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China's Road to Greater Financial Stability

Chapter 2. Financial Reform: An Essential Ingredient in Transforming China’s Economic Development Model

Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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Managed well, financial reform in China will generate significant benefits to the Chinese economy in terms of growth, employment, and improved standards of living that will help sustain the country’s spectacular growth performance and accelerate the ongoing rebalancing of its growth model. Done right, it could be as significant as the state-owned enterprise reform of the 1990s. Conversely, a prolonged delay in financial liberalization, or implementing it in a poorly designed or badly executed manner, would pose substantial risks for China. It would also have important negative spillovers for an already-fragile global economy. This chapter discusses the rationale for reform and outlines a roadmap that could be implemented over the next five years.

The Status QUO: China’s Financial System

Two words immediately come to mind when defining China’s financial system as it stands today: liquidity and control. The system is flush with liquidity, both because of a high stock of savings that is held domestically by China’s closed capital account (Figure 2.1) and large inflows associated with the country’s balance of payment surpluses (and the corresponding foreign currency intervention necessary to resist appreciation of the exchange rate). To prevent this liquidity from fueling dangerous lending booms and asset bubbles, the People’s Bank of China (PBC) relies on control—predominantly direct tools such as quantitative limits on bank credit and regulations of deposit and loan rates, and indirect tools such as relatively high reserve requirements (Figure 2.2). These have proven effective in recent years, given the historically bank-based nature of China’s financial system, in conducting macroeconomic management. A by-product of these policies has been to keep both loan and deposit rates artificially low, create incentives for banks to allocate much of their lending to very large, capital-intensive enterprises, and lower costs of sterilizing China’s foreign currency intervention.

Figure 2.1Saving Decomposition

(In percent of GDP)

Source: CEIC.

Figure 2.2Sterilization by the People’s Bank of China

(Change in percent of net foreign assets change over 12 months)

Source: CEIC.

Note: Reserve repo maturity excluded before January 2012.

Why Should We Care About Financial Reform in China?

First and foremost, as China is the world’s second-largest economy, it is in everyone’s interest for it to have a safe, stable, well-regulated, and efficient system of financial intermediation. Over the past three years we have learned all too well of the enormous global social costs that financial instability in systemic economies can create.

Second, sustaining China’s spectacular growth record will be impossible without a modern financial system that efficiently intermediates savings and allocates capital. Indeed, financial reform will be necessary to achieve many of the key themes identified in China’s Twelfth Five-Year Plan, including (1) boosting household income by increasing the returns to savings; (2) increasing consumption through prudently managed household credit as well as instruments that smooth consumption and hedge risk (Figure 2.3); (3) reducing income disparities through better access to financial services, including in rural areas; (4) increasing employment through a more appropriate pricing of capital and by moving toward a more labor-intensive means of production (Figure 2.4); and (5) supporting the development of new industries by reallocating resources on market terms and making more financing available to small and medium-sized enterprises and start-ups, including in the services sector.

Figure 2.3Household Consumption

(In percent)

Source: CEIC.

Figure 2.4Average Employment Growth, 2004–10

(In percent)

Source: CEIC.

And third, China is, in any case, outgrowing the current system of direct government influence over the allocation and pricing of credit. This managed approach certainly allowed for strong growth following the start of China’s reform efforts, in part because sectors with high-growth potential were easier to identify. However, the system was not perfect and, as a side effect, this approach generated significant downsides in the form of overcapacity, capital-intensive means of production, a tendency for asset bubbles, and a periodic need for publicfunded bank recapitalizations. With the Chinese economy growing in size and complexity, the ability to steer credit directly is diminishing and the costs from misallocating resources is growing (Figure 2.5).

Figure 2.5Imputed “Subsidy” to Capital

(In percent of marginal product of capital)

Source: IMF (2011).

1Includes Indonesia, Korea, Singapore, and Taiwan Province of China.

2Includes the euro area, Japan, United Kingdom, and United States.

What are the Risks of Continuing with the Current System?

