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Strengthening Market Mechanisms to Build China's Modern Financial System

        2018-11-30

Strengthening Market Mechanisms to Build a Modern Financial System in China[1]

 

Huang Yiping

Chairman of CF40 Academic Committee

Deputy Dean, National School of Development, Peking University

 

Abstract: Recently China Finance 40 Forum released The 2018 Jingshan Report (hereinafter the “Report’). The theme of the report is “Strengthening Market Mechanisms to Build a Modern Financial System in China”. The Report holds that the past 40 years of financial reform and development in China shows a distinctive characteristic of ‘expanding market scale over building effective market mechanisms’. The model has maintained China’s financial stability and created a growth miracle, but it no longer meets the demands of economic development in the current stage. In the future, China should strengthen market mechanisms and establish a modern financial system. To this end, the Report makes policy recommendations across seven areas. 

 

Giving preference to market scale over market mechanisms

 

40 years of financial reform and development in China has shown a clear preference for expanding market scale over building market mechanisms. On one hand, China now boasts a great number of financial institutions with enormous assets: China’s four largest state-owned commercial banks rank among the global top ten each year, and the market capitalizations of the stock and debt markets rank the second and third in the world, respectively. But on the other hand, the market mechanisms only plays a limited role in financial resource allocation, and policy interventions are prevalent, e.g. imposition of limitations on deposit and loan benchmark interest rates, guidance on capital allocation, management of the exchange rate and cross-border capital flows, and control over large financial institutions. In 2015, among the 130 economies with available data, China ranks the 14th in terms of financial repression.

 

One root cause of this model is the “dual track” reform strategy, which aims to sustain the state-owned enterprises (SOEs) while creating a more favorable environment for non-SOEs. In implementing this strategy, the government has carried out “asymmetric market reforms”, i.e. fully liberalizing the product markets while allowing distortions to persist in the factor markets. The purpose is to artificially depress factor prices and influence resource allocation, providing a disguised form of subsidy to SOEs. Financial repression is just an example of factor market distortion.

 

During the first 30 years of reform, this strategy helped China to maintain financial stability and created a growth miracle. Empirical analysis also shows that in the early stage of reform, financial repression has a positive effect on economic growth, and only later on did its effect turn negative. In fact, the impact of repressive financial policy on economic growth is non-linear, as two effects could exits simultaneously: first is the “McKinnion effect”, which indicates financial repression lowers financial efficiency, limits financial development and economic growth; the second is the “Stiglitz effect”, which shows financial repression helps convert savings into investment, and supports financial stability and economic development. It could be said that the Stiglitz effect dominated in China’s economy, but today the McKinnon effect dominates.

 

What is alarming is that in recent years the marginal capital output rate has risen steeply, indicating China’s capital or financial efficiency is deteriorating. China has been the only major emerging market economy to not experience a severe financial crisis, and currently preventing systemic financial risk is one of three “critical battles” of the government. The decrease in financial efficiency and increase in financial risk require heightened vigilance.

 

A trigger for this change is that China’s economy has reached upper-middle income level, thus it must overcome the “middle-income trap”. The labor-intensive, low value-added manufacturing businesses built on low-costs are no longer competitive. China today needs to nurture and develop high-cost but competitive new industries to support a new phase of economic growth. If in the past China’s economic growth was factor driven, today it must transform into one driven by innovation. The financial system that once successfully supported factor-driven growth is now in urgent need of transformation.

 

The shortcomings of China’s financial system

 

China’s financial system has quite a number of problems, and is unable to meet the needs of economic growth in the new phase. The three areas with the most pronounced problems are as follows: first, the financial system is unable to meet the needs of the real economy. The declining savings rate and increasing consumption rate will increase household demand for capital gain income. The rise of the service industry and upgrading of manufacturing have led to the enterprises’ increasingly diverse demand for financial services. However, the financial system is extremely weak in these areas. Second is the boundary between government and the market is unclear. The “financialization of fiscal risk” is a common phenomenon, and the government is forced to provide bailout for financial institutions. The government frequently intervenes in, or even performs the functions of the market, and the market cannot effectively price risks or allocate capital. Because the government does not follow market rules, it frequently does harm despite good intentions. Third, financial regulation is ineffective and has been unable to control risks. In the past, financial stability was achieved mainly through government bailout. Over the long run, this approach created serious moral hazard and is unsustainable. The current regulatory framework emphasizes institutional regulation and separate-business regulation. Under this framework, regulatory gaps and redundant regulation are prevalent. In addition, lack of coordination among regulatory policies have created many risks.

