China Is Accelerating Financial Reforms

In the past three decades, the focus in China was on economic reforms. Current changes – including accelerating RMB internationalization – reflect impending financial reforms.

China is already one of the world’s largest importers of iron ore and copper, and a force in the gold market. Nonetheless, the story of commodities reflects the kind of centrifugal pressures that China is currently coping with.

On the one hand, China is the world’s largest consumer of commodities. On the other hand, the mainland is largely on sidelines with regard to global commodity prices, which continue to be set in London, New York City, and Chicago.

In the future, this is likely to change as the renminbi (RMB) is expected to become a key commodities currency. Some analysts expect that to happen in “just 10-20 years.” But change could occur faster.

Due to its continued urbanization drive, coupled with high global demand for commodities, and rising inflation, China cannot stand on the sidelines when it comes to having a say in setting commodity prices.

True, the continued reliance on Western markets to set prices is based on trust in established legal systems and the security of pricing contracts in a freely convertible currency.

But even the U.S. dollar cannot rule indefinitely markets driven by China and other large emerging economies.

Fostering capital account convertibility

A few years ago, a number of nations – reportedly, China, Russia, Brazil, Japan and oil producers in the Middle East – agreed that oil should no longer be priced on U.S. dollar by 2018. It is only prudent to assume that significant pricing changes in one commodity are likely to parallel those in other kinds of commodities.

China may be moving faster to foster capital account convertibility, declaring that the RMB can be used more internationally while the latter remains partly inconvertible. Concurrently, Chinese regulators may reserve the right to reduce liberalization at times of turmoil. After the Asian financial crisis in 1997-1998 and the global crisis of 2008-2009, there is more understanding toward such policies worldwide.

In turn, higher foreign earnings from international capital market and asset management activities will further increase the power, profitability and status of Chinese banks. These banks are also expected to move into asset management, trade finance and project finance, which Western banks used to see as their exclusive playing field.

Stepping up RMB internationalization

As China is stepping up market and financial reforms, it hopes to make Shanghai a key global financial hub by the end of the decade.

In March, 2009, the State Council approved Shanghai’s plans to develop modern service and manufacturing sectors and to forge itself into one of the world’s leading financial and shipping centers by 2020.

Reportedly, China and Japan will launch direct yuan-yen trade in the Shanghai and Tokyo markets from Friday to facilitate trade and financial transactions between Asia’s two biggest economies

In the past three years, the internationalization of the RMB has accelerated, while Shanghai’s role as a global financial hub has increased significantly. Today, Hong Kong also ranks as the leading global financial center, according to World Economic Forum.

Recently, the first Hong Kong – London forum promoting the offshore RMB business pledged to cooperate in boosting the offshore business. The alignment of these two global financial hubs provides China a financial center in Europe, which will contribute to the RMB internationalization.

In London, a number of initiatives were announced or signaled. One plan is to “provide direct foreign exchange quotes of RMB against GBP, Euro, and other currencies.”

Years of currency friction between Washington and Beijing and the ongoing harsh election rhetoric in the United States may contribute to such plans. China is enhancing the international position of the RMB, while reducing China’s dependence on the U.S. dollar.

Some areas of financial reforms

Despite three decades of success in economic reforms and a decade of rapid achievements in financial reforms, China’s financial system has a long way to go.

True, China’s banking, brokerage, insurance, and asset management industries have enjoyed robust growth and sound profits for more than half a decade. In the process, equity, bond, and currency markets have expanded substantially.

Today, the 75% ceiling for loan-deposit ratio (LDR) continues to constrain commercial banks from growing their lending.

China’s nascent and fragmented bond market remains too small to fulfill the needs of corporate financing.

Commercial banks are coping with increasing capital adequacy pressure and must raise capital frequently. Securitization of loan portfolios could be one way to alleviate such pressures.

China’s financial markets remain relatively closed to most foreign investors and financial institutions. The gradual lowering of entry barriers could support a secure and gradual internationalization of Chinese financial markets, while boosting competition in the system.

In 2012, much of the financial reforms will occur vis-a-vis pilot programs, which herald acceleration in the equity markets in the coming years.

Recently, China’s stock exchanges in Shanghai and Shenzhen also moved to allow small firms to sell bonds via private placement, opening another fundraising avenue for the country’s cash-strapped small-business sector.

Moreover, China’s brokerages will be allowed to take on twice as much debt in relation to their net assets, and will be given easier access to the capital markets.

Expect financial deregulation, gradually

Instead of a rebound, the economic slowdown in China accelerated in April. The policy loosening measures introduced after October 2011 have not yet contained the downtrend. As a result, more policy support is needed to prevent a sharper downturn in the coming months.

As the inflation pressure continues to recede, China can initiate more forceful loosening measures. New reserve requirement ratio cuts are to be expected, along with other similar measures.

The government is also more likely to soften the tightening policies on infrastructure and property investment to prevent a sharper decline in investment growth.

It would be naïve to expect the impending policy shift to translate into a profit bonanza for American banks. Along with real estate, U.S. financial sector played a central role in the global financial crisis in 2008-2009. These highly concentrated, gigantic banks remain “too-big-to-fail.” Similarly, giant banks in Europe are highly exposed to high-risk regional debt.

It was the gradual approach that made Chinese economic reforms a success. It is that rare combination of ambition and caution that is now needed even more in financial reforms.

China is moving toward financial reforms, decisively – and gradually.

Slightly modified, longer version of “From Economic Reforms to Financial Reforms,” China-US Focus, May 25, 2012

4 Responses to "China Is Accelerating Financial Reforms"

  1. Beth Morton   June 3, 2012 at 7:17 pm

    "It is that rare combination of ambition and caution that is now needed even more in financial reforms."

    Totally agree, Dan. I'd say that it is the ONLY combination nowadays to defeat the actual pre-colapse worldwide financial situation. Thanks, twetted this great article.

  2. Lucky Wu   June 5, 2012 at 7:10 pm

    In many p,aces this writer mistakes form for substance. The most critical set of reforms is about the allocation of capital. At present reported regulatory ratios are a farce, beneath which there is massive unreported risk. This has gotten markedly worse during the past 5 years, so whenever the government makes pronouncements about what it wants to do, temper judgements on what the most likely outcome is given the high degree of systemic distortion. There is just too much cheerleading here.