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China's Road to Greater Financial Stability

Overview: China’s Road to Greater Financial Stability

Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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China’s economic ascendency is generating both positive financial sector developments as well as complex financial stability challenges. With rapid growth has come a substantial expansion of the financial services sector and a marked improvement in China’s ability to transform its savings into productive and growth-inducing investments. The interconnections between macroeconomic outcomes and the financial sector are deepening. And while the banking system is likely to continue to play a dominant role, conditions are falling into place for the rest of the financial sector to assume a larger share of the intermediation function. Even as these positive changes are unfolding, however, the steady maturation of China’s financial system is also bringing to the fore risks embedded in the structure of its financial industry, capital markets, and the limitations of ad hoc policy responses.

China has made it clear in several official statements that preserving financial stability is a major economic policy priority. There is a consensus that a consistent macroeconomic policy framework is intrinsic to the country’s financial stability. So even though the financial system may appear stable in prudential terms, China acknowledges that much more needs to be done to make the financial sector more viable by improving incentive structures, institutions, and allocation processes. The contingent risks from the financial system to the state exchequer also need to be contained. Although ongoing improvements in risk management, prudential regulation, and supervision remain critical, further deepening and maturation of the financial system will be influenced in large part by the process by which the macroeconomic policy framework evolves.

This book is about some of these financial stability challenges facing China. It seeks to improve understanding of the financial sector policy processes under way and the shifts in China’s financial stability priorities. The book has two central messages. The first is that the design, pace, and quality of implementation of financial reform and ensuing economic growth will heavily influence financial stability outcomes. The second is that continued and coordinated interagency efforts are needed to build a comprehensive macroprudential framework to measure and manage systemic risks. Reactive and piecemeal approaches to reform and to addressing gaps are risky because the different reform measures are interrelated. The experience of other countries suggests the need for an overarching approach to reform with a well-reasoned sequencing of actions. Furthering commercially oriented market reform may be the least-risky way to support the potential growth of China’s financial sector. Such an approach might also help influence the role of the state in the financial services sector in a way that creates an environment conducive to China’s pursuit of sustainable, balanced, and inclusive growth. At the same time, such an approach could better equip the government to handle China-specific sources of financial stability risk.

As noted in this volume, China is moving toward a more integrated macrofinancial approach to financial stability. It is looking to learn from the reform experiences of other countries and to adapt modern and internationally acceptable financial and prudential know-how to China’s particular circumstances. The country’s awareness of risk surveillance and financial stability monitoring at the technical level is growing impressively. The need for institutional changes in the regulatory setup is being given careful thought, and some reforms are being considered. China already has several prudential tools that may be used to address financial risks, including dynamic provisioning, variable capital requirements, reserve requirements, and rules related to loan-to-value and loan-to-deposit ratios. Further efforts are needed to assess the effectiveness and use of these tools and to refine policies in terms of how and when these buffers and requirements will be applied as China’s reforms progress. Among the key challenges in this regard will be the resources, capacity, and interagency collaboration necessary to monitor financial stability and integrate the findings in other policy areas.

The task ahead for China on the financial stability agenda is thus significant. A transition from a planned to a market-based financial system on a scale as vast as that of China has no precedent in the history of modern policymaking. Chinese financial firms face credit, market, operational, and liquidity risks, and economic cycles are inevitable, as evidenced by the 2008 global financial crisis. Moving along the reform path will pose additional risks and new challenges. Hence, priority must be given to establishing the institutional and operational preconditions that are crucial to successfully manage a wide-ranging financial reform agenda and the objectives outlined in China’s Twelfth Five-Year Plan. The official agencies, as well as the financial industry, need to build economic forecasting skills and the capacity to make timely judgments in response to changing economic conditions and to mitigate adverse spillovers.

From the macroadjustment viewpoint, implementing effective policy instruments to dampen sharp swings in the economy is very important. Given the structural features in China, industries with excess capacity and asset bubbles in the real estate sector are a constant vulnerability. Effective macroeconomic management and aggregate analysis could contribute to reducing sharp fluctuations in the economy, reducing the risk of nonperforming assets building up in the financial system, and, hence, preserving financial stability. Data collection should be enhanced to facilitate a better understanding of financial institutions’ balance sheets and their interconnections, and to develop a forward-looking early warning system to identify trends and activities that have the potential to threaten financial stability.

Against this backdrop, this volume brings together expert perspectives on what would contribute to financial stability in China. The book is set up in four parts: the financial policy context, the key macroeconomic factors affecting financial stability, the critical role of financial system oversight, and the future outlook for the financial system, with final comments from the governor of the People’s Bank of China.