 

Financial systems around the world are diverse and each has its own unique characteristics. Two perspectives can be used to assess and compare these systems. The first is ‘financial structure’. Based on this, financial systems can be divided into two groups, one consists of those dominated by commercial banks, such as Germany and Japan, the other consists of those dominated by capital markets, such as the United States and the United Kingdom. The second is the method of resource allocation. One group of financial systems is based on market mechanisms, such as Hong Kong and Singapore, and the other group is based on government intervention, such as China and India. In reality, the two perspectives can be aligned with each other. International data shows that countries where the banking system dominates usually have a high degree of financial repression. Germany and Japan both have high percentages of bank assets, and their levels of financial repression are higher than those of the US and UK, while China’s levels of bank assets and financial repression are both much higher than those of Germany and Japan.

 

It is difficult to conclude which type of financial system is better. The US, UK, German, and Japanese systems are all different, but these are all successful developed economies, which indicates that various financial systems can all effectively support the economy. However, from the perspective of economic development, capital markets are normally associated with decentralized decision-making and follow market rules, and are better adapted to technological revolutions. Thus technologically advanced countries usually have a financial system dominated by capital markets. On the other hand, commercial banks are better are mobilizing large amounts of cheap capital, and can better help the promotion and dissemination of mature technology, thus a financial system led by commercial banks is frequently the method of choice for technologically underdeveloped countries that must catch-up with those on the technological frontier.

 

China’s bank capital and financial repression are both very high by international standards, which indicates that not only is China’s financial system heavily dependent on the banking system, but also the government intervenes a great deal. The model has its roots in the country’s historical and cultural tradition as well as economic reality. On the one hand, the Chinese culture does not have a strong tradition of liberalism. Historically, the market economy has also been underdeveloped. The country implemented a central-planned economic system for over 20 years prior to reform, and the government’s means to intervene in the economy were abundant. Although there has been more than 20 years of development, the capital market is still rather primitive. On the other hand, when reform and opening up were first launched, China was a very poor country that needed to catch up with other countries. Banks can not only mobilize a great amount of capital, but can fully implement the government’s policy strategy through various means, i.e. subsidizing loss-incurring SOEs, investing in infrastructure projects, supporting the development of strategic industries, and providing inclusive financial services.

 

The direction of reform

 

The government has proposed “building a modern financial system” as an integral part of a modern economic system. The “modernity” of a financial system is mostly reflected in the role of “market mechanisms”, which should include three important features. The first is to increase the weight of capital markets in financial transactions, or to “develop multi-tiered capital markets”; second is to strengthen the role of market mechanisms in resource allocation, which is to “allow the market to play a decisive role in resource allocation”. One key function of the market mechanism is to realize market-based asset pricing which fully reflects investors’ risk preferences and market supply and demand and forms benchmark yield curves for financial assets with various maturities.

 

It should be noted the market-based financial reform in China cannot be reverted just because the US and EU have experienced major financial crises. The problem of excessive market liberalization did exist in the US and EU, and we must be vigilant against this. But the key lesson from the financial crises is that timely and effective regulation should be in place to keep up with financial innovation. Furthermore, we cannot view problems with China’s shadow banking and FinTech sectors simply as the result of financial market liberalization. The expansion of off-balance sheet business is a result of different regulatory standards applied to on- and off- balance sheets activities, and the excessive control by the authorities (such as interest rate controls). The most critical problem with China’s financial system is not excessive liberalization, but under-marketization, though the market-based reform must go hand in hand with the establishment of an effective regulatory framework.