China has long been characterized by a very deep financial system, but one that has relied predominantly on banks to intermediate enormous levels of household and corporate saving. However, this bank-dominated structure is now changing. Since the global financial crisis, China has seen acceleration in the pace of financial innovation, an expansion of new ways to intermediate savings, and a migration of resources out of banks and into other forms of financial intermediation such as trusts, wealth management products, and corporate bonds (Figure 2.6).

Figure 2.6Social Financing

(In trillions of renminbi)

Source: CEIC.

The diversification and development of financial markets and instruments is generally healthy. It will facilitate more efficient means of allocating China’s capital, open up financing opportunities for companies that previously were unable to get bank loans, and increase the level of remuneration that households receive on their savings.

However, these changes also pose risks to financial and macroeconomic stability. First, regulation of the nonbank system of intermediation is weaker and less developed than that for banks. Second, care is needed to ensure the banks are healthy enough to withstand a steady loss of resources that a growing nonbank system could imply. In this regard, we are already seeing evidence of growing liquidity pressures for smaller banks in China. Third, the underlying system of macroeconomic control needs to evolve with the times. In particular, the current regulation of interest rates distorts the pricing of both deposits and loans and creates huge incentives for resources to migrate out of the banks to institutions that are not subject to such controls on the rates of return they offer. Why put your money in a bank deposit that earns less than inflation when you can choose from a convenient array of more lucrative wealth management products instead? Further, international experience tells us that the use of administrative limits on the quantity of bank lending as a means to exercise macroeconomic control is likely to become less and less effective as financial innovation takes hold and more and more intermediation takes place outside of the banks.

Financial reform is, therefore, essential to sustain the ability of Chinese policymakers to effectively guide the macroeconomy, ensure that the expansion of nonbank channels proceeds in a safe and sound way, and prevent the banking system from being undermined by a loss of deposits and funding.

What Lessons can be Gleaned from International Experience?

A number of China’s G20 peers have reformed their financial sectors, and their experiences provide important lessons. As in China, their pre-reform financial sector landscapes were often characterized by a heavy bias toward bank intermediation, rigid segmentation across financial institutions by function, low levels of competition, regulated interest rates, a large public sector role (including directed lending and state guarantees of financial institutions), the conducting of monetary policy mainly through direct instruments, and capital controls. In addition, countries embarking on financial liberalization have encountered several challenges, and their reform efforts have often led to periods of financial volatility and crisis. Boxes 2.1 to 2.4 outline some of the major steps and mistakes made by some of the other G20 economies as they moved toward a more modern and market-based financial system. From international experience, a few broad lessons that stand out are detailed below.

Lesson 1: Financial sector weaknesses should be sought out and addressed before liberalization begins. This includes examining the ability to adequately price and manage risks, recapitalizing or restructuring systemic institutions, and enhancing corporate governance. If unaddressed, weaknesses create the potential for financial institutions to take growing risks to boost returns and cover up their underlying vulnerabilities. These vulnerabilities will then grow as financial reform proceeds, potentially revealing weaknesses within systemic institutions.

Box 2.1Financial Reform in Indonesia, 1982–96

Initial Conditions

Indonesia’s financial sector reforms were part of a broad effort to diversify the economy and expand the role of the private sector. The economy had demonstrated robust, albeit resource-driven growth, had an open current account, and pursued a managed float. The financial sector was dominated by five large state-owned banks, government-directed lending was prevalent, interest rates were regulated (and typically negative in real terms), and the growth in bank credit was subject to administrative ceilings. On the capital account, outflows had been mostly liberalized but inflows were subject to strict controls.


Reforms proceeded in two broad steps:

  • Phase I (1982–86): Indirect monetary policy instruments were introduced, interest rates were liberalized, and credit ceilings were phased out.
  • Phase II (1987–92): Restrictions on the activities of banks were loosened, directed lending was reduced, and there was greater latitude on the operations of foreign banks. Reserve requirements were equalized across the banking industry, removing a source of preferential treatment for the state banks. Prudential regulation and supervision was enhanced. Capital account liberalization began in 1989, with controls on portfolio and bank capital inflows steadily eased.


