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China’s Financial Reform: ‘Making Progress While Maintaining Stability’

Chinese Premier Wen Jiabao (front) attends the National Financial Work Conference in Beijing, Jan. 7, 2012. (Xinhua Photo)

There were no great expectations of the fourth quinquennial national financial work conference that has just ended in Beijing. And it seems to have met them.

These two-day meetings set broad policy objectives for the coming five years. In the past they have provided a blueprint for significant financial-system reform. But with a leadership transition already underway, the start of a new five-year plan and growing nervousness among policymakers and political leaders about the volatile outlook for the global economy and the potential implications for China’s growth, there is no great appetite for much beyond keeping a steady ship.

“Risk-aversion should be the lifeline of our financial work,” said Prime Minister Wen Jiabao, seen in the Xinhua photo above arriving for the start of meeting with the men and woman in whose hands so much rests. Wen also said that there would be greater supervision of the banks, which, he said needed to improve their governance and risk management.

Risk control and prudent macroeconomic management were the order of the day, as they were at last month’s annual economic work meeting. “Making progress while maintaining stability,” is the mantra. The emphasis is currently on the stability.

More detail about the financial work meeting will likely drip out over the coming days. The post-meeting statement dealt in generalities, but two leading topics of discussion were the currency and interest rates. Moves towards more market oriented interest rate mechanisms are necessary if China is to become more efficient at capital allocation, as it needs to be as its economy develops from its invest and export model of the past three decades. But steps have been tentative in the face of some vested interests who have thrived on cheap and ready bank loans. We expect the equally tentative steps to develop bond markets to be given priority over interest rate liberalization, with provincial and local governments being given more scope to sell bonds to firm up their finances. However, when it comes to developing a corporate bond market, don’t underestimate the political task in getting the big state owned enterprises to be supportive of a new source of credit that will be more demanding of their performance.

The internationalization of the yuan is also likely to continue at a measured pace, while the exchange rate against the dollar won’t be allowed to drift much higher. Policymakers feel that with the trade surplus shrinking the currency is at the right sort of level. It has risen by a third since the peg with the U.S. dollar was first broken seven years ago. Wen said China “will steadily proceed with efforts to make the renminbi convertible under capital account to improve its management of the foreign-exchange reserves”–though that is pretty much boilerplate.

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China, The IMF And The Stasis In Financial Reform,

Beijing’s response to the IMF’s recommendations on China’s financial system, published under the G20’s Financial System Stability Assessments, provides a litmus test of both the state of the balance of power between reformers and conservatives in the jockeying for position in the leadership succession, and of the balance between the economy’s optimists and the pessimists. The People’s Bank of China’s comments understandably accentuated the positives in the assessment, but there was something there, too, for those looking to read between the lines:

There are certain views in the report that are insufficiently comprehensive and insufficiently objective….Some of the recommendations such as the timeframe and the prioritisation of reforms lack a thorough understanding of China’s reality.

We have noted before that reform is running into substantial resistance from vested interests. The reformers will welcome some IMF recommendations as support for reinvigorating reform. There is nothing much new in what the IMF is suggesting, which includes increasing the role of market forces in allocating credit, currency appreciation and measures to improve corporate governance, transparency, regulatory capacity and the autonomy of regulators. Yet reformers will have to be selective about how far and hard to push on any of those fronts.

This Bystander would be remiss not to note the IMF’s acknowledgment of the health and robustness of China’s financial system, and its resilience to isolated shocks, such as could be caused by something going badly wrong in one of the economy’s danger zones – off-balance sheet lending, informal credit markets, high property prices and rapid credit expansion – and thus causing a banking crisis. The IMF’s fear, though, is that a succession or convergence of any or all of those shocks could pose a systemic risk. It sees “a steady build-up in vulnerabilities”, the cost of which “will only rise over time, so the sooner these distortions are addressed the better.”

Political conservatives and economic pessimists make common cause in not being prepared to pass control of the financial system to market forces or independent regulators lock, stock and barrel. The first group is inherently of such a mind, or stands to lose materially from that happening; the second group fears that the global economy hangs a dark cloud over China’s and has more faith in the state to resolve a financial crisis than in the ability of market forces and independent regulators to stave off one. Both groups have had their beliefs only reinforced by what has happened in Europe and the U.S. since 2008.



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China’s Financial Reform On Hold

The report on China’s economy prepared by the IMF as part of its annual bilateral discussions with Beijing highlights the importance of advancing financial reform in the cause of rebalancing the economy.

Financial reform holds significant promise in contributing to the needed transformation of the Chinese economy. Over the horizon of the 12th Five-Year Plan, reforms should seek to secure a more modern framework for monetary management, improve supervision and regulation, deepen the channels for financial intermediation, transition to market-determined deposit and loan rates, and open the capital account. In all of this, a stronger renminbi will be an important complement.

Financial reform alone isn’t sufficient for rebalancing the economy in the IMF’s view. There will also need to be a stronger social safety net, higher household incomes and increases in the costs of various factors of production–i.e. an unwinding of price-distorting subsidies to things like energy. But the need for financial liberalization is pressing.

[The] potential combination—of rising inflationary pressures, already-high prices in the property market, and a weakening of direct monetary control—poses significant risks to financial and macroeconomic stability. In addition, the current system for financial intermediation continues to hold back rebalancing and the development of the service sector, generating industrial overcapacity that could present negative implications for long-run growth prospects.

China’s economy has become complex. Further financial liberalization will have to advance on a wide front: appreciating the currency, absorbing liquidity and strengthening monetary management, improving regulation and supervision, developing financial markets and products, particularly in fixed-income to help develop institutional investors, liberalizing interest rates and, once more market-based macroeconomic policymaking is in place, easing controls on capital flows.

The new five-year plan is broadly aligned with these needs. The question will be how far and how fast the reformers can push. Policymaking on this, and most other fronts, is now in stasis because of the leadership transition. There will always be economically delicate and politically difficult trade-offs between growth, inflation, financial stability and structural liberalization of the economy. Tackling inflation is the short-term political priority for economic policymakers, and absent a property or bank-credit crisis, there won’t be much political appetite for tackling financial reform until the factional jockeying for position within the Party’s new leadership calms down. That won’t happen for at least a couple of years, by which time the five-year plan will be deep into its second half, and the financial sector, we suspect, not look a lot different from what it is today.


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