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China's Road to Greater Financial Stability

Chapter 14. The Impact of Financial Liberalization on China’s Financial Sector

Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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The growing consensus in China that it should internationalize its currency—driven by a mix of national pride, external demand, and perceived economic benefits for the Chinese economy—is beginning to serve as a commitment device for pushing forward other financial reforms. This is because financial liberalization—including interest rate liberalization, exchange rate flexibility, capital account liberalization, and opening up of the financial industry—is a precondition for a meaningful internationalization of the renminbi.

Of course, there are other important rationales in addition to internationalization of the renminbi for financial liberalization, as outlined in the paragraphs below.

First, China is facing structural headwinds such as the erosion of demographic dividends that will inevitably lead to a moderation of economic growth. It is thus becoming increasingly urgent for China to look for alternative sources of growth. Financial liberalization (especially interest rate liberalization) will help improve the efficiency of resource allocation and mitigate the downward pressure on growth potential.

Second, an open financial system is essential for developing China’s international financial centers such as Shanghai. The financial services sector is viewed as the next growth driver by several other major cities in China.

Third, existing controls on foreign exchange conversion and cross-border flows, as well as interest rate controls, are becoming increasingly difficult to enforce given rapid financial innovations. For example, the massive growth of informal lending activities has become a source of concern of late. Trust loans and other wealth management products have significantly destabilized the deposit base and undermined the effectiveness of monetary policy.

Finally, political backlash against big banks is gaining popular support, as banks are often viewed as making too much profit but not providing enough credit to small and medium-sized enterprises (SMEs). In March 2012, Premier Wen Jiabao authorized a pilot financial liberalization reform program in Wenzhou permitting the establishment of smaller financial institutions.

This chapter discusses the implications of the financial liberalization program for China’s financial companies, with an expectation that the proposed reform process will be largely completed over the next three to five years.

Nonbank Financing will Gain its Market Share

Financial liberalization will gradually reshape the structure of China’s financial system and open a range of new business opportunities. A major change is for the financing structure to move away from a bank-dominated indirect financing model toward greater use of nonbank direct financing. These nonbank financing or direct financing options include bond issuance, equity financing (public and private), and trust loans. Based on Japan’s liberalization experience in the 1980s, the share of bank lending in domestic financing will likely shrink while direct financing and overseas lending/borrowing will increase.

China’s corporate debt financing has been growing below its full potential, owing to eight key constraints: (1) debt financing limits that restrict the scale of corporate debt financing; (2) inefficiencies in primary debt market pricing mechanisms; (3) the quality and standing of domestic credit rating firms; (4) further modernization of the current legal framework; (5) low secondary market liquidity; (6) the shallowness of the domestic bond market investor base; (7) continuation of investment restrictions on domestic institutional investors’ market risk exposure; and (8) the nascent state of the domestic credit derivatives market.

Going forward, regulators can be expected to launch policy initiatives to address these constraints, and therefore corporate debt financing will grow at a much faster pace than bank lending. Specifically, we forecast the size of the credit market to grow fourfold over the next five years to RMB 20 trillion. This outlook is consistent with Japan’s experience—bond issuance as a percentage share of total financing almost doubled during Japan’s financial liberalization in the 1970s and 1980s.

The acceleration in credit market growth will reinforce the substitution effect between debt financing and bank loans. Therefore, medium-to-long-term loans could gradually become a less significant driver for new lending growth in the coming years. Moreover, regarding the asset composition of commercial banks, substituting loans with corporate bond holdings implies a narrowing interest rate margin. This could tip the balance of commercial bank lending toward SMEs, which would improve capital allocation to less-privileged sectors over the medium term. In addition, the expansion of the bond market can be expected to improve brokers’ earnings from corporate bond underwriting revenues (Figure 14.1).

Figure 14.1Forecast of China’s Credit Market

(Outstanding amount in billions of renminbi)

Source: Deutsche Bank.

In addition to the rapid growth of the bond market, equity initial public offerings (IPOs) could double in the coming years, as the China Securities Regulatory Commission (CSRC) is planning to replace the approval process with a “registration process” (Table 14.1).