During the early stages of reform, real interest rates moved higher to market clearing levels and the more efficient private banks began to build market share. Macroeconomic policies were kept restrictive, particularly with fiscal policy steadily tightening. Vulnerabilities began to build up in the second phase of reforms from 1987–92, but these risks were left largely undiagnosed. In large part, the risks were due to weak corporate governance, inadequate regulation and supervision, and a macroeconomic policy mix that encouraged large speculative capital inflows. Despite increasing competition, bank ownership remained highly concentrated, and large private banks, which were subsidiaries of politically powerful business conglomerates, were able to use their influence to circumvent regulatory limits related to connected lending. Large parts of the financial sector (and its largest corporate borrowers) were perceived to be covered by implicit public guarantees, a perception that had been strengthened by a succession of opaque bailouts. There was an absence of a clear framework to resolve failing institutions, and banks had few incentives to manage downside risks. Overcapacity in the financial sector grew over a number of years, spurring excessive lending to relatively unproductive sectors, including real estate.

The Path to Crisis

As the capital account became more open, domestic imbalances in the financial system combined with a tightly managed exchange rate gave rise to a surge in speculative capital inflows. Domestic banks borrowed heavily offshore in foreign currency to fund rapid growth in local currency loans. Regulatory efforts to dissuade such carry trades were largely too little and too late. As the Asian financial crisis unfolded in 1997, the weaknesses were exposed in the Indonesian financial sector—including currency and maturity mismatches—putting strains on corporate and bank balance sheets and, eventually, ending in a full-blown systemic banking crisis.

Lesson 2: The macroeconomic policy framework should move toward market-based monetary policy at an early stage, based on indirect instruments and with increased exchange rate flexibility. Before financial reform proceeds, the monetary authority needs to have at its disposal sufficient tools for macroeconomic control to prevent an unintended surge in lending or creating the conditions for large capital inflows.

Lesson 3: Implicit public guarantees of financial institutions should be explicitly withdrawn during the early stages of liberalization. Instead, such blanket backing should be replaced with an explicit scheme for deposit insurance. Ensuring that banks face hard budget constraints would be an important prerequisite for a more commercially oriented banking system that adequately prices risk and efficiently allocates credit. It also helps mitigate moral hazard risks and prevents banks from taking undue risks as restrictions on bank activities are eased and new markets opened.

Lesson 4: The financial, legal, and accounting framework should be revised before embarking on major reforms. The major prerequisites for an effective regulatory and supervisory framework include (1) clear objectives and mandates for the agencies; (2) regulatory independence, with appropriate accountability; (3) adequate resources (staff and funding); and (4) effective enforcement and resolution powers.

Lesson 5: The regulatory and supervisory perimeter needs to be sufficiently wide and well coordinated to prevent regulatory arbitrage and to identify emerging vulnerabilities. Virtually all post-liberalization crises can be traced to inadequate supervision or regulations not keeping up with changing financial landscapes. All potentially systemically important financial institutions, including nonbank financial institutions, need to be covered before restrictions on financial activities are significantly relaxed and new markets developed. The regulatory and supervisory framework should be empowered to limit concentration in bank ownership and clearly identify beneficial owners (to mitigate the risks of connected lending). Activities in nonbank financial institutions in particular should be monitored closely. These institutions should be prohibited from taking deposits.

Lesson 6: Measures to deepen financial and capital markets should move in parallel with reform of the banking system. Financial market development is important to improve the allocation of capital and create competition. However, lopsided sequencing can have significant effects on bank balance sheets by undermining their deposit base or by eroding their pool of corporate clients. This, in turn, can lead banks to increase risk exposures.

Lesson 7: Many of the important objectives of financial sector reform—including greater competition and efficiency, and enhanced risk management—depend on having market-determined deposit and loan rates. Interest rate liberalization facilitates the development of a market-based monetary policy framework based on indirect instruments with an effective transmission mechanism. This provides increased scope for macroeconomic control to mitigate the risks of instability as reforms proceed. Other goals, such as enhanced competition, allocational efficiency, and stronger risk management, all rely on allowing prices (interest rates) to provide the right market-based signals.

