Special Report

China's Ongoing Financial Reforms


The Old Regime and the Revolution, a classic written by French historian Alexis de Tocqueville nearly 200 years ago, regained popularity among academics and policy researchers in Beijing this year. It's hard to judge whether this is due to the similarities of 18th century France and 21st century China, as was asserted, but one point that most people would agree upon is that the title of the book can be regarded as a vivid portrait of the ongoing financial reforms in China. Financial markets are struggling to escape the old regime and achieve revolutionary breakthroughs, which is destined to be a rough yet exciting process.

Accelerating financial reforms in 2012

At the beginning of 2012, it was widely acknowledged that the Chinese central government would make "stability" as its top policy priority, therefore no major breakthroughs or changes in reforming the financial sector were likely to occur. This has been proven to be a rather incorrect anticipation. Hitherto, financial reform in China is progressing faster than previously thought. The following table gives a short description of selected financial measures issued in 2012. China's reform drive clearly has not shifted down a gear, at least at the policy-making level.

Table: Select recent financial reforms in China
Before 2012Reforms in 2012Breakthroughs and significance
Capital account liberalization
Renminbi's (RMB) daily trading band (against the U.S. dollar) 0.5%Widened to 1%Breakthrough after 5-year hiatus, since 2007, in order to promote greater currency flexibility
Quotas for foreigners buying onshore stocks and bonds $30 billionIncreased to $80 billionBreakthrough after 5-year hiatus, since 2007, in order to promote the opening up of the domestic financial markets to foreign portfolio investors
Interest rate liberalization
Lending rates floor90% of benchmark rates70% of benchmark ratesBreakthroughs after 8-year hiatus, since 2004, especially the loosening of deposit rates cap has made key progress toward full liberalization of interest rates
Deposit rates cap100% of benchmark rates 1.1 times of benchmark rates
Banking sector
Well-performed loan companies to become rural banksOfficial financial institution was required to hold 20% share in the bank as the main initiatorReduced the holdings requirement to 15%Applicable in Wenzhou, a pilot financial reform zone in order to promote competitiveness within bank sector
Bond market
Private placement bonds for small and medium enterprises (SMEs)Did not existAvailable with simplified issuing procedures in the Shanghai Stock ExchangeFirst high-yield bond market in China in order to promote direct financing channels for SMEs
Market in which Qualified Foreign Institutional Investors (QFIIs) are allowed to investQFIIs were restricted to exchange-listed debt, which is less than 5% of the interbank equivalentQFIIs are allowed to buy bonds on the interbank bond marketBreakthrough since 2002, when QFII programs was launched, in order to attract more foreign investors into the Chinese bond market
Capital markets
Over-the-counter (OTC) equity marketFragmented markets including several regional OTC equity markets and hundreds of regional property rights exchange centersThe new Third Board based on the Zhongguancun OTC market in Beijing begins its roll out Consensus over a nationwide OTC equity market under uniform regulation first reached; a very crucial progress toward construction of multiple-layer capital markets
Insurance market
Loosened fund investmentOnly insurance asset management companies could be entrusted to manage insurance proceeds, except for internal investment teamsSecurities and asset management companies are now also permitted to manage insurance proceeds on behalf of insurance companies, and vice versaEntirely new reform in order to promote development of non-bank institutional investors

Revolutionary changes toward a positive direction

How shall we comprehend these policy changes through specific measures? These changes are not common but are components of revolutionary breakthroughs in China's financial system's old regime.

(1) Overall principle in promoting the development of the previously non-existent financial sector
China's 4th National Finance Work Conference, held on January 6, 2012 , laid down the overall principle of the financial sector reform--finance should serve the real economy, in particular, financial services should be enhanced in the two weakest fields of SME financing and rural financing. Although it sounds like a cliché, it is essentially a top-down design targeting the big picture and is created through consensus based on experiences and lessons from advanced nations such as the United States as well as China itself. Most of the followed financial measures are under the guidelines that so long as they are conducive to serving the real sector, the policy is good. The logic in the reform progress is no longer just "crossing the river by groping the stones."