TABLE 14.1Financial Intermediation Structure(In percent)
China 2011Japan 1965–74Japan 1975–84Japan 1985–90
Bank loans79705548
Offshore borrowing5335
Overseas lending281128
Sources: Bank of Japan; CEIC; China State Administration of Foreign Exchange; and Deutsche Bank.
Sources: Bank of Japan; CEIC; China State Administration of Foreign Exchange; and Deutsche Bank.

Banks’ Net Interest Margins will Contract, but a Further Downside may be Limited

A major concern for Chinese banks during the liberalization process is that interest rate deregulation will lead to a contraction in their net interest margin (NIM) and a slower pace of deposit/lending growth. First, with the gradual removal of deposit and lending rate restrictions, banks will be encouraged to bid more aggressively (by raising deposit rates and cutting lending rates) for deposits and loans. Second, some large corporates that have been the banks’ most profitable clients will likely switch to bond financing due to lower funding costs. This will also increase the pressure for banks to cut lending rates. Depositors will also be attracted by the liquidity and attractive yields offered by bond funds, thus forcing banks to raise deposit rates. Third, banks will face relatively high regulatory costs (a high reserve requirement ratio and tax burden) compared to their offshore competitors in Hong Kong SAR or Singapore and thus might lose some clients to offshore financial centers.

While the NIM will narrow, the key question is by how much is it likely to fall during the liberalization process. An IMF staff study shows that China’s deposit rates will likely rise by 30 basis points following interest rate liberalization (Feyzioglu, Porter, and Takats, 2009). Deutsche Bank analysts estimate that the NIM might contract by 37 basis points if deposit rates converge to short-term interbank rates with similar maturities. Of course, the initial monetary condition also matters. If the regulated deposit rates are close to the interbank rates with similar maturities, the overall deposit rates may not change much after deregulation. A general conclusion could thus be that if macro conditions are well under control—that is, consumer price index inflation is modest, real interest rates are positive, and interbank rates are broadly in line with deposit rates—then the impact of deposit rate deregulation on the NIM can be within a 20–30 basis point range.

In June 2012, the People’s Bank of China (PBC) expanded the floating range of deposit and lending rates. Lending rates are now allowed to be priced at or above 0.8 times the benchmark rates (previously the lower bound was 0.9 times) and deposit rate ceilings are set at 1.1 times the benchmark rates (previously the ceilings were the benchmark rates). Immediately after the deregulation, all large banks raised their one-year deposit rate to 3.5 percent (7.7 percent above the new benchmark rate), while many smaller banks raised their one-year deposit rate to 3.575 percent (1.1 times the benchmark). The NIM of the banking system contracted immediately by about 10 basis points.

Given that the deposit and lending rates of large banks are no longer constrained by the lower or upper bounds, this implies that the rates at most banks are close to their equilibrium rates. Even if the floating ranges for interest rates are expanded further, the average lending and deposit rates may not change significantly from their current levels. Therefore, the most difficult phase of interest rate liberalization is perhaps now behind us and a large one-off NIM contraction has already occurred and is likely to not repeat itself going forward.

There are several other reasons to believe that further downside risks to the banking system’s NIM may be limited. First, the NIM of Chinese banks does not appear excessive when compared to global peers. It is normal for foreign banks to maintain a 2 to 3 percent NIM regardless of the stage of financial development and capital account openness (Table 14.2).

TABLE 14.2Comparison of Bank Net Interest Margins in the Asia Pacific Region(In percent)
Hong Kong SAR21.71.61.5
South Korea32.62.82.6
Taiwan Province of China1.91.41.4
Source: Deutsche Bank.
Source: Deutsche Bank.

Second, after the June 2012 reform, the ceilings on three-year and five-year deposit rates were already close to or even higher than the lower bounds for three-year and five-year lending rates. This means that although the scope for extreme margin contraction is already provided under the current policy, excessive margin compression is unlikely.

Third, the Chinese banking system is dominated by five banks that account for nearly 50 percent of outstanding loans and deposits. These banks will likely retain their rate-setting influence in the banking market. In Hong Kong, for example, retail banking business was dominated by three major banks. Following the removal of the interest rate agreement in the early 2000s, there was no significant hike of deposit rates, as the large banks continued to set the key rates while the smaller banks followed.