Box 2.2Financial Reform in Japan, 1975–90

Initial Conditions

The pre-reform financial sector landscape in Japan was dominated by banks with limited options for savers, low regulated interest rates, and strict limits on bond issuance. The financial sector was also characterized by rigid segmentation of financial institutions by function. Discretionary administrative guidance was the principal method of financial regulation, with “convoy regulation” aimed at ensuring financial institutions evolved at the same pace, implicitly inhibiting competition. As financial liberalization began, Japan did, however, have a largely open capital account.


The following key features characterized Japanese financial sector liberalization:

  • The capital account was liberalized early in the process. In the 1980 Foreign Exchange Control Act, corporate borrowers were given greatly expanded opportunities to raise funds overseas.
  • Liberalization was asymmetric. Corporate borrowers were provided access to a broader range of funding alternatives before savers were given choices in investment instruments. A number of new markets grew, including a commercial paper and corporate bond market, but retail investors were given only limited access.
  • Deposit rate liberalization proceeded slowly and at a slower pace than lending rates. Indeed, it took until 1994 before deposit rates were fully market determined.


The lopsided pace of liberalization caused the banks to quickly lose many of their best borrowers, while savers had few choices but to remain in bank deposits. As a result, many large and medium-sized enterprises reduced their dependence on bank financing and increased their funding from bond and equity markets, where nonbank financial institutions were large investors. From 1980–90, the ratio of bank debt to total assets for large, publicly listed manufacturing firms dropped by almost 20 percentage points (to less than 15 percent). On the other hand, household deposits continued to rise as barriers to entry into the investment trust business remained high and banks were not permitted to market investment management services. The loss of corporate clients and banks’ efforts to continue to build market share led them to expand their exposure to the property market and to smaller firms. Lending decisions became heavily influenced by collateral values (rather than a notion of capacity to repay), credit standards weakened, and from 1980–90, loans to the real estate industry doubled. Much of the remainder of the banks’ loan book was devoted to small firms, with correspondingly higher credit risks.

The Path to Crisis

In the early 1990s, Japan’s real estate bubble burst and the resulting decline in property prices, equity prices, and economic growth exposed the underlying vulnerabilities on bank balance sheets. The deceleration of economic growth impaired the capacity of small businesses to repay, nonperforming real estate loans skyrocketed as collateral values plummeted, and the fall in equity prices shrunk bank capital. The banking system became mired in a collapse from which it has yet to fully recover.

Lesson 8: Successful liberalization of interest rates needs several preconditions. These preconditions include a stable macroeconomic environment, absorption of excess liquidity, an interest rate structure that is not in serious disequilibrium prior to liberalization, an active and well-functioning money market, and a sound payments system. Strong supervisory policies and instruments and a flexible and effective monetary policy framework are also required. In particular, monetary policy needs to guard against an excess supply of credit as interest rate constraints are removed (Figure 2.7). In successful cases of liberalization (e.g., Australia, Canada, and Belgium), credit expansion was mitigated by a deliberate containment of liquidity and increases in real interest rates (Figure 2.8). Conversely, other countries (e.g., Argentina, Chile, and Mexico) lost control of monetary aggregates as they liberalized, injecting enormous amounts of credit and monetary stimulus into their economies that culminated in asset bubbles and banking crises.

Figure 2.7Private Credit

(Percent of GDP)

Source: CEIC.

Note: T = time of interest rate liberalization, normalized to equal 100.

Figure 2.8Real Interest Rates

(In percent; three-year average post-interest-rate liberalization)

Source: CEIC.

Lesson 9: Opening to international portfolio flows should occur only after the bulk of financial sector reform has been achieved. The current scale of global capital flows and the increasing sophistication and interconnectedness of the world’s financial markets create large risks for countries that open themselves up to international capital flows before the distortions and misalignments in their domestic financial systems are resolved. The early stages of capital account liberalization can open up to stable long-term sources of financing, such as direct investment inflows. However, full liberalization—including that for short-term portfolio flows—should be put in place only after the bulk of financial sector reform is in place.

What are the Benefits of Financial Liberalization and Reform?

So far, we have outlined the downsides of allowing reform efforts to languish and the risks of incorrect implementation of the reform agenda, with cautionary tales from four important cases outlined in Boxes 2.1 to 2.4. But what are the benefits for China to liberalize its financial system?

