As one of the most important resolutions after the 1978 meeting, Decision issued by Third Plenary Session of the 18th Central Committee of the Chinese Communist Party is both significant and profound. It is reasonable to believe that, after the full implementation of the reform proposed by Decision, the Chinese market will witness remarkable improvements in the maturity of its economic system and the concurrent progress in its economic growth and social development.
Decision involved several aspects including society, politics, economy, culture and ecological civilization, however, economic reform still plays the core role. Among all the economic reform policies, financial reform holds a dominant position. According to Decision, financial reform will include the improvements of three basic aspects: the financial market system, the price mechanism and the regulation system. It in detail refers to the reform in banking industry and capital markets, the liberalization of interest rate and exchange rate, RMB capital account convertibility, the innovations of financial products and the reform on financial regulation. Although most of them are in urgency, there is an unavoidable problem in strategies, that the reforms should be pushed forward as a whole or in sequence.
According to the reform experiences of other countries, there are two modes of the market-oriented financial deregulation: the aggressive mode and the gradual mode. The aggressive mode implies that in a short time of 1-2 years, achieve the deregulation of all financial fields, abolish the access restrictions in banking industry, realize the interest rate liberalization, transfer to the floating exchange rate system and remove the restrictions on capital account etc. Some Latin American countries in the 1970s and some East European countries in the early 1990s respectively tried this mode. Gradual mode implies that in a relatively long time and in sequence, step by step, remove the restrictions stated above. Compare these two modes, both show pros and cons. Aggressive mode implies high reform efficiency, accompanied by pain in short term and the relatively high risk of financial turbulence. Most of the countries that took aggressive mode experienced financial crisis soon after reform. In contrast, those that took gradual mode seldom met such crisis, yet they paid certain delay cost.
It has been more than 30 years since China first started its financial reform in the 1980s. Consistent with the strategies of the economic reform, the financial reform takes the gradual mode. Although many reforms still need continually propelling and deepening, the achievements so far cannot be underestimated. The biggest success is that, through 30-year reform on banking industry and capital market, China has developed a modern financial sector from nothing without experiencing significant financial turbulences! China is a country with a large population; therefore any financial turbulence may have severe socioeconomic consequences, and it may even interrupt or retrogress the ongoing reform progress. Based on the theories and China’s reform experiences, it can be assumed that although the economic and financial reforms in the near future are still urgent, they should be accelerated as a whole but gradually propelled in strategy.
The core of gradualism is that, before any reform is introduced, we should consider whether the conditions are mature and the time is proper. In the meanwhile, from an operational level, special attention should be paid to the sequence of different policies. Right sequence will promote successful development of reform, while the wrong sequence may lead to turbulences and chaos. Look into the financial reform policies proposed by Decision, it can be assumed that we should stick to the three principles listed below when planning the sequence.
Firstly, the reform on market players should be put on schedule soon, prior to the reform on financial resources pricing. This is because to form financial market system needs enough market players, or the market would be inefficient and the emulative price level cannot be achieved. Currently, the banking industry shows obviously too high a degree of concentration. According to statistics, the market share of China’s four biggest state-owned banks as a whole reaches up to 70%, in the meanwhile, for more than 20 stock-holding commercial banks, small and medium-sized banks and foreign banks, the statistics are 23%, 5-6% and 2%, respectively. In comparison, the top 10 out of more than 8000 banks in U.S.A only occupy 30% of market share. This means that policies that lower entry barriers and permit the establishment of private financial institutions should be introduced as soon as possible.
For the same reason, the reform on IPO system in capital market should be put into practice soon. Because to a large extent, the approval system of regulators restricts the listed company to transform into market players, thus it restricts the long-term development of China’s securities market. For a long time, due to the unreasonable IPO system and some other factors, there are only 2200 or slightly more listed companies in China. This number is far below that of developed countries, and even far below that of some developing countries such as India. It has eventually become one of the root reasons why the percentage of direct financing in China is so low.
Secondly, accompanied by integrally balanced progress, the liberalization of internal financial market should be prior to that of external financial market. This implies that the reform on easing market access, liberalizing the interest rate and expanding the elasticity of RMB exchange rate system should be prior to the reform on capital account convertibility. Interest rate liberalization is especially the key success factor of optimizing financial resources allocation. Only when the domestic financial resources allocation system becomes reasonable and market-based, can the opening of capital account achieve the best results.