Part I: Reforming the Financial System and Ensuring Financial Stability

The book starts by setting the policy context and overall intent of financial policy reforms in China. In Chapter 1 (“Reform and Development of China’s Financial Sector”), Shiyu Liu outlines China’s major financial reforms over the last decade and how they have been fundamental to maintaining the country’s financial stability. He summarizes the major changes that have occurred in China’s financial industry and emphasizes that the country’s financial institutions have been quick to adopt modern corporate governance practices. The chapter also discusses how financial markets today play an important role in helping China rebalance consumption and investment patterns as well as the policy thinking behind exchange rate and interest rate liberalization by way of developing a long-term mechanism to strengthen financial stability.

With the process of financial reform and liberalization ongoing, reform initiatives will need to be carefully crafted to the risks to financial stability. Country experiences have shown that although financial liberalization may spur growth and development, it also often entails risks if not properly designed and sequenced. A flexible strategy is required that anticipates the complications and disruptions that may arise and provides guidance on how best to arrange the policy measures without delaying necessary changes. In Chapter 2 (“Financial Reform: An Essential Ingredient in Transforming China’s Economic Development Model”), Nigel Chalk and Murtaza Syed discuss the rationale for reform and the risks of maintaining the status quo. Anchored against the lessons learned from international experiences, the chapter stresses that reform without the necessary preconditions in place can be extremely perilous for financial stability. Summarizing the benefits of financial reform, the authors outline a roadmap that could be considered in the next phase and suggest establishing a new framework for monetary policy, developing broader channels for intermediation, and dismantling repressive financial policies and practices.

Chapter 3 (“Strengthening the Financial Stability Framework in China”) by Keith Hall and Tao Sun discusses global trends in financial stability and the macroprudential policy framework, and how China’s institutional arrangements measure up. The authors investigate China’s endeavor to promote financial stability through three broad streams: surveillance, the early identification of potential threats to financial stability; mitigation, the measures that need to be taken to make the financial system more resilient to shocks; and crisis management, the principles and procedures for responding to distress or failures in the financial system. The chapter provides policy suggestions that include preparation of a data set that might provide the authorities with some early warning of systemic risks and the formalization of the shared responsibilities on financial stability matters among official agencies and industry associations. The chapter also discusses contingency plans for responding promptly to a crisis involving one or more systemically important financial institutions and striking the right balance between “open” and “closed” resolution outcomes.

Part II: Macroeconomic Factors Affecting Financial Stability

The second part of the book includes three chapters on macroeconomic factors affecting financial stability. In Chapter 4 (“China’s Sovereign Balance Sheet Risks and Implications for Financial Stability”), Yang Li and Xiaojing Zhang compile a first-time-ever sovereign balance sheet for China from 2000 to 2010 to analyze structural changes and institutional developments. They show that the short-term sovereign risk mainly arises from housing credit and local government debts, while medium-to long-run vulnerabilities are due to risks in the external balance sheet, corporate debt, and underfunded social security liabilities. They also simulate China’s debt dynamics and highlight the importance of maintaining higher GDP growth, and thus a positive gap between the GDP growth rate and interest rates. The authors argue that transforming the development model to sustain higher growth is the fundamental approach to managing risks to China’s sovereign balance sheet and preserving financial stability.

Chapter 5 (“Systemic Liquidity, Monetary Operations, and Financial Stability in China”) by Nuno Cassola and Nathan Porter sets out ways in which domestic liquidity and monetary policy operations intersect with financial stability in China. It highlights how central bank operations and facilities influence liquidity and financial prices and the role these factors play in mitigating a crisis. The chapter also discusses liquidity management in China and some of the key implications of financial liberalization. The authors argue that future financial stability would benefit from further reforming standing liquidity facilities, developing the ability over time to undertake daily open-market operations, and introducing reserve averaging. Further adaption of liquidity management objectives and active use of indirect liquidity management instruments should help ease the task of monetary management in China as the money multiplier becomes less stable. Moreover, the efficiency of financial prices should improve as the financial sector is further liberalized and market liquidity grows, ultimately strengthening the interest rate transmission channel.

China has made significant progress toward liberalizing capital flows and taking measured moves toward the international use of the renminbi. In Chapter 6 (“Capital Flows, International Use of the Renminbi, and Implications for Financial Stability”), Shaun K. Roache and Samar Maziad review recent progress in these areas and assess how this process may evolve in the future and the implications for domestic financial stability. The experiences of other countries demonstrate that the appropriate sequencing of reforms is critical for full international financial integration. Financial market deepening and a robust macroeconomic and regulatory framework provide the necessary preconditions for full capital account liberalization. Moreover, as interest rates are liberalized and quantitative restrictions lifted, there may be a need to absorb liquidity from the financial system, adjust relative prices, and place increased reliance on indirect monetary tools.

