Opinion: Pace of Financial Reform Key to Its Success

After rosy signals about China’s financial market opening earlier this year, President Xi Jinping’s speech at the Boao Forum for Asia Annual Conference ensured that promises to open up insurance and financial sectors would be implemented, with broader market access and the removal of restrictions on foreign firms. Later, the newly appointed governor of the People’s Bank of China, Yi Gang, announced a slew of detailed measures.

China accelerated the speed of its financial market opening after its World Trade Organization (WTO) accession and has achieved considerable progress. Since 2004, the four major state-owned banks have gradually introduced foreign strategic investors.

This move was accompanied by transfers of advanced financial technologies, business models and management skills. The introduction of “The Rules for the Establishment of Foreign-Shared Securities Companies” in 2002 marked the opening of the Chinese securities industry to foreign equity investment. Foreign capital continued to rise in the Chinese market, demonstrated by the number of foreign-owned insurance companies operating in China and their share of premium income. As for the capital market, as of February, the total quota of Qualified Foreign Institutional Investor (QFII) investment was $99 billion, compared with $350 million in 2003; the accumulated purchase amount in the Shanghai and Shenzhen Stock Connect programs exceeded 730 billion yuan ($115.7 billion); the process of yuan internalization steadily moves forward.

International practices and China’s own experience show that opening financial markets requires not only determination but also deliberation. Specifically, the following issues should be considered.

Above all, adjusting the speed at which financial markets open should be a dynamic process in which the macro background matters. The pace needs to be controlled because both blind acceleration and stagnation without consideration of the international macroeconomic situation would impose adverse effects on the domestic market. During the Asian financial crisis and the 2008 financial crisis, the slowdown of China’s financial opening proved favorable to preventing the rapid spread of international risks into the domestic market. In contrast, the subsequent acceleration measures around 2004 and 2011 are believed to have expected outcomes and exemplified “seizing the window of opportunity.”

A close look at the current situation would seem to show that now is not a good time for a rapid opening of the Chinese financial market. On one hand, China is grappling with a high leverage ratio, and a massive capital inflow would likely impair efforts to control debt and pose risks to financial vulnerabilities. On the other hand, as worldwide interest rates enter a rising cycle, the pro-cyclical nature of foreign capital in emerging markets could make China subject to enormous pressures in terms of short-term cross-border capital outflows. Chinese market volatility could be exacerbated by further linkage with global financial markets, which was illustrated by the slump in A-shares this February following the plunge of the U.S. stock market.

Second, specific opening measures should correspond to domestic goals in various development phases. For example, the acceleration after WTO accession aimed to attract foreign strategic investors and spur the reform of the domestic financial system. The measures since 2011, including the introduction of the Renminbi Qualified Foreign Institutional Investor program and the stock and bond connects between Shenzhen and Hong Kong, aimed to deepen the reform of the financial system at home and effectively advance yuan internalization.

Against the backdrop of financial deleveraging, guiding capital into China’s real economy is key. In the short run, opening up China’s financial sector should be leveraged to develop the real economy with reduced financing costs and widened financing channels. In the medium term, the quality and efficiency of Chinese financial services should be the target. Lifting market access restrictions and introducing foreign financial institutions could help enhance market competition, forcing domestic market players to strengthen the quality and efficiency of their service. In the long run, yuan internalization is one of the most crucial strategic goals. Free convertibility of the yuan and liberalization of the capital account serve as the only way to deepen the financial opening in the future.

Third, the relationship between financial opening and financial supervision should be addressed. Opening financial markets is by no means equivalent to the absence of supervision. Instead, it requires regulators to fix loopholes, promote the efficiency of supervision, and more importantly, avoid across-the-board regulation. The root causes of chaos in internet finance and shadow banking are the loopholes in the financial supervision system and the resulting regulatory arbitrage. Under these circumstances, foreign capital would fail to completely demonstrate its vitality despite easier market access. In addition, the Chinese government should also set as a priority the establishment of a supervision system for foreign capital, to prevent the disguised inflow of hot money that could lead to instability on the domestic financial market.

Last but not least, we need to coordinate the relationship between exchange-rate reform and financial-market opening. In the short run, supervisors need to adjust the pace of reform and seek an optimal balance. A more-flexible exchange-rate system would act as a buffer against external shocks and thus should be realized before opening up China’s financial market in all aspects. This is the key lesson of the Thai baht crisis in 1997. After the Asian financial crisis, many economists such as Dani Rodrik and Joseph Stiglitz reflected on the dangers of blindly loosening capital controls and indicated the importance of capital account management. From August 2015 to the first quarter of 2016, the Chinese government used $355 billion of its foreign exchange reserves to preserve yuan stability. By resisting shocks from capital-flow reversals, China’s central bank strengthened its control of the capital account.

In conclusion: While China’s financial-market opening will never stop, there is still a long way to go. In the process, controlling speed is key, while improving the quality and efficiency of financial services is the core. Dealing with the relationship between opening financial markets, financial supervision and exchange rate reform will continue to test the patience and determination of the Chinese government.

He Fan is a professor of economics at Peking University’s HSBC Business School (PHBS) and director of the Research Institute of the Maritime Silk Road (RIMS). Zhu He is postdoctoral research fellow at PHBS. Ye Qianlin is a junior researcher at RIMS.