Here we mainly discuss the sequence of reforms on exchange rate and on capital account convertibility. Decision has stated that, to actively promote capital account convertibility is one of the key points of the financial reform over the next few years. After more than 10 years’ effort, the degree of capital account convertibility has increased. According to the standards of IMF, out of more than 40 items, China has 14 items achieve basic convertibility, accounting for 35% and 4 items still be completely unconvertible, accounting for 10%. The rest 22 items are partly convertible, accounting for 55%. In terms of the specific items restricted, currently they are the purchase and sale of assets conducted by foreigners in China’s securities market and the overseas investments conducted by Chinese residents, including securities investment and direct investment.
Look into the future, it is an unavoidable trend to ease the restrictions on these items in order to enlarge the scale and increase the frequency of cross-boarder capital flow. In face of such a new trend, it is conspicuously urgent to reform the existing RMB exchange rate system. The plasticity of RMB exchange rate should be improved with the least possible delay, so that the managed floating exchange rate system can be really realized. This is because: firstly, in the condition of free capital flow, flexible exchange rate arrangement could greatly enhance the independence of China’s monetary policies, in the meanwhile, it can also act as a ‘firewall’ that prevents external turbulent market from shocking the domestic economy. In the future, with the improvements in capital account convertibility, China’s economy will blend with global economy more largely and more deeply; as a result, China’s economy will also experience global economy impact more frequently(e.g. the impact of QE). In rigid exchange rate system, any international commodity price fluctuations and international financial market turbulences will be directly passed into domestic economic system; therefore the stability of domestic economy would be influenced. However, in a flexible exchange rate system, the immediate adjustment of RMB exchange rate can effectively resist or impede those adverse impacts. Secondly, in a time of capital inflow and outflow in large scale, the corresponding variation in exchange rate (i.e. appreciation or depreciation) will play a reversely regulatory role. The result is that capital inflow and outflow are impeded due to the increased cost and risk premium. Thirdly, the lessons learned from other emerging markets including the Asian financial crisis in 1997, all imply the importance of flexible exchange rate to capital account convertibility.
It has been 20 years since China started its reform on RMB exchange rate in 1994. During this period, due to the restrictions on export-oriented development strategy as well as the impact of Asian financial crisis and American subprime mortgage crisis, the reform on RMB exchange rate system progresses slowly, with the floating range of RMB exchange rate against U.S dollar maintained at 1%. It can be assumed that this is the moment to accelerate the reform on RMB exchange rate and to expand the floating range. This is because: firstly, the current account surplus has dropped distinctly, from 11% of GDP in 2007 to below 3% of GDP now, which implies low possibility of substantial appreciation once the plasticity is expanded. Secondly, since the U.S.A has started QE exit strategy, it is unlikely that international capital will flow into China in large scale and consequently, after expanding the plasticity of exchange rate system, RMB is unlikely to appreciate, which implies low possibility of conspicuous adverse effects on real economy. In case of large scale of capital inflow, the appreciation itself has inhibiting effect on inflow. Thirdly, before capital account convertibility achieves a higher degree, expanding the flexibility of exchange rate will contribute to accumulating management experiences.
Thirdly, the reform on financial regulation and the corresponding supporting reforms should be put on schedule. A lower entry barrier and interest rate liberalization both will intensify market competition, which is highly likely to cause the excessively risky actions of market players, and eventually to exacerbate the systematic financial risk. Although the subprime mortgage crisis in U.S.A in 2007 is a result of macroeconomic problems in many aspects (e.g. excessively easy monetary policies, large scale of foreign capital inflow etc.), there is a key factor in microeconomic aspect – after the financial liberalization in the late 1970s, the authorities failed to impose necessary regulation on the escalating competitive landscapes within the industry, especially on the many off-balance sheet activities. Lessons learned from subprime mortgage crisis in U.S.A deserve our emphasis. It means that, during the time of domestic financial liberalization, we have to enhance and improve the corresponding financial regulatory measures. Currently, special attention should be paid to the potential risk brought by shadow banking and the innovations of Internet finance, in the meanwhile, the relevant regulatory polices should be established and improved as soon as possible.
In terms of the systematic financial risk coming together with financial reform deepening, we should not only enhance the regulation before and during the reform process, but also reinforce the establishment of the coping mechanism after the reform. It is sensible that Decision clearly states the urgency of establishing deposit insurance system. A well-planed deposit insurance system is the premise for financial liberalization, especially for deposit interest rate liberalization, because it can effectively prevent the systematic financial risk from coming into being and widely spreading when financial institutions exit markets due to bad management.