First, a well-executed financial reform program will allow the Chinese economy to steadily adapt to the ongoing evolution in financial intermediation and to maximize the benefits from an increasingly diverse set of financial markets and instruments. Developing credible competition for the banks—in the form of corporate bond markets, deeper and more liquid equity markets, mutual funds, exchange-traded funds, derivatives, and other financial products—will create incentives for the whole financial system to operate in a more effective and productive manner. Capital will be allocated more efficiently, and companies (particularly smaller enterprises) that at present are mostly denied access to bank loans will have new options to finance their operations (Geng and N’Diaye, 2012; Feyzioglu, 2009).

Box 2.3Financial Reform in Korea, 1980–96

Initial Conditions

The Korean financial sector was largely state owned, highly regulated, and used as an allocation tool by the government to advance its economic development agenda. Monetary policy was conducted using interest rate and credit ceilings as well as reserve requirements. The government guided resources to its preferred sectors by a combination of directed credit and preferential lending rates. The capital account was largely closed.


  • Early reforms included bank privatization and measures to increase financial competition, although the banking sector emerged from the privatization process with ownership concentrated among large industrial conglomerates. Nonbank institutions developed, albeit increasingly owned and controlled by these industry groups.
  • Progress was also made in developing money and interbank markets, an important precursor for a move to a more indirect monetary policy, and the government somewhat scaled back its efforts to direct credit.
  • Interest rates remained tightly regulated until 1993, in part to protect certain sectors.
  • Regulatory standards for loan classification, provisioning, accounting, and large exposures saw little improvement, while supervision remained fragmented.
  • Restrictions on capital inflows began to be weakened in 1989, largely by allowing financial institutions to borrow offshore.


In 1994, the ceiling on foreign currency lending by domestic banks was eliminated, but limits on banks’ medium-and long-term borrowing from international markets were retained. As a result, Korean banks began to finance their domestic long-term foreign currency lending with short-term foreign currency loans. At the same time, there were large gaps in the prudential regulations relating to foreign exchange exposures in overseas branches and offshore funds, which accounted for a significant build-up in short-term external liabilities.

The Path to Crisis

From 1994–97, banks rapidly built up huge maturity mismatches on their balance sheets and the financial sector became exposed to economically nonviable projects through a complex network of cross-holdings within industrial groups and connected lending. By 1997, banks and nonbank institutions found it increasingly difficult to roll over their external short-term funding, leading to an exhaustion of official reserves and an all-out balance of payments crisis.

Second, well-designed reform, accompanied by a robust regulatory infrastructure that spans all forms of financial intermediation and guarantees seamless coordination across regulators, will help ensure that the financial system continues to develop in a robust way without excessive risktaking, lowering the possibility of future financial volatility and disruption.

Third, making a broader range of alternative investment instruments available to households will increase the return on their savings (Nabar, 2011), allow households and corporate savers to hold a more diversified portfolio of assets, and reduce the tensions that are currently evident from having housing viewed as a preferred store of value (Figure 2.9).

Figure 2.9Distribution of the Returns to Bank-Intermediated Capital

(Real returns in percent)

Source: CEIC.

And finally, financial reform will facilitate China’s move toward a more modern means of macroeconomic control, one that deploys market-clearing prices to determine the availability and cost of credit rather than having both the price and quantity of loans regulated by the government (Figure 2.10). This will strengthen the monetary transmission mechanism and give the central bank greater ability to fine-tune policy in response to changing economic conditions (Feyzioglu, Porter, and Takats, 2009).

Figure 2.10Real Cost of Capital, 2005–09

(In percent)

Source: CEIC.

Note: Vertical line is the global average.

These benefits are well known to China’s policymakers and were highlighted in the Twelfth Five-Year Plan, which included a clear commitment to moving ahead with the reform of the country’s financial system.

What are the Main Elements of the Needed Reforms?

