Sunday, October 12, 2008

New Frontiers for China's Financial Sector

Redrawing supervisory boundaries and relaxing controls would benefit China's financial services sector - and its economy.
By Wu Xiaoling, deputy director of the Financial and Economic Committee of the National People's Congress - 10-07 / Caijing Magazine

Thirty years of economic reform set a course for the enormous achievements now apparent in China's financial sector. By and large, a macro-regulation mechanism and a financing system are solidly in place, providing a proper environment for market development.

Nevertheless, China's financial services sector lags far behind the relatively sound system in the United States. Although the United States is currently plagued by an unprecedented financial crisis, it still plays a leading role around the world, with the U.S. dollar holding a dominant position.

China's economy has been integrated into the world economy; we cannot and should not close our door again. However, decision makers that set policy for the financial sector have been excessively cautious. The lack of a trailblazing spirit has created a bottleneck that restricts the further development of China's financial services industry and negatively influences efficient resource allocation.

Thanks to globalization, a nation today can choose to build a sound and energetic financial system, or merely participate in the world's financial markets while passively accepting risks. China should choose the first option. But first, a new round of financial sector reform is needed. Chinese enterprises must be encouraged to grow and encourage creativity by shedding superfluous controls, allowing the financial services industry to better serve the real economy.

Financial Reform

Financial reform will determine the future of China's competitiveness and the power of its enterprises. China boasts advanced technology, aggressive entrepreneurs, a large domestic market and liaisons with the global market. However, tight financial market controls can restrict full play of these positive factors. In a market economy, the financial services industry plays a leading role in allocating resources. Eliminating unnecessary controls can enhance the efficiency of resource allocation so talented people can get the resources and capital they need to raise national productivity.

Some worry that releasing controls may lead to more crime and market risks. But it is impossible to completely avoid risk in a market characterized by risk. The key is to let the right individuals and corporations bear market risks, and provide proper rewards for those risk-bearing parties.

When citizens are given the right to make choices, they are willing to be responsible for their own decisions. When an increasing number of fair players enter a financial market, illegal dealers and financial criminals are suppressed. With 30 years of reform and opening up behind them, Chinese investors are now more mature. Their confidence has swelled. Of course, financial reform may bring new risks to the system but, at the same time, the market's maturation may be encouraged.

The United States has survived many crisis periods. Still, its market has become the world's most extensive, with deep roots. Its success is based on respect for the free will of the market, supervisory enforcement, and learning from their crises.

The latest turmoil marked by the subprime credit crunch has exerted a negative impact on the U.S. and global economies. Now these risks are being borne by the world, not the United States alone. Although this crisis was not caused by innovative financial products, it will be blamed on these innovations as well as supervisors who strayed from basic economic and banking principles. Ignored were the facts that excessive lending on the real estate market may create bubbles, that basic financial products carry risks, and that derivative product dangers can rise perilously like a high tide on a beach.

Loan packages sold as securities should be supervised. Derivative products scatter, but cannot decrease, risk. Derivative products prevent clients from seeing a clear picture of financial risks, which can accumulate beyond a market's acceptable range. Risk-bearing parties are necessary in a financial market, but supervisors must control risks.

Appropriate Controls

Given the present circumstances in the world economy and inflation pressure, how should China shape its policy? The answer is to give full play to market price signals and market oriented resource allocation mechanisms. Such a macro-regulation policy would effectively guide the economy to higher efficiency levels.

Reforms over the past three decades were aimed at changing price distortions and subjective resource allocation. Prices should reflect the market’s demand for limited resources, and the development mode based on wasting resources should be changed.

Streamline the pricing mechanism, change the economic growth mode and control inflation – these are the immediate tasks. I think tighter monetary policy, a flexible financing policy and moderate easing of fiscal policy should be combined to reach these goals. We should distinguish between macro-monetary policy and micro financial activities. Restricting financing channels may stifle the economy and eliminate controls on monetary flows; restricting financing channels offers nothing more than disaster for the economy.

Inflation, regardless of its actual cause, is a monetary issue. An adequate money supply is needed to match a price surge. If a surge is caused by excess demand, measures to suppress demand may be adopted. If inflation is driven by more expensive imports or higher costs, economic restructuring and controls on monetary demand are required.

Simply put, monetary demand controls are always needed, and a moderately tight monetary policy that's aimed solely at controlling the money demand M2 can have the greatest impact on inflation. Only commercial banks that offer deposits and loans can increase a market's M2. Other financial institutions can enhance monetary flow but do not contribute to the total money supply.

