Liu Shengjun: Financial System Reform
China’s Financial Liberalization: An Obscure Promise
Dr. Liu Shengjun is Executive Deputy Director of CEIBS Lujiazui Institute of International Finance, a think tank based in Shanghai. He was one of six economists whom Chinese Premier Li Keqiang invited to the State Council for a policy-consultation meeting on July 15, 2014.
Last November, China unveiled an aggressive reform plan at the Third Plenum of the Chinese Communist Party’s 18th Congress. To many observers’ surprise, the plan almost completely embraced the so-called Washington Consensus. Several years ago, even some Western scholars were discussing an alternative economic model they called the “Beijing Consensus.” But at the Third Plenum, the Party in fact rejected the notion of a Beijing Consensus by promising to let market mechanisms play a decisive role in the economy.
Financial reform is the most eye-catching reform in China. It is both critical and imperative.
So far China’s financial system is still a typical “financial repression,” a term put forward by Ronald McKinnon. First, banking is at the core of China’s financial system. The ratio of banking assets to GDP is 250% in China, while the ratio in the U.S. is only 80%. Second, what makes things worse is that most banks are state-owned banks. Among the top 20 banks in China, only PingAn Bank and Minsheng Bank are non-state banks. Third, China’s interest rate has been regulated. In 2013, the People’s Bank of China (PBOC) liberalized loan rates but continued to regulate deposit rates. This created an ample interest rate gap between loans and deposits, helping the big banks make profits comfortably. Finally, China’s stock market is still highly regulated. IPO registration became a process full of rent-seeking and uncertainties. In 2012-2013, the China Securities Regulatory Commission (CSRC) even closed the IPO market for one year. No wonder Alibaba chose NYSE for its public listing.
Not surprisingly, China’s financial system is of low efficiency and causes significant distortions. After the 2008 global financial crisis, the PBOC raised the bank deposit reserve ratio to a historic high of 21.5% in December 2011. This led to the rapid growth of shadow banking and formed dual interest rates. For instance, peer-to-peer (P2P) lending in China can provide 8% to 20% year-on-year returns to investors, while the rate for borrowers can be as much as 30% or higher. In comparison, the return on a 1-year time deposit is only 3.3%, and the loan rate can be as low as 6%. It is not hard to imagine why only big companies, especially state-owned enterprises (SOEs), can borrow from banks. Small and medium-sized enterprises (SMEs) are usually forced into shadow banking. The 20% per annum borrowing rate in shadow banking proved to be a heavy burden for SMEs. Obviously, this is not sustainable—we are seeing more and more Chinese SMEs run into financial difficulty.
Almost contrary to his predecessor, the Chinese Premier Li Keqiang is cool-headed about the financial situation. He resisted the idea of printing more money to solve the problem, even caused an inter-bank liquidity crisis in June 2013. Instead, he urged to make full use of the money supply in order to improve the efficiency of financial system. After all, China’s 200% ratio of M2 to GDP is already dangerous enough.
China’s financial system, despite its low efficiency, is very useful to help SOE and local governments to get cheap money for investments. But the social cost is huge. The 50% investment ratio led to widespread overcapacity in most industries. A negative real interest rate implies that households are subsidizing borrowers, including SOEs and local governments. Now the business sector is overleveraged, and it is time to deleverage.
Real Interest Rate in China
The solution lies in financial liberalization. In the 2013 reform plan, China put forward several key elements for financial reform, including a registration-based IPO system, the opening of the banking sector to private capital, interest rate liberalization, and encouragement of inclusive finance such as internet finance. China promised to finish the key reforms by 2020. Most recently, PBOC Governor Zhou Xiaochuan pledged to realize interest rate liberalization by 2016.
At least Xi Jinping and Li Keqiang are serious about reform. They are facing probably the last window of reform. In the financial area, they are making progress. First, the CSRC will announce a detailed plan for a registration-based IPO system in 2014, and the Securities Law is under revision. Second, the China Banking Regulatory Commission (CBRC) approved five new private banks, including Tencent bank and Alibaba bank. Third, Internet finance like P2P is booming in China, which is a catalyst for financial innovation. For instance, the rapid growth of Alibaba’s Yue’Bao Fund, which quadrupled in less than a year, created wide panic among big banks, and thus exerted more pressure favoring interest rate liberalization in the banking system.
However, it is far too early to celebrate. China’s financial reform is still facing great uncertainties. First, interest rate liberalization means that SOEs and local governments need to pay a higher real rate for borrowing, which will be resisted by them. Also, big banks are very reluctant to adapt to a liberalized interest rate. They will manage to slow down the reform process. Second, China’s stock market is considered an extremely convenient tool for princelings to make quick money, and the reform of the IPO system may be strongly resisted by interest groups. Third, local governments are always ready to save big companies that run into financial problems, which creates huge moral hazards among companies and investors. Finally, China’s economy continues to slow down, and the possibility of a hard landing is increasing. The vulnerable housing bubble makes the situation even tricky. Very likely, China would give priority to economy stimulus and postpone financial reform.
In sum, the Third Plenum put forward a very wise financial reform plan, and the new Premier Li Keqiang has the knowledge and will to implement those reforms. However, he needs to skillfully overcome the resistance from financial institutions and interest groups, and a stable economic environment, which is indispensable for financial reform, may not last for very long because of the looming slowdown.