There is certainly no “one-size-fits-all” approach to sequencing financial sector liberalization, especially in an economy as sophisticated and complex as China’s. In many cases, the appropriate pace and sequencing of reforms will involve balancing multiple trade-offs. Dynamic judgment will be required as the financial system evolves in potentially unpredictable ways and as reforms are implemented. As the situation for many comparator countries demonstrates, the agenda for financial reform is a complex, multiyear undertaking. However, starting now will ensure this process can be largely completed within the horizon of the Twelfth Five-Year Plan. A broad roadmap for reform should include adopting a new monetary policy framework; raising real interest rates; strengthening and expanding regulatory coverage of the financial system, including putting in place a broad set of tools for crisis management; developing financial markets and alternative means of intermediation; deregulating interest rates; and, eventually, opening up the capital account.

Box 2.4Financial Reform in Mexico, 1988–93

Initial Conditions

To combat high inflation and low growth, Mexico undertook a broad set of reforms in the late 1980s to increase the role of markets in various aspects of the economy. The banking system was largely publicly held and segmented across sectors, interest rates were regulated, and supervision was generally weak.


Mexico pursued a rapid pace of financial reform alongside a broad effort at macroeconomic stabilization and capital account liberalization that included the following:

  • A big-bang program of sweeping reforms introduced in 1989–90, including eliminating interest rate controls; replacing very high reserve requirements with liquidity ratios; removing restrictions on private sector lending; ending mandatory lending to the public sector; and removing sector segmentation (which allowed for the emergence of universal banks).
  • Privatization of 18 domestic banks from 1991–92. Before the banks were sold, the government provided unlimited state-backed deposit insurance.


Bank balance sheets grew rapidly both before and after privatization, as banks tried to capture market share in a newly liberalized market. In response, the authorities began to tighten prudential regulations between 1991–93 by increasing minimum capital adequacy ratios (from 6 to 8 percent); strengthening loan classification and provisioning rules; and imposing stricter limits on foreign exchange positions. However, the new regulatory and supervisory framework was seriously deficient and concealed a range of increasing vulnerabilities, not least weaknesses in the Mexican accounting system. Banks were required to classify as nonperforming only that portion of the loan (or the interest payment) which was due but had not yet been repaid. Banks were also permitted to exercise significant discretion in the risk classification of their loans, which allowed them to inflate capital ratios. In addition, there was no consolidated accounting for universal banks, making it hard to judge risks at a group level. Domestic banks were able to circumvent prudential regulations designed to prevent currency mismatches, while large interest rate differentials and the exchange rate peg provided strong incentives for carry trades.

The Path to Crisis

In the wake of liberalization, the newly privatized Mexican financial institutions began to increasingly fund their operations through over-the-counter structured notes that were linked to exchange rate developments. Accounting rules allowed the banks to book these positions as claims that were not counted toward their net open foreign exchange position. The increasing bank exposures triggered a balance of payments and financial crisis in 1994, which was amplified by the balance sheet weaknesses that were hidden within the system.

A New Framework for Monetary Policy

Financial reform should involve a reinvention of the monetary policy framework in order to move away from the current system—which is reliant on controls on deposit and loan rates, the exchange rate, and the quantity of credit—to one in which the central bank has clear objectives in terms of growth, inflation, and financial stability. In addition, the PBC should be given flexibility and control over the macroprudential and monetary tools that will be needed to achieve these goals.

As a first step, the high levels of liquidity currently residing in the financial system would need to be absorbed. Judging this liquidity absorption, however, will be complicated by the lack of reliable price signals and the fact that the “true” level of liquidity in the system is masked by the lack of fully market-determined interest rates, direct controls on credit, and administrative determination of both the price and quantity of paper issued by the central bank. Nevertheless, as a first step, open-market operations should be deployed to absorb the liquidity overhang by placing central bank paper at market-determined rates, allowing interbank rates to rise closer to the top of the regulated loan-deposit rate corridor, and moving the structure of deposit and loan rates up closer to the neutral real interest rate.

At the same time, the ongoing liquidity injection that is created by large-scale foreign currency intervention will need to be decreased by appreciating the exchange rate to a point where the currency market is more balanced and there are genuine two-way flows in the balance of payments and two-way movements in the exchange rate (Figure 2.11). This would lessen the need for monetary tools—including the use of reserve requirements and open-market operations—to be geared so much toward sterilizing foreign currency inflows and managing the currency. Instead, policies could be refocused toward a more market-based and countercyclical approach geared toward the domestic economy.