However, monetary policy can change financial activity costs by adjusting commercial bank operations in ways that control society's demands for financing. Meanwhile, a flexible financing policy would encourage many financial institutions -- aside from commercial banks -- such as trust funds, asset management companies and agents that handle stocks and bonds.

Market interest rates can help with restructuring by adjusting demand for financing. But essential production inputs in China are currently subjected to distorted prices, even during what's now an extensive economic development mode. Adjusting the price mechanism may increase inflationary pressure, but this influence can be controlled. Pushing forward with price mechanism adjustment requires that society put up with inflation pressure for a period of time, even if the money supply is tightened. But fiscal policy can be moderated with basic living subsidies for the unemployed and underprivileged to prevent social turmoil, all the while inefficient enterprises are eliminated.

Protecting Property Rights

Protecting citizen property rights, which have been guaranteed by constitutional amendment in China, should be an incentive for the government to release its grip on the financing market. The reason is embedded in the market economy’s concept of private ownership. Individual property rights include the right to possess, use, benefit from and dispose of property. Benefit and disposal rights are key. Property can be consumed or donated. It also can be managed for profit-taking, savings, or managed for securities and lending. As these financial activities do not involve public interests, they should be freely respected. Actually, these activities can serve as a foundation for economic development.

Supporting the intermediary role of financial institutions is also important. Banks and insurance companies take in money from clients and provide financing for others. Securities firms, investment banks, trusts and asset management companies build bridges between investors and fund-raisers. Since these organizations do business in the realm of public interest, many countries supervise their operations. However, financial institution supervision should not apply to individuals exercising their right to profit by disposing property. Encroaching on the right to dispose property hinders the smooth development of a financial market.

Meanwhile, personal lending among individuals has not received proper attention in China. This type of financing is in a gray zone. Lending and borrowing is a civil behavior; citizens and companies who lend their own money should not be restricted. Simple contract law can regulate these deals, although legal restrictions should protect public interests. Individuals and companies that cut loan deals with public funds should be supervised.

The People's Bank of China, the nation's central bank, is calling for legislation aimed at regulating lenders and lending companies that do not tap public funds. The proposal would respect the rights of individuals and companies to use and dispose of property.

Boundary Line for Supervision

Invigorating the financial sector market requires setting supervisory boundaries. Administrative costs will be extremely high if supervision is limited to industry watchdogs or the government -- a fact proven during China's experience with 30 years of reform. Besides, such supervision would be ineffective. Economist Andrei Shleifer has described several regulatory stages for a society, ranging from anarchism to government control. I realize some principles have to be followed to increase economic efficiencies and reduce business costs.

For example, two parties should be allowed to negotiate contracts entirely on their own. If disputes arise, they should resolve differences alone or with a mutually agreed upon third party. Some disputes may be handled by courts to prevent social conflict, and some multiparty contracts can be supervised by an industry watchdog, as is the current practice of financial industry regulators. Other issues involving national interests, such as those raised during financial crises, would require government intervention. From the perspective of lowering deal costs, self-management rights should be permitted for only when issues involve several parties. Issues involving large groups should be administrated by a supervisory agency.

This principle is accepted by most countries with developed financial markets. The operations of some eligible investors, such as private equity traders, are not included in the range of supervision. Some non-bank financial institutions are supervised in a more relaxed way, while others are regulated by an industry association or through self-governance. China’s legislation regarding financial market practices, such as regulations for private companies with fewer than 200 unlisted shares, also provides for more relaxed supervision.

China has reached a stage of abundant wealth accumulation. This has led to the emergence of asset management services as a focus of expansion among financial institutions. Banks, trusts, brokerage houses, insurance companies and fund management companies all have set eyes on this sea of wealth. Satisfying this market demand was one goal of the Qualified Domestic Institutional Investor program known as QDII. At the core of the QDII services offered by banks, securities firms and insurance companies is a trust relationship. Through this trust, investors who agree to bear risks consign their funds to trustees. These trustees are then responsible for investing and earning service commissions.

Now, unified supervision standards should be established to reduce costs and increase the efficiency of supervisory efforts. Finding ways to distinguish between high- and low-risk bearers, as well as drawing lines between the financial activities of small groups and the public, is a basic means for setting supervisory boundaries. Granting self-governance rights in financial markets to those who have the ability to cope with high risks is conducive to increasing market funding sources and unleashing creative energy.

At the same time, supervision efforts should focus on the financial activities of members of society from different walks of life, including those who pose potential dangers to social stability and the financial system. In this way, administrative costs can be controlled while the financial services industry grows in a sound environment.