Part III: Strengthening Financial System Oversight

The theme of the five chapters that make up the third part of the book is financial system oversight. China has made impressive strides in the regulation and supervision of its financial system. There have also been marked improvements in risk management, backed by a regulatory system that demands high-quality capital and liquidity, often through simple and basic regulatory requirements. As further reform and broadening of the financial service sector takes place, however, complexity and risks will increase. Consistent implementation of global regulatory standards and improvements in supervisory effectiveness become the two essential components of financial sector reform and the management of financial stability. Inconsistencies or laxity in application run the risk of misaligning incentives and distorting expected reform outcomes. As liberalization progresses, China must balance calls for local concessions while creating a level and even-handed playing field for all. It will also have to manage gaps in the global regulatory framework that could impact financial stability in China, such as the absence of a global loss-sharing arrangement for troubled internationally active banks.

In Chapter 7 (“Structure of the Banking Sector and Implications for Financial Stability”), Silvia Iorgova and Yinqiu Lu analyze the structure of China’s banking system and its relevance for financial stability. They argue that it is vital to keep the structural factors in mind as reform unfolds in order to avert the potential undesirable accumulation of credit risks and internal macroeconomic imbalances. More broadly, policies should seek to reduce moral hazard and improve banks’ credit risk management and corporate governance. Moreover, to curb the incentive to excessively use the banking system for fiscal policy purposes—such as for funding local infrastructure projects—future reforms should reduce fiscal revenue-expenditure mismatches faced by local governments. The chapter makes the point that such reforms are a complex undertaking that go beyond the remit of financial sector policies.

In Chapter 8 (“Practical Experiences in Strengthening Banking Supervision and Regulation”), Huaqing Wang outlines the seven areas of supervisory policy that have been the focus of the China Banking Regulatory Commission in recent years. These policies are helping strengthen the financial condition of banks active in the securities markets and improving the level of disclosure and transparency. The chapter summarizes specific steps related to improving banks’ capital, liquidity, leverage, and risk management; implementing the Basel III regulatory framework; strengthening the supervision of systemically important financial institutions; addressing shadow banking; and managing cross-border financial risks.

As it continues to strengthen its supervisory system, China confronts a choice. Should it follow the mainstream supervisory model of allowing banks to independently determine their business models and lending strategies? Or should China continue to closely control and oversee the operations of banks, giving them relatively limited discretion in terms of the choice of business models? The financial infrastructure within China remains underdeveloped, with the need to improve credit risk management, including the management of nonperforming loans, and reduce loan concentrations. Intermediaries such as accounting firms, law firms, assessment agencies, rating agencies, and credit reporting agencies are still in the early stages of development. In Chapter 9 (“Seeking the Middle Ground for Supervision), Jonathan Fiechter and Aditya Narain take a look at the strengths of the current system and the challenges it needs to navigate. They recommend priorities to help China transition to a supervisory regime that can effectively oversee a commercially driven financial system that can meet the needs of a growing Chinese economy and the varied needs of Chinese savers and borrowers. There is an urgent need for forward resource planning and for a government-backed strategy to upgrade the skills of supervisors by making financial supervision a sought-after career stream. The authors recommend that China aim to meet the mainstream model halfway by retaining some of the elements of its current regime, including the focus on simplicity and conservatism, while at the same time embracing the lessons that came out of the 2008 financial crisis regarding the risks of not holding bank management accountable, including the importance of making bank management more accountable for building their own risk management systems.

In Chapter 10 (“Strengthening Macroprudential Management”), Changneng Xuan discusses the recent development of macroprudential regulatory policies and measures taken by the central bank. He examines in detail the approaches China is considering in terms of enhancing monitoring and the management of systemic risks. He also discusses the institutional setup and stresses the need for accountability and coordination. The chapter touches on the challenges to implementing macroprudential policy in China given that systemic risk is multidimensional and often difficult to identify and measure owing to data gaps and structural complexities. Xuan highlights that effective macroprudential policymaking depends on its effective coordination with other public policies and on filling information gaps. In addition, the growing importance of cross-border systemic risks and regulatory arbitrage underscores the critical importance of effective domestic and international coordination.

An effective financial market infrastructure is a necessary though insufficient (as the recent global financial crisis demonstrated) condition for a safe transition to a more market-based financial system. As Chinese banks and financial firms broadly become more commercially oriented, financial market deepening could help avoid some of the risks of disorderly disintermediation in times of stress and macroeconomic uncertainty. China’s capital markets have experienced rapid development in the last two decades. Shuqing Guo in Chapter 11 (“Capital Markets and Financial Stability”) examines China’s capital markets and the implication for financial stability. Specifically, the chapter summarizes the development of China’s capital markets as well as current issues and recent reforms. Guo then explains the low level of systemic risk in China’s capital markets and why now is an opportune time to push forward bolder securities market reforms. The author argues that developed capital markets in China would help promote financial stability through multiple channels, including risk distribution, availability of hedging instruments, direct small and medium-sized enterprise financing, lower risk concentrations in trust companies, and avoidance of a real estate bubble, by broadening the investment channels.