 

While advancing reform of the financial system, several market and institutional constraints should be taken into consideration: first is the need of the government to control the financial system. The ideal approach would be for the government to exercise control through macroeconomic management policy or ownership rights, and refrain from interfering in the financial markets or activities of financial institutions at the micro level. Second, non-market behavior of some economic actors may persist for a long time. Although the government has repeatedly emphasized the importance of a level playing field for SOEs and non-SOEs, in reality this is very difficult to accomplish. For this reason, additional rules such as quantitative restrictions should be made to limit non-market behavior and control risks. Third, in the foreseeable future, banks will continue to dominate the financial system. Developing a multi-level capital market is a long process, and cannot be accomplished overnight. Commercial banks should proactively reform and transform in order to better serve the new needs of the real economy. Overall, the direction of financial reform should be to push ahead with liberalization, however this shouldn’t be a laissez-fair process.

 

We offer the following policy recommendations on how to build a modern, market-based financial system that effectively supports an innovation-driven economy.

 

Firstly, let the market play the decisive role in the allocation of financial resources. The government should leave financial decision-making power with the market, and at the same time establish rules for the market access and exit of financial institutions, end implicit guarantees, reduce and eliminate the distortion of capital prices and investment behavior, improve the pricing and allocation mechanisms of funds, and restrict the functions of the government to macro-control, maintaining order, supporting stability and correcting market failure.

 

Second, further promote the transformation of banks, improve the corporate governance structure, form an effective internal check and balance mechanism, establish a new type of bank-enterprise relationship, improve the risk pricing ability of commercial banks, and fully realize the marketization of loan and deposit interest rates. Improve market access and exit mechanisms for commercial banks, and set up risk disposition and market exit mechanisms on the basis of a deposit insurance system.

 

Thirdly, develop a well-functioning capital market centering on fiduciary duty. The fair and reasonable pricing of financial assets can be achieved through sellers' due diligence and caveat emptor. Reform the tax system for capital markets, encourage long-term investment to provide high-quality capital for innovation and development, and reduce incentives for short-term speculation and regulatory arbitrage. Provide more financial products and enhance the price discovery and risk management functions.

 

Fourth, formulate financial policies to support innovation and industrial upgrading. Decision-making in relation to providing support to innovation should be left to the market participants. Have the government play its role in making and implementing industrial policy. The power and responsibility of decision-making should be aligned, and "image projects" by governments should be reduced including all kinds of “fund towns” and “industry guidance funds”. Use reform pilot programs and regulatory sandboxes to balance innovation and risks.

 

Fifth, financial regulation should hold the “bottom line” of no systemic financial risks. Full coverage of financial regulation should be realized. Institutional and functional regulation should be given equal weight, and both behavioral and prudential regulation should be carried out. At the same time, coordination of regulatory policies needs to strengthen. More personnel and funds should be assigned to financial regulation, and the resources need to be better allocated in order to increase regulatory effectiveness and meet the needs of an ever expanding and increasingly complex financial system.

 

Sixth, monetary policy should transform from a quantity-based framework to a price-based framework. Establish the central bank’s policy interest rate to anchor and guide expectations. Stabilize the liquidity operation mechanism of the central bank to stabilize market expectations. Improve the effectiveness interest rate adjustment policy by adjusting the balance sheet of the central bank. Streamline the interest rate transmission mechanism, improve the decision-making and operation process of monetary policy, and establish a sound information disclosure system for monetary policy decisions.

 

Seventh, improve the legal system for a modern financial system. Unify financial legislation, and change the mode of separate-business legislation and institutional legislation. Update outdated laws in a timely manner and enhance forward-looking financial legislation. Tighten law enforcement, enact and implement laws relating to market exit and risk disposition of financial institutions. Continue to build the social credit system, discipline bad credit, and establish a personal bankruptcy system.

 

 



[1] This article is the overview of the 2018 Jingshan Report. The research group includes Huang Yiping, Yin Jianfeng, Zhang Bin, Xu Zhong, Ji Zhihong, Sun Guofeng and Hong Lei. All the members participated in the research project in their personal capacity. Huang Yiping authored the overview which summarizes major analysis and conclusions of six sub-reports, although some views expressed herein do not necessarily represent those of the authors of the sub-reports.

 

 
 
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