Finally, the deposit mix matters in China. Demand deposits account for 40 percent of total deposits, and interest-rate-sensitive corporate time deposits are only 17 percent of total deposits. Demand deposits are much less sensitive to changes in interest rates than corporate time deposits.

Banks’ Incomes from Fees will Rise Rapidly

Despite the challenges posed by interest rate and capital account liberalization, banks will also benefit from new business opportunities. First, Chinese banks are already the dominant players in the interbank bond market. The booming bond and foreign exchange businesses will bring in extra fee and trading incomes. Currently, daily renminbi-related foreign exchange spot trading volume is only US$30 billion, compared to U.S. dollar daily foreign exchange trading volume of US$4 trillion. Once the renminbi assumes a floating character without capital account restrictions, the hedging and trading demand will significantly pick up. Renminbi trading revenue could rise by as much as 50-fold to 5 percent of total bank income over the medium term. Current fee income from trading foreign exchange is only about 0.3 percent of Chinese banks’ total revenue. As a comparison, major global banks such as HSBC derived 4 to 5 percent of income from foreign exchange trading in 2011. Among Chinese banks, the Bank of China, given that it has a 30 percent market share of foreign exchange trading, should benefit the most from the surge in foreign exchange trading due to capital account liberalization.

Other trading and fee incomes from selling interest rate and derivative products will also rise. During financial liberalization in Japan in the 1970s, foreign exchange transaction volume (spot and swap) rose 500-fold, from US$12 billion in 1970 to US$6 trillion in 1990, and bond market volume rose sixfold from JPY 29 trillion in 1975 to JPY 184 trillion in 1991. Total bond market transactions increased from JPY 56 trillion in 1980 to JPY 534 trillion in 1991, an increase of 9.5 times.

As the process of liberalization unfolds and the capital account opens further, Chinese banks will be able to sell many more global financial products to domestic clients, and provide more services to international clients (such as custody and bond trading services for Qualified Foreign Institutional Investor clients). Chinese banks are also currently involved in the distribution of mutual funds offered by Qualified Domestic Institutional Investor (QDII) managers. Given the limited size of QDII operations, the potential for distributing more global mutual fund products to Chinese clients is sizable. Finally, Chinese banks can also benefit from the overseas expansion of Chinese companies by providing trade finance, merger and acquisition (M&A), and global treasury services.

Global Expansion is a Double-Edged Sword

Despite the fact that China is the second-largest economy in the world, Chinese banks have had a very limited presence to date in major financial centers. Some Chinese banks will follow the overseas expansion of Chinese companies and find new business abroad. Some others may seek a stronger presence in major markets to serve local clients.

Of course, the overseas expansion is also risky given the lack of experience of Chinese financial institutions in global markets. In the 1970s, Japanese banks became major players in other financial centers, with the number of offshore offices rising from 139 to 327 and offshore assets jumping from JPY 25 trillion (in 1980) to JPY 127 trillion (in 1991). Overseas lending by Japanese banks also rose from JPY 10.9 trillion in 1980 to JPY 73.5 trillion in 1991. Simultaneously, foreign banks also expanded their businesses in Japan. Not all Japanese overseas investments were successful, with some suffering from serious losses in the U.S. property markets and others incurring trading losses due to poor risk management.

Given the Japanese experience, foreign borrowers can also be expected to be more active in China. Panda bonds will likely take off together with the Dim Sum bond market. Again, for historical perspective, between 1980 and 1991, the outstanding amount of Samurai bonds rose from JPY 1.8 trillion to JPY 6.2 trillion, and euro-yen from JPY 200 billion to JPY 18.1 trillion (Figure 14.2).

Figure 14.2Composition of International Investment Position

(In percent)

Sources: China’s State Administration of Foreign Exchanges; and Japan’s Ministry of Finance.

Given the limited experience and significant cultural differences between Chinese and foreign institutions, the chance of success for large-scale M&As by Chinese banks is not high. It would be prudent for Chinese financial firms to pursue organic growth initially, with a focus of serving Chinese companies going abroad. In addition, they need to be sensitive to returns on equity for business expansion, rather than base decisions solely on a concept that certain geographic regions will have attractive growth potential. Finally, Chinese banks should also leverage Hong Kong as the place to test the waters before they venture further away from their turf.