(2) Full range of policy updates toward a previously vague positive direction
It's not difficult to determine from the table above that the latest financial reforms are comprehensive. Some are resumed reforms, e.g., loosening of the lending rates floor and deposit rates cap is a restart of interest rate liberalization after an 8-year hiatus. Others are entirely new reforms, such as the first high yield bond market for SMEs, construction of a national OTC equity market under unified regulation, etc. Still other reforms are either at the macro level with systemic importance or at the micro level which will deepen a specific domain. Finally, there are reforms targeting the promotion of competiveness and the promotion of opening up.

(3) Pilot financial reform zones which have equal importance with pilot economic reform zones
Regional financial reform was previously often regarded as part of economic reform, e.g., the northern Chinese city of Tianjin has been actively developing financial reforms and innovations in recent years, which resulted from the role of the Tianjin Binhai New Area as a pilot city in economic reform. Since March 2012, change has occurred as the eastern city of Wenzhou was approved to set up a pilot financial reform zone with the purpose of regulating private financing activities. Not long afterward, Lishui was approved as a pilot zone for rural financing activities, and Qianhai in Shenzhen for cross-border financing activities. Independent financial trials indicate that high expectations exist for the financial sector to play leading roles in the structural changes in China's growth model.

(4)" Deep waters" reforms which focus on quality rather than quantity
After decades of previous ongoing reforms, China's financial system has achieved remarkable accomplishments. At the end of 2011, China had the world's largest banking sector (central bank and commercial banks), second largest stock market, fourth largest bond market, and sixth largest insurance market. Tasks for future reforms have become increasingly difficult to push forward as a result. It's easy to establish a regulatory agency but difficult to transfer supervision modes from quantity to quality. It's easy to promote initial public offerings (IPOs) for state-owned banks but difficult to decrease credit spreads. It's easy to establish an interbank bond market for OTC bond trading but difficult to change the bond issue procedure from approval to registration. It's easy to allow foreign banks to operate in China but difficult to open immature domestic financial markets to variable foreign portfolio investors. Financial measures depicted in the table can be regarded as efforts of overcoming hardships and moving gradually toward "deep waters" reform, which is quite different and difficult to achieve.

No return to the old regime

2012 will end in less than two months. Compared with policies being issued at an exciting pace, implementation is much less stimulating. One good example is in Wenzhou where the pilot financial reform has not achieved significant progress seven months after its implementation. Perhaps specific innovative measures under correct guidelines are not sufficient to ensure that the old regime be destroyed and a new sustainable one be established.

The world is a different place these days. Addressing Wenzhou again, the flourishing underground financing activities, which have stirred up financial disputes and threatened economic stability, have pressed the central government to make decisions in setting up a pilot reform zone. To some extent, reform is self-occurring rather than caused by external forces. Ironically, this market-driven reform is still dominated by a government with traditional ideas. That's the key reason why implementation lags behind.

For example, much of the financial reforms in 2012 are being implemented through pilot programs. That is the way China has traditionally used, expecting to control risks and accumulate experiences for nationwide reform. However, it might not be applicable to financial reforms due to funds with high flow. The pilot zone model restricts financial reforms within a small region where the local government does not have enough power and capacity to implement material changes.

In Tocqueville's book, he wrote, "The revolution ...did not break out in countries where these institutions were in full vitality and practically oppressive, but on the contrary, in a country where they were hardly felt at all, whence it would follow that their yoke was the most intolerable where it was lightest." Since China has stepped onto the road of reforms, there is no return: implementing nationwide financial reforms; raising risk tolerance by governments; and giving more trust to market mechanics. We have to overcome fear and greed on the way toward the final victory, with no other options.

November 14, 2012