces) could mitigate the run on few and geographically concentrated assets. A gradual RMB appreciation could hurt the export sector in the short run. But it also provides an opportunity to rebalance China’s economy and a coordinated policy response could help the country further climb up the supply chain to more sophisticated sectors which are less sensitive to exchange rate movements. Additionally, greater regional financial integration and policy coordination in the ASEAN+3 area could mitigate some potential risks.
Liberalize the Banking Sector, Privatize State-run Commercial Banks and Use Only Policy Banks for State-directed Lending
A liberalized banking sector may reduce credit-rationing against SME, induce more efficient capital allocation due to increased competition and may further stimulate domestic financial development. Politically driven lending could be restricted to only two domestic policy banks run by the central government, i.e. the Agricultural Development Bank of China (ADBC) and the China Development Bank (CDB). The privatization of state-run commercial banks allows them to operate more efficiently, generates revenues, and reduces risks such as NPL emanating from political interference. Competition in the banking sector could be strengthened further by allowing foreign institutions full market access.
Further Open Up the Capital Account and Diversify Foreign Exchange Holdings
A more open capital account implies not only advantages stemming from incoming capital, but allows Chinese capital to be invested abroad without restrictions which could help to diversify portfolio risks and to strengthen financial market development. Similarly, the gradual diversification of China’s sovereign foreign exchange assets combined with their partial transfer from the PBOC into Chinese sovereign wealth funds not only reduces dependence on the US dollar, but is also likely to increase the return on these assets. As Chinese capital outflows increase due to more liberal regulations, speculative appreciation pressure on the RMB could be reduced. Increasing Chinese outward foreign direct investments could support China’s global quest for commodities.
Steps in this direction could be the expansion and liberalization of the Qualified Foreign/Domestic Institutional Investor (QFII and QDII) programs, the promotion of foreign listings by Chinese firms and local listings by foreign firms, and relaxations on foreign exchange accounts in China. To mitigate foreign fears of many Chinese takeovers of foreign firms, China could strengthen the separation of business and political interests, and improve domestic corporate governance. China could seek to establish bi- or (even better) multilateral investment treaties that clarify rules and limits of cross-border investments and reduce protectionism and discretionary blocks. These treaties would also help win foreign investor confidence in the mainland.
Focus monetary policy on inflation targeting and GDP growth.
A more flexible RMB and more cross-border capital flows allow the PBOC to focus on fewer goals and reduce the need for sterilization. A reduction in the number of interest rates and the unification/standardization of capital markets could help the development of a benchmark interest rate which increases monetary policy effectiveness in liquidity management (Yu, 2008). This move would improve the utilization and effectiveness of monetary tools and could help achieve financial stability, growth and low inflation (Prasad, 2009).
China’s financial markets are growing, but are still relatively weak and underdeveloped. The hike in bank lending in 2009 (and a still above average lending level in 2010) could bring back the problem with NPL. China’s capital controls still work, but gaps have arisen. Monetary policy tools are no longer able to fully sterilize, thus enabling unwanted capital flows to occur. The central bank’s effectiveness is constrained by trade-offs arising from a multitude of objectives and targets. Policy tools often over- or undershoot the targets and resorting to clumsy measures such as reserve requirements is inefficient.
Financial liberalization can offer many benefits, but can entail also pitfalls. The development of China’s financial market could be further supported by carefully calibrated and sequenced liberalization steps. First, the gradual internationalization of the RMB could reduce transition risks before reaching full convertibility. A more flexible exchange rate fixed to a currency basket could reduce inflation pressure from inflowing capital, guide expectations and thus reduce currency speculations. Second, a liberalized banking sector would benefit SME by allocating capital more efficiently and reduce NPL risks. Competition and market development could be strengthened by relaxing restrictions on foreign competition. Third, opening the capital account, i.e. reducing restrictions on cross-border capital flows, can help portfolio diversification. A shift of China’s foreign exchange reserves into more non-dollar assets and into a wider variety of securities can bring higher returns and less sensitivity to the dollar. Fourth, a monetary policy focus on inflation in combination with the first three points allows a more effective policy implementation and supports financial development.
As China’s growth rate will rise again in 2010, NPL, asset bubbles, and inflation could become core concerns and monetary as well as fiscal policy could start to tighten slowly. It will be very interesting to follow how policymakers react to new challenges, what tools they employ, and how effective they will be.
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