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Capital Market Reforms: Two Out of Three Ain’t Bad

本文发表于Bloomberg Brief的三中全会一年后回顾专刊,转载请注明出处。


Liberalization of the financial sector is at the heart of the government's reform agenda. A year on from the Third Plenum, the market is playing a significantly greater role in setting interest and exchange rates, and private firms are poised to change the character of the banking sector. On the opening of the capital account, a complex international environment and growing domestic financial risks mean progress has been more limited.

 

It wasn't necessary to wait long after the end of the Third Plenum to see the government's commitment to financial reforms. In March, the daily fluctuation band of the yuan against the dollar was widened to plus or minus 2 percent. The yuan depreciated about 3.5 percent against dollar in the first half of 2014. That reflected the central bank intervening in the foreign exchange market to curb the carry trade, liquidation of bets on yuan appreciation, and deteriorating macro-economic data. With the current account surplus shrinking and short-term capital flows volatile, the yuan's one-way appreciation trend has already ended. Looking forward, the risk of capital outflow triggering significant yuan depreciation can't be ignored.

 

All interest rates except the benchmark deposit rate have already been liberalized. In 2014, commercial banks were encouraged to issue more medium-term certificates of deposit, with interest rates determined by market supply and demand. Wealth management products and money market funds continue to offer savers market rates for their funds - a type of back door interest rate liberalization. According to central bank governor Zhou Xiaochuan, liberalization will be completed in the next 1 or 2 years. The national deposit insurance company - a pre-requisite for market set rates - could be established by the end of 2014 or the early 2015. That would also pave the way for some small and medium size banks to fall into bankruptcy, without triggering widespread panics about the health of the sector or runs on the remaining banks.

 

Several private firms have received licenses to start operating banks, including internet giants Alibaba and Tencent. In the short-term, private banks will not have the scale to compete directly with state-owned banks. Looking longer-term though, firms like Alibaba - which already work with millions of small businesses on their Taobao e-commerce platform, could plug the gaps left by the state banks - which tend to focus loans on major industrial projects. Both interest rate liberalization and the creation of private banks introduce new risks. In other countries - including the U.S. and Japan - interest rate liberalization has triggered financial crises. That means stronger macro-prudential regulation - for example ensuring banks have an adequate capital buffer - has to accompany reforms.

 

Despite continued controls on the capital account, both the scale and the volatility of short-term fund flows have increased noticeably in the past several years. For example, the short-term capital outflow reached USD 14.8 billion in 1H14, compared to a USD 92.1 billion short-term capital inflow in 1H11. Yuan internationalization has opened new loopholes for funds to move across the border under the disguise of yuan trade settlement. The Shanghai Free Trade Zone and the tie up between the H share market in Hong Kong and A share market in Shanghai also create new openings for international capital flows.


Still, progress on capital account opening - including the development of the Shanghai Free Trade Zone - has been below expectations. That reflects a tough balancing act for China's government between increasing efficiency by liberalizing capital flows and avoiding the crisis that might follow from sudden capital outflows. The coming increase in interest rates in the US as the Federal Reserve completes its exit from quantitative easing raises the chance of capital outflows from emerging markets - including China. Past excesses in China's lending make the problem more acute. Excess capacity in industry and real estate mean the banks face a potential surge in non-performing loans - increasing their vulnerability to an exodus of funds. The fear of sudden outflows triggering yuan depreciation and a financial crisis rightly makes the People's Bank of China proceed with caution.

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