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ViewpointFebruary 24 2014

Regulating China's economic reforms

The Chinese government is promising far-reaching economic reforms, but these are likely to put the financial sector under strain. Former chairman of the China Bank Regulatory Commission Liu Mingkang tells Philip Alexander how the authorities can manage the transition.
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Regulating China's economic reforms

The institution that Liu Mingkang helped to build as its first chairman from 2003 to 2011 – the China Banking Regulatory Commission – is under scrutiny. The plenum of China’s Communist Party in November 2013 set out a blueprint for economic reform that included liberalising the financial sector. And investors around the world are asking questions about asset quality in China, amid the near-default of a large trust company loan in January 2014. Now at one of Asia’s leading business think-tanks, the Fung Global Institute, Mr Liu emphasises the significance of the decisions facing China’s new policy-makers.

“China is at a turning point in the course of its development. The third plenum sent out a signal of intense and comprehensive reform, to turn around the country’s growth model. The government thinks moving forward only with mass production and mass investment will never be sustainable, so it is acknowledged that in the future the market will play a decisive role. China does not want to increase overcapacity and the pollution caused by credit-fuelled fixed-asset investment and mass exportation, which has also brought China too much exposure to external volatility,” Mr Liu tells The Banker.

He anticipates reforms to state-owned companies and local governments, the liberalisation of prices, and land reform to increase labour mobility. In addition, he expects efforts to enhance the rule of law and a range of financial liberalisation including “interest rate and exchange rate liberalisation and the development of the renminbi as a global currency”.

He says the world should welcome a more modern China, but acknowledges that restructuring legacy industries will be “painful”, potentially resulting in a slowdown in economic growth and a rise in non-performing loans (NPLs).

Shadow banking

The major concern around NPLs focuses on the fast-growing shadow banking sector, which is the main source of credit for real estate development, privately owned companies and local government borrowing platforms that finance municipal infrastructure development. Two shadow banking strands currently in focus are trust companies that lend funds raised from sophisticated investors and corporates, and wealth management products (WMPs) distributed by banks to give retail customers higher rates of interest. Many WMPs repackage underlying bank assets such as loans and securities transactions.

“There is a duty to educate the public better, to enlighten the whole market. Shadow banking is sometimes helpful, but in many cases it is risky. The first task is to guard the potential investors who are fuelling shadow banking; we need to teach them that deposits are safe. Traditional banking has some shortcomings and can never satisfy all the needs of the real economy, but we should push forward with reform of the financial sector to make traditional sources of finance such as the banks, insurers and securities markets serve the real economy more thoroughly and to bank all those who are bankable,” says Mr Liu.

He adds that China is moving to a better monitoring system of shadow banking to improve the supply of data from the sector and ensure a “convincing analysis”. This is especially important, he warns, because of the growing interconnectedness between shadow and conventional banking sectors.

“When banks sell products, they need to follow prudential guidelines and do the due diligence to ensure customer protection – more needs to be done in this area to avoid the build-up of social consequences,” he says.

Chinese entrepreneurs say the liberalisation of interest rates is a vital way to curb the rise of risky WMPs among retail customers. Higher rates would tempt savers back into commercial banking, and enable banks to lend to smaller private companies without breaching interest rate caps. However, Mr Liu believes this is not a panacea.

“More flexible interest rates will create market forces and allow Chinese banks to better price their assets and liabilities. But it will take more than simple tools to manage shadow banking. The US and western Europe liberalised interest rates in the 1960s and 1970s, and it is clear that this has not guaranteed their economies against financial volatility,” he says.

Economic reforms

Alongside financial liberalisation, Mr Liu believes macroeconomic reforms are vital to strengthen asset quality. Investment in value-added sectors such as renewable energy, chemicals, metallurgy, shipbuilding and textiles should all help to improve loan books, as long as due diligence by lenders is adequate. All this must happen in a context of heightened uncertainty as the US begins tapering its quantitative easing programme and moves towards higher long-term interest rates.

“Worldwide demand for Chinese goods is very different today. A rising cost of debt would put Chinese government budgets and banks under additional stress at a time when global demand is changing. We will face difficult choices between cutting overcapacity and keeping jobs, but this is something we must do,” says Mr Liu.

Additionally, he suggests an overhaul of the tax system would reduce the risks of shadow banking. The division of revenues between central and local governments needs to be conducted “more scientifically”, he says. This would curtail the recent surge in local governments borrowing via financing platforms, and relying on soaring property prices to buoy sales of state-owned land.

Liu Mingkang is the first distinguished fellow at the Fung Global Institute.

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