Cambridge Judge Business School

Like dismantling a nuclear bomb: liberalising the Chinese financial system

Simon TaylorDirector, Cambridge Master of Finance

CCBN

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The message

Liberalising a distorted financial system is dangerous

China has a very distorted financial system

And it is the largest attempted liberalisation in history

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Liberalisation is like un-damming a river

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Financial liberalisation is dangerous

Source: IMF “Do inflows or outflows dominate?” WP 13/189 http://www.imf.org/external/pubs/ft/wp/2013/wp13189.pdf

Financial or exchange rate crises following capital flow liberalisation

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The context: rebalancing the Chinese economy

Rebalancing needed:

From state to private sector

From manufacturing to services

From investment to consumption

Source: IMF Article IV report 2013 http://www.imf.org/external/pubs/ft/scr/2013/cr13211.pdf

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All require (among other things) liberalisation of the financial system

1. Internal: Market based interest rates

2. External: Allowing free capital flows into/out of China (“internationalisation of the RMB”)

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The government intends to liberalise

“Since the onset of the new millennium, China has clearly put forward the strategic objective to build a market-oriented and more open economic system.”

Liu Shiyu, Deputy Governor, People’s Bank of China, 2013 (*)

“We need to ensure that the market plays the decisive role in allocating resources and make the government better play its role, vigorously advance reforms conducive to economic structural adjustment, remove constraints on market actors and efficiently allocating factors of production, fully tap the creative potential in society, promote fairness and justice, and enable everyone to share in the fruits of reform and development.”

Premier Li Keqiang, report to National People’s Progress, 2014

(*) in Das, Udaibir S.; Fiechter, Jonathan; Sun, Tao (2013). “China's Road to Greater Financial Stability: Some Policy Perspectives” (IMF)

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People's Bank of China

Banks

Securities companies

Insurance companies

China’s financial system is dominated by banks

Holdings of financial assets, 2012

Source: PBOC

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State Council

State-owned Assets Supervision and

Administration Commission

123 Central State-owned Enterprise Groups

National Development and Reform Commission

China Banking Regulatory Commission

China Insurance Regulatory Commission

China Securities Regulatory Commission

China Import-Export Bank

Agricultural Development Bank of

China

Administrative reporting line

Regulatory reporting line

Ownership based on equity investment

Ministry of Finance

People’s Bank of China

China Investment Corporation

Central Huijin Investment

Agricultural Bank of China

Bank of China

China Construction Bank

Industrial and Commercial Bank of China

China Development Bank

Huarong Asset Management Company

Orient Asset Management Company

Huida Asset Management Company

Cinda Asset Management Company

Great Wall Asset Management Company

SAFE Investment Corporation

State control of key banks

Source: Walter & Howie (2011) “Red Capitalism” Appendix

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The economics of liberalisation (1)

Interest rate

Quantity of lending

Demand for loans

Supply of funds

Market clearing rate r

q*

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The economics of liberalisation (2)

Interest rate

Quantity of lending

Demand for loans

Supply of funds

Market clearing rate r

Government set rate g

q2q1

Excess demand q2 – q1

Results in:1. SMEs starved of credit2. Depositors looking for

better rates

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Non-bank lending has grown dramatically since the financial crisis

Total social financing (RMB trillion)

Source: IMF “China’s monetary policy and interest rate liberalisation” WP 14/75) http://www.imf.org/external/pubs/ft/wp/2014/wp1475.pdf

WMP rates and bank deposit rates

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International capital flows have become less restricted

1997

2010

Source: IMF “Effects of capital flow liberalisation” WP 12/275 https://www.imf.org/external/pubs/ft/wp/2012/wp12275.pdf

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But not China’s capital account

Source: IMF “Do inflows or outflows dominate?” WP 13/189 http://www.imf.org/external/pubs/ft/wp/2013/wp13189.pdf

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The restrictions are gradually being lifted

Source: IMF “Do inflows or outflows dominate?” WP 13/189 http://www.imf.org/external/pubs/ft/wp/2013/wp13189.pdf

Qualified domestic and foreign institutional investor flows

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Huge FX reserves are evidence of managed exchange rate

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

2014 (*)

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

China’s foreign exchange reserves (US$ billion)

(*) End of Q1 2014

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Liberalising China’s international capital flows could bring big benefits

Effects of liberalising China’s capital flows (%)

Source: IMF “Effects of capital flow liberalisation” WP 12/275 https://www.imf.org/external/pubs/ft/wp/2012/wp12275.pdf

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China could see 15-20% of GDP worth of outflows

Source: IMF “Do inflows or outflows dominate?” WP 13/189 http://www.imf.org/external/pubs/ft/wp/2013/wp13189.pdf

China

India

Equivalent to:0-2% of US equities1-3% of US bonds4-10% of EM equities & bonds

Goldman Sachs estimate $6 trillion of Chinese outflows

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Some things to worry about

Mass corporate bankruptcies: higher market interest rates put many highly indebted businesses into crisis

Japanese-style bubble and bust: surge in RMB followed by further asset appreciation then collapse

Real estate market collapse: sudden portfolio shift from domestic property to foreign assets, causing banking crisis

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China’s debt is now high for a country of its income per head

Source: IMF Article IV Report 2013

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China’s exceptionally high savings and investment rates

Source: IMF Article IV reports

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Household savings and investment

Household savings are high: removal of the “iron rice-bowl”, one child policy

Where do you put your savings?

Bank – low interest rates

Stock market – not trusted

Bond market – barely exists

Mutual funds – invest in the above, not trusted

Foreign assets – not allowed

Real estate – yes!

So, on top of genuine need for new housing, the Chinese economy is systematically biased towards investing in real estate

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The real estate market: is it a bubble?

Peak investment in housingHousing inventory

Share of housing stock built before 2000Breakdown of fixed asset investment 2013

Source: Nomura Asia Insights 14 March 2014

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The Japanese nightmare: index of property prices

CommercialResidentialIndustrial

Source: Japanese Real Estate Institute http://www.reinet.or.jp/en/pdf/2013/Nov2013-Ur-Nationwide.pdf

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Reasons to be hopeful

Not going first: China can learn from other countries’ experience

Track record: China dealt effectively with a serious banking problem in the late 1990s

Pragmatism: the government will not adopt a “big bang” approach but steadily move in the right direction

s.taylor@jbs.cam.ac.uk