Figure 2.11Exchange Rate and Foreign Reserves

Source: CEIC.

With liquidity absorbed and interest rates clearing the capital market, the central bank could then shift toward the use of more indirect monetary instruments to exercise macroeconomic control. The central bank would be able to move to using short-term rates—perhaps the seven-day repo rate—as its effective operational target for monetary policy and phase out direct influence on the growth, allocation, and pricing of credit. The PBC would be able to effectively influence short-term rates through open-market operations and to conduct those operations with quantities determined by achieving market clearing at a given target level for the policy interest rate. Reserve averaging could be introduced to decrease interest rate volatility, and reserve requirements could be remunerated at a market-determined rate (Figure 2.12).

Figure 2.12Short-Term Interest Rates

(In percent)

Source: CEIC.

Note: PBC = the People’s Bank of China.

As financial innovation and development makes money demand unstable, targeting M2 would no longer be a feasible proposition and a new framework for the conduct of monetary policy would be needed. In particular, the PBC could move toward a monetary policy regime directed toward growth, inflation control, and financial stability, and achieved through a combination of interest rates and macroprudential tools.

Improving Regulation and Supervision

As the system evolves, the government will need to be nimble in adapting to the changing environment by increasing the commercial orientation of the banking system, bolstering its crisis management capabilities, and strengthening supervisory efforts to identify and manage macrofinancial vulnerabilities.

Further advances in the regulatory and supervisory regime will be needed to ensure it is sufficiently adaptable and dynamic to react in a new environment of tighter liquidity, indirect monetary control and, eventually, liberalized interest rates. In a more liberalized environment, strict supervision will be needed to prevent banks and nonbank institutions from engaging in unsafe practices to boost profitability or gain market share. Particular attention will be needed to address the supervisory and regulatory gaps that will inevitably emerge in a more dynamic and liberalized setting. To this end, investments should be made to improve stress-testing capabilities; increase oversight of the largest financial institutions; overhaul the crisis management and resolution framework; build a process for the orderly exit of weak or failing financial institutions; develop clear rules on central bank emergency liquidity support; put in place a formal deposit insurance scheme; and pursue better data quality and collection. Interagency regulatory and supervisory coordination will also need to become more ongoing and systematic, identifying and resolving regulatory gaps. A key step will be to establish a permanent, high-level interagency Financial Stability Committee to monitor and identify macrofinancial vulnerabilities and implement a macroprudential framework geared toward preventing the buildup of systemic risks (see Chapter 3 for a more detailed discussion).

Developing Broader Channels for Intermediation

Strengthening nonbank financial intermediation will be an important objective of financial reform. Such institutions will act as competition to the banking system, offer companies alternate avenues for project financing, and provide households with a broader range of financing and investment possibilities. Expansion of nonbank areas of intermediation will, however, need to largely move in tandem with reform of bank-based intermediation. Failure to do so could create incentives for faster migration of resources out of the banks (into bonds, equities, trusts, leasing, and wealth management products), with accompanying supervisory and regulatory challenges and the potential for destabilizing the banking system.

The focus should be on dismantling impediments to the development of alternate markets and instruments, but with corresponding clarity about regulations and responsibilities of those new institutions. Priorities include reducing segmentation, increasing liquidity, and simplifying regulatory requirements in equity and bond markets. In addition, efforts should be made to encourage a broad institutional investor base, including pension, insurance, and mutual fund companies.

In conjunction with developing a wider range of investment products, enhanced regulation and supervision would help ensure that risks to financial stability are well managed. In addition, a comprehensive framework for disclosure and consumer protection will be needed to ensure investors are fully aware of the risks they undertake when diversifying their assets away from bank deposits. For prudential reasons, precedence should be given to gaining experience with plain-vanilla instruments before allowing more sophisticated ones such as securitized and trust products.