Brokerage and Asset Management Sectors will Benefit

Securities brokers in China currently engage mostly in domestic equity underwriting and trading business, but their international business is very limited. Brokers will benefit from financial liberalization in at least two ways. First, local brokers will benefit from Chinese investing abroad. Currently, the private sector (including Chinese households and private corporates) has about 1 percent of assets offshore. Most of China’s overseas assets are held by public sector entities such as the State Administration of Foreign Exchange in the form of foreign exchange reserves (US$3.3 trillion). In Japan, by comparison, US$7.3 trillion of overseas assets are mostly held by portfolio investments (US$3.4 trillion). So the pent-up demand for Chinese investors to invest in overseas equities and bonds could be huge. This will create significant business opportunities for local brokers in terms of commissions for trading foreign financial products and facilitating cross-border M&A businesses.

Second, foreign investments in Chinese bond and equity markets will also increase substantially. Currently, foreign ownership in Chinese bonds and the A-share equity market is only 1 percent of the market cap or outstanding amount. Compared to other emerging market countries, which on average have a foreign participation rate of 26 percent for equity markets and 13 percent for bond markets, the room for growing foreign portfolio investments into China is easily a fivefold increase in the coming five years. Portfolio inflows will also increase trading commissions for local brokers.

In addition to benefits for brokers, asset management companies should also see a significant increase in assets under management (AUM) as private investors invest more in overseas securities markets and a wider range of liquid domestic products become available. Currently, total AUM by China’s asset management industry are only about RMB 2.5 trillion, a third of that in Hong Kong. As a comparison, total deposits in China reached RMB 87 trillion by the end of 2011. In developed countries, the ratio of AUM to deposits tends to range from 100 to 200 percent, compared to China’s 3 percent (Figure 14.3).

Figure 14.3China’s Underdeveloped Asset Management Industry

(Top panel in billions of U.S. dollars; bottom panel in percent)

Source: Deutsche Bank.

Insurance will Likely see Improved Returns on Investment

The impact of interest rate liberalization on insurance companies is negative in the short term but positive over the long term. Insurance companies have been mainly selling savings and investment policies, so low and regulated deposit rates have provided advantages to them. But in a liberalized interest rate environment in which deposit rates tend to rise, these insurance products will become less attractive. Their savings products will face direct competition from bank deposits, bond funds, and other wealth management products. This is the negative impact that insurance companies are experiencing right now.

On the other hand, higher deposit rates tend to benefit insurance companies by boosting their asset returns, given that the majority of insurance premiums are invested in bonds and deposits. This positive impact on insurance companies’ investment returns will be realized in the longer term, as the impact mainly benefits new investments made by insurance companies.

Liberalization Measures will Benefit Banks Based in Hong Kong

As discussed earlier, capital account liberalization will be the most important next step toward internationalization of the renminbi. Once the capital account is open, there will be multiple channels through which renminbi liquidity can flow to the offshore market, including Hong Kong. These include individuals’ and corporates’ remittances of renminbi to the offshore market, the ability of Hong Kong and foreign residents to more freely convert foreign currencies to the renminbi in the offshore market, and a higher multiplier effect due to more active offshore renminbi lending (partly due to free remittance of renminbi into and out of China). The offshore market will likely continue to grow rapidly during and after the opening of China’s capital account.

On July 1, 2012, Chinese President Hu Jintao visited Hong Kong to attend the celebration of the 15th anniversary of Hong Kong’s return to China’s sovereignty. During his visit, the Chinese government announced additional liberalization measures that could boost CNH liquidity, CNH trading, and Dim Sum bond issuance on the renminbi offshore market.1 The Bank of China (Hong Kong) (BOC), which has more than half of renminbi deposits in the Hong Kong market, will likely see a significant upside to its renminbi lending, bond issuance and trading, renminbi foreign exchange conversion, and other renminbi-related businesses. For example, outstanding Dim Sum bonds can be expected to rise from the current RMB 230 billion to RMB 1.5 trillion in 2015. BOC (HK) will be the biggest beneficiary from the growth of the renminbi offshore market.


    FeyziogluTarhanNathanPorter and ElodTakats2009Interest Rate Liberalization in China,IMF Working Paper 09/171 (Washington: International Monetary Fund).

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The acronym CNH is used to represent offshore renminbi.

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