Practical analysis for investment professionals
14 November 2013

The Case for Financial Sector Liberalization in China

In early August, I had the privilege of attending a Future of Finance salon session in Beijing. Participants represented various stakeholder groups from China’s financial industry. This article highlights some of the key takeaways.

One thing I found illuminating is how standard industry definitions we take for granted do not apply in China. One example is how we perceive the word market. For most people in the West, this term is defined as a place in which a product’s value is reflected in the demand and supply of that product at a given point in time. However, the local view is that for the ordinary person in China, “market” is defined simply as “the government.” This view is due to the importance of the government’s involvement, through state-owned enterprises (SOEs), in the various activities in China’s domestic economy.

Although China is transitioning toward a capitalist system, SOEs continue to play an important part in China’s economic development. The involvement of SOEs has led to very little progress in the financial markets, which, in turn, has caused distortions in the allocation of capital to unproductive industries.

The panelists highlighted three consequences of this structure. First, the dominance of local domestic banks has led to high intermediation costs between depositors and borrowers, with the spread estimated to be between 2 and 3 percentage points. This burden stifles the development of an interest rate market, and with the artificially low interest rates paid on savings accounts, depositors seeking a greater return on their funds have to find alternative assets. Two asset classes have benefited. The first is the property market. The second is the “trust” product market, which consists of products structured to finance local developers and local governments outside the banking system. In the case of the property market, many believe that the quick rise in prices looks like a bubble in the making. Meanwhile, in the case of trust products, the product originators and distributors are potentially sitting on a time bomb if defaults are not addressed appropriately when they occur. The panelists explained that currently for small defaults, firms tend to absorb the losses and make whole the customers’ principal. Given that the size of this market is estimated at US$1.4 billion, this practice may become a moral hazard problem if the economy slows down and the rate of defaults accelerates.

Second, from the perspective of local banks, their credit risk is minimal if their lending activities are directed to SOEs. This practice has led to an over-allocation of funding to SOEs at the expense of small and medium-size enterprises (SMEs), which are forced to find alternative funding sources to develop their businesses. This outcome is considered the primary reason for the existence of China’s shadow banking market, which SMEs use as a source of their funding requirements. Despite the negative opinions portrayed in the media, however, the consensus view was that the shadow banking market is actually satisfying a capital market function, albeit in an opaque manner. Regulators seem to be aware that the shadow market is fulfilling a role in the development of the Chinese economy and are monitoring it from a distance.

Third, although China is slowly liberalizing its financial markets, retail investors have little understanding of the investment process. One example cited was the development of the government security market, which was widely regarded as a casino when it began in 1992. The panelists lamented that some 20 years later — and after a shift from debt securities to equities — the public still holds the same view.

So, what can China do? The panelists suggested that China quicken the pace of its financial liberalization. This process should start at the top with a consolidation of the regulatory functions of three main bodies: the Ministry of Finance, the China Securities Regulatory Commission, and the People’s Bank of China. This approach would avoid the confusion and complications associated with regulatory oversight by three separate bodies. Second, the intermediation cost of money should be reduced by letting interest rates be determined by market forces, allowing for a better allocation of capital in the economy. Finally, for all of this to work, financial literacy in China must improve considerably so that investors can effectively participate in the development of the Chinese financial industry.

CFA Institute and the newly established CFA Society Beijing have a role to play by encouraging more people to sign up for the CFA Program and by advocating for investor-focused policies.

This article originally appeared in the November/December 2013 issue of CFA Institute Magazine.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: CobbleCC

About the Author(s)
Tony Tan, DBA, CFA

Tony Tan, DBA, CFA, is co-head of the CFA Institute Ethics, Standards, and Professional Conduct division. He is particularly responsible for ethics education offerings and the professional standards of CFA Institute. He is also a member of CFA Society Singapore.

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