Liberalizing Loan and Deposit Rates

With a robust monetary framework in place, and with interest rates rising to clear the capital market, the next step will be to move away from the regulation of loan and deposit rates by the central bank. The preferred strategy would be to gradually lift the ceiling on deposit rates and allow such rates to be determined by banks on a competitive basis. This would facilitate an increase in the cost of funding and move toward a corresponding increase in the loan rates. The lifting of the ceiling could be phased in based on the term of the deposits in order to allow banks time to adjust. As the deposit rate ceiling is raised, the floor on loan rates will become increasingly less binding and could eventually be removed (Figure 2.13).

Figure 2.13Inflation and the Deposit Rate

(In percent)

Source: CEIC.

With interest rates liberalized, financial institutions should be held accountable for managing their risks. In particular, regulated firms that are deemed by their supervisor to be well capitalized and well managed could be granted more discretion and held accountable for conducting their operations prudently and in compliance with the regulatory framework. Similarly, customers of financial products could assume greater responsibility for their own financial decisions, complemented by adequate consumer protection, disclosure, and improved financial literacy.

As this transition proceeds, it will be essential to ensure that it does not translate into an unintended loosening of monetary and credit conditions. This will be complicated by the fact that the ongoing financial reform and liberalization will make the appropriate pace of monetary growth very difficult to predict. Nevertheless, monetary policy would need to be attentive and used actively to counter the potentially unpredictable impact of interest rate liberalization on liquidity, credit growth, and monetary conditions.

The process will need to be carefully managed—through the use of both monetary policy tools to adapt liquidity conditions and the application of macroprudential restraints—in order to counter any surge in credit growth as interest rates become more market-determined. Particular attention will need to be paid to ensuring credit does not expand at a precipitous rate either in the aggregate or to particular sectors (e.g., real estate or consumer credit). It will, therefore, be important as interest rates are deregulated that regulatory and supervisory tools be used to their fullest to ensure that banks do not engage in overly aggressive competition or unsafe practices to attract deposits, expand lending, or compress margins to gain market share.

Greater freedom to set loan and deposit rates will create incentives for banks to better manage and price risk and will make money market interest rates more representative of true financial conditions. At the same time, a more marketdetermined system of interest rates will provide valuable price signals for macroeconomic policymaking and strengthen the transmission mechanism for monetary policy.

Opening Up the Capital Account

As the domestic financial system becomes more marketbased, with fewer distortions in the determination of market-clearing levels of credit and interest rates, China can then proceed to dismantle its extensive system of controls on capital flows.

The early stages of capital account liberalization should focus on removing restrictions on more stable, long-term sources of financing such as direct investment flows (as is already being done). As the reform process advances—with interest rates that are market-determined, a robust monetary policy and regulatory framework in place, a flexible currency, banks operating prudently, and the domestic financial system liberalized—the stage would be set to ease restrictions on short-term inflows. In doing so, the current Qualified Foreign Institutional Investor and Qualified Domestic Institutional Investor systems could be effectively used to gradually open up the account in stages and at a different pace for different forms of investments.

Concluding Thoughts

In sum, both the rationale and the agenda for financial reform in China are clear. Prior to the global crisis, China was on a firm trajectory toward a more modern financial system capable of addressing the challenges of a more mature and complex economy. However, as financial systems across the globe suffered severe setbacks, Chinese policymakers paused. In some ways, this was natural. But over the medium term, China needs to maintain the pace of change. Thus, it is encouraging to note the prominent role assigned to financial reforms in the Twelfth Five-Year Plan. Indeed, the roadmap laid out above can be completed over a five-year horizon. Done right, financial liberalization would be the next big wave of reform that China needs. It could be as significant as the state-owned enterprise reform of the 1990s, laying the foundation for continued strong growth in China in the coming decades.

This chapter has aimed to outline a roadmap toward that end that encompasses both the key elements and sequencing of the required financial reform effort. Continuing to defer progress in this area runs the risk that the financial system might evolve in an uncoordinated and disorderly fashion, outpacing supervisory capacity and revealing regulatory gaps. Indeed, the likelihood is high that developments are already proceeding on a timetable that is being driven not by careful, preemptive, and concerted policy planning, but rather in ad hoc fashion, propelled by the accelerating pace of market disintermediation and innovation. Such a trajectory is in the interest of neither China nor the rest of the world.

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