China's Financial Reforms Face Big Challenges

China's Financial Reforms Face Big Challenges

September 2016


China’s leadership has several challenges before it: to increase economic growth while implementing much-needed reforms to improve the market orientation and efficiency of the economy and maintaining stability in the financial system.  All of these challenges are particularly steep: economic growth is slowing due to changes in the domestic and global economic structure, creating the need for additional stimulus and policy measures; reforms are necessary to move the economy toward a service and consumption-based system, but economic headwinds and vested interests have dramatically slowed this process; and financial stability remains a concern due to aftershocks in the stock market and potential bubbles elsewhere.

Certainly, strides have been made on the financial front.  The People’s Bank of China’s Financial Stability Report released at the end of June 2016 states that in 2015 the financial system was relatively sound, with reforms aimed to increase credit to small enterprises, control credit risk, improve opening of the capital market, increase trading volume in money markets, expand bond issuance, and grow the futures and interest rate derivatives trading volume.  Financial infrastructure strengthened, with improvements in the RMB cross-border payment, clearing, and settlement system, better financial regulations, consumer protection, and macroprudential management.

Reforms carried out follow the desired paths of financial modernization as indicated by the government.  The RMB is gradually becoming more internationalized, as reforms have been piloted in 15 regions across China to carry out cross-border RMB financial transactions and offshore RMB clearing arrangements have expanded.  The RMB exchange rate mechanism has been reformed to reduce reliance on the dollar.  Interest rates are slowly better reflecting market forces.  The deposit interest rate ceiling was removed in order to allow banks to compete more easily for deposits and provide a positive yield to customers.  Deposit insurance was put into place to remove the role of government as primary risk mitigator. This is a big step toward removing the implicit government guarantee of bank funds and marketizing the banking system.  Innovations and regulations in stock, equity and futures markets were put into place to modernize these sectors.  The CSI stock index futures market was launched, as were the tin, nickel, and crude oil futures markets.  Mechanisms to supervise private equity funds were put into place, and margin trading on securities was limited.

Reforms are happening, just seemingly not fast enough.  After the stock market fiasco last year, one could hardly say the stock market is now modernized.  Government intervention, the old standby, fell flat as investors lost confidence in the market. Heavy reliance on the banking sector has highlighted the potential problems that may arise from non-performing loans, and direct finance through debt and equity channels are highly underdeveloped. Perhaps worst of all, no one seemed to believe last August’s devaluation was due to marketizing the exchange rate, revealing a woeful lack of policy credibility.

There are several factors that can inject a boost into China’s economy and help to speed financial reforms.  First, a decline in global economic uncertainty (particularly in the Eurozone and Japan), as well as stabilization of commodity prices, can reduce pressures on China’s regulators to lock in financial stability, freeing them up for deeper implementation of reforms.  Second, clearer timing of the US benchmark interest rate hike or, better although unlikely, an end to US rate hikes, can soothe China’s market jitters and reduce capital outflows.  The last US rate hike of December 2015 roiled China’s stock markets through February 2016; after a year of volatile stock movements, equity losses are the last thing Chinese financial regulators want to see.  Capital outflows dampen economic growth and reduce the stockpile of foreign reserves, creating greater challenges to financial reforms.  Third, surges in growth from other sources, such as a rise in consumer demand or breakthroughs in non-financial service sector reform can provide policy makers with some breathing room to focus on reform rather than growth.

Unfortunately, none of these scenarios is highly likely, meaning that policy makers will be forced to trudge through financial reforms that are on the agenda but not as credible or effective as they could be in a buoyant economy.  China’s leadership has a clear list of items to carry out in the face of naysayers and bearish investors, and this is likely to remain a challenge for the near future.


This article was written by Sara Hsu from Forbes and was legally licensed through the NewsCred publisher network.

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