• Unwelcome capital outflows forced China to take a break in its very gradual financial liberalization. New leadership have decided to accelerate efforts to modernize the financial sector
  • Because of systemic importance, China must manage the trifecta of sustainable and balanced growth promotion, financial liberalization and financial stability
  • Successful financial liberalization must include: Stronger institutions and Financial Literacy; A modern, integrated and innovative financial system; and State-of-the-art Asset and Liability Management

Backwardness:’ advantages Step-by-step Financial Liberalization

Financial liberalization, or the deregulation of domestic financial markets and the liberalization of the capital account, is an engine of growth, for middle income countries. It also comes with risks that must, and can be minimized. Policy- and business-related lessons may be of relevance to successful financial liberalization in China.

Financial liberalization can lead to productive credit expansion and a better allocation of capital, both serving as growth boosters. But it can also aggravate boom and bust cycles and worsen inequality. This duality has played out in previous recent episodes of financial liberalization in East Asia, Latin America and the Nordic countries, thereby providing insights for other countries, including China, to seize the opportunities of financial liberalization while minimizing key risks.

Firstly, financial literacy plays an important role in getting the balance right. Secondly, holistic regulation and supervision mechanisms are essential to success. Thirdly, relevant reform sequencing and a flexible approach to crisis management are needed.

China has adopted a gradual approach towards financial liberalization and this strategy has proven right so far. The economy has to manage the trifecta of sustainable growth promotion, financial stability strengthening and financial liberalization development.

Firstly, economic growth must be sustainable in order to move the country up from the middle-income category and keep social stability in check. A more balanced growth, based on private consumption will help achieve this goal. Secondly, maintaining financial stability will be essential to avoiding boom-bust cycles. Note that The Bank for International Settlements (BIS) data, points to a high leverage of 257% of GDP in Q3-2017 (compared to 146% of GDP in Q1 2006). Thirdly, financial liberalization has already begun and had results. Progress has been made, with policy makers showing considerable agility and willingness to learn from experience, theirs and others. Interest rate liberalization is formally completed and monetary policy is modernizing.

The authorities have been gradually moving towards the liberalization of the capital account, though efforts have slowed in 2015-17: risk-off mode led to strong capital outflows (USD647bn and USD646bn in 2015 and 2016 respectively) and authorities stepped up capital flow management measures (e.g. additional documentation for outward investment; caps on annual overseas withdrawal).

2018: A turning point?

At the end of 2017, China took steps to encourage capital inflows and its authorities announced plans that would ease limits on foreign ownership of banks and securities companies (November 2017).

The China Banking Regulatory Commission followed up on the promise with a revised regulation, facilitating administrative procedures for foreign banks conducting business and investing in China, beginning of this year.

In March 2018, financial markets welcomed some good news including the launch of oil crude oil futures in Shanghai Futures Exchange and the internationalization of China’s iron ore futures market. In June 2018, 233 A-shares has been added in MSCI’s global benchmark. Concerning outflows, there has been little change; however, more favorable economic conditions (e.g. solid growth in private consumption, producer reflation) and a more stable RMB provide a window of opportunity for renewed progress and greater reform.

On the political and policy fronts, the nomination of Mr. Liu He as Vice Premier in charge of Economic Affairs, Mr. Yi Gang as a the new People’s Bank of China governor points to further pro-liberalization efforts. Early this year, Liu He provided a keynote speech at the World Economic Forum about China’s Economic Policy for the next years. Key messages resonate with a cautious, holistic but gradual financial liberalization process:

The necessity to transition the Chinese economy from a phase of rapid growth to one of high-quality development; The necessity to prevent and resolve major financial risks, especially through decreasing shadow banking and hidden debts for local government. The main goal is to effectively decrease overall leverage ratio in the next 3 years; and

The necessity to reform and open up at a faster pace. China will further integrate with international trade rules and ease market access, and will also substantially open up the services sector, the financial sector in particular, and create a more attractive investment environment.

Mr. Yi Gang in his first public speech as central bank governor also highlighted the importance of a gradual financial opening. The latter must continue as it leads to progress but should be associated with measures to reduce financial risks. He identified three critical tasks for his institutions: (i) the implementation of a prudent monetary policy; (ii) the opening of the financial sector; and (iii) the reduction of financial risks. These announcements were followed by a more detailed plan during the Boao forum.  He announced six measures which should be implemented by June 2018, five others should be enacted by the end of this year (see table 1).

Table 1 Key measures announced in the Boao Forum (April 8-11, 2018)