Part IV: Outlook for the Future

The global financial crisis has heightened risks to financial stability in China. Adversely affected by the crisis, the country had to implement policy and support measures to maintain banking and market activities. The crisis forced policymakers and agencies involved with financial stability to reexamine their goals, parameter assumptions, and risk thresholds related to financial stability. Against this challenging backdrop, the final part of the book focuses on the future outlook for financial stability in China.

In Chapter 12 (“China’s Road to Sustainable Growth and Financial Stability: A Systemic Perspective”), Andrew Sheng and Geng Xiao explore from a systemic perspective a feasible path for China to achieve sustainable growth alongside financial stability. As it assumes a larger global role in areas such as social, ecological, and global stability, China needs to adopt key reforms to enable the financial sector to develop on a stable footing. The authors argue that to maintain system stability, China must not only strengthen institutional infrastructure and the span of policy tools but also rebalance credit access to the private sector and increase competition. Improving social inclusion would require removing financial repression and paying labor a fair share of total factor income, while exercising discipline on the efficiency of investment.

Joseph Yam then discusses how to strike a balance between attaining market freedom in finance and addressing market failure. In Chapter 13 (“Delivering Financial Stability in China”), he argues that it is necessary for China to place greater emphasis on arrangements that allow the potency of financial markets to be harnessed in the public interest. Delivering stability, integrity, diversity, and efficiency in financial intermediation is important to promote economic growth and development. The chapter concludes that maintaining financial stability is not an academic issue. While difficult to achieve, financial stability is easier to maintain in a culture where the basic function of the financial system is viewed as supporting the economy and not as “a playground for money making.” Yam calls for a “cultural revolution” in the world of finance so that stable conditions can be maintained at a low social cost.

In Chapter 14 (“The Impact of Financial Liberalization on China’s Financial Sector”), Jun Ma and Hui Miao discuss the implications of the financial liberalization program on China’s financial sector. Assuming that these reforms will be largely completed within the coming three to five years, the authors’ impact analysis shows that nonbank financing will gain market share from banks, and banks’ net interest margins will contract and be replaced by fee income. Global expansion by Chinese financial firms will be a double-edged sword. While brokerage and asset management sectors will benefit, and the insurance sector will likely see improved return on investment, this may be offset by a rise in domestic deposit rates and the rebalancing of global business opportunities, with further liberalization of the financial sector.

Victor Shih, in Chapter 15 (“This Time Is Different: The Domestic Financial Impact of Global Rebalancing”), compares the 1998–2002 financial reform with the current situation. During the period reviewed, Shih argues that the Chinese authorities successfully brought the country through a difficult period with sweeping financial reform. Today, however, China is facing financial and macroeconomic stress and has fewer policy options and a narrower financial space to buffer a significant worsening of the financial sector balance sheet. Shih argues that going forward the central bank will need to be much more aggressive in releasing sufficient liquidity into the economy to address any imminent risks, especially if significant financial reforms are carried out at the same time.

The future of the international monetary system has seen heated debate since 2007. Drawing on extensive data and international experiences, Eswar Prasad and Lei Ye in Chapter 16 (“The Renminbi’s Prospects as a Global Reserve Currency”) review recent steps toward the international use of the renminbi and evaluate its prospects as a global reserve currency. The chapter argues that China’s low level of financial market development remains a major constraint to the likelihood of the renminbi attaining reserve currency status. Moreover, in the absence of an open capital account and free convertibility of the currency, it is unlikely that the renminbi will become a prominent reserve currency. However, on the basis of the anticipated pace of reforms, the authors believe that the renminbi will become a competitive reserve currency over the next decade and in some measure become a substitute for the U.S. dollar, although the dollar will retain its dominance.


We hope that this collection of papers will help improve understanding of the various paradoxes China confronts as it pursues financial sector reform. It is intended to provide some new perspectives while reaffirming the validity of many of the ideas already echoed by Chinese policymakers, academics, and capital market participants. The overall objective is to complement existing work while emphasizing the need for China to place a sharper focus on financial stability issues. To the extent that the book is informative regarding the source and potential impact of risks to macrofinancial stability in China, we view it as a small contribution to a large and evolving policy topic. The global financial crisis has clearly demonstrated the important domestic and cross-border spillovers that stem from disruptions in domestic financial systems that are interconnected. Proper institutional arrangements, a risk-based system of monitoring financial markets, and appropriate prudential tools (both micro and macro) are a must if China is to maintain financial stability as it moves forward to liberalize and open up its financial markets and continues to make the needed macroeconomic adjustments.

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