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From Economic Reforms to Financial Reforms

May 25 , 2012

Recently, the U.S.-Chinese Strategic & Economic Dialogue (S&ED) was overshadowed by international politics, rapid escalation of challenges in the Eurozone, and debates on the slowdown in Asia.

Nonetheless, the Dialogue was surprisingly productive, in light of the magnitude of challenges facing the global economy and Sino-U.S. bilateral relations today. 

Most importantly, it precipitated a major shift in China from economic reforms toward financial reforms.

Centrifugal pressures in commodities

Another result of the S&ED was a deal that will let foreign groups establish joint venture brokerages for Chinese commodity futures.

China is already one of the world’s largest importers of iron ore and copper, and a force in the gold market. Nonetheless, the current status quo is unsustainable. On the one hand, China is the world’s largest consumer of commodities. On the other hand, China is largely on sidelines with regard to global commodity prices, which continue to be set in London, New York City, and Chicago.

In the future, this is likely to change as the renminbi (RMB) is expected to become a key commodities currency. Some analysts expect that to happen in “just 10-20 years.” But change could occur faster.

Due to its continued urbanization drive, coupled with high global demand for commodities, and rising inflation, China cannot stand on the sidelines when it comes to having a say in setting commodity prices.

True, the continued reliance on Western markets to set prices is based on trust in established legal systems and the security of pricing contracts in a freely convertible currency. But even the U.S. dollar cannot rule indefinitely markets driven by China and other large emerging economies.

Accelerated RMB internationalization

A few years ago, a number of nations – reportedly, China, Russia, Brazil, Japan and oil producers in the Middle East – agreed that oil should no longer be priced on U.S. dollar by 2018. It is only prudent to assume that significant pricing changes in one commodity are likely to parallel those in other kinds of commodities.

China may be moving faster to foster capital account convertibility, declaring that the RMB can be used more internationally while the latter remains partly inconvertible. Concurrently, Chinese regulators may reserve the right to reduce liberalization at times of turmoil. After the Asian financial crisis in 1997-1998 and the global crisis of 2008-2009, there is more understanding toward such policies worldwide.

In turn, higher foreign earnings from international capital market and asset management activities will further increase the power, profitability and status of Chinese banks. These banks are also expected to move into asset management, trade finance and project finance, which Western banks used to see as their exclusive playing field.

Recently, the first Hong Kong – London forum promoting the offshore RMB business pledged to cooperate in boosting the offshore business. The alignment of these two global financial hubs provides China a financial center in Europe, which will contribute to the RMB internationalization.

In London, a number of initiatives were announced or signaled. One plan is to “provide direct foreign exchange quotes of RMB against GBP, Euro, and other currencies.”

Years of currency friction between Washington and Beijing and the ongoing harsh election rhetoric in the United States may contribute to such plans. China is enhancing the international position of the RMB, while reducing China’s dependence on the U.S. dollar.

Year of privatizations?

In the past few months, the more-or-less-informed observers in the West have been betting that China is about to suffer a “hard landing.” And certainly, China is not immune to the recessionary conditions that have swept the West.

However, it may be useful to recall that when the world economy was amidst its free fall in fall 2008, same observers were confident that China faced imminent collapse, plummeting growth, divisive riots and social chaos.

China is at a new crossroads, but the sense of gloom and doom may miss the big picture. In February, China’s State Council defined the execution of a new round of privatizations as the paramount priority among all planned reforms in the ongoing year. The “New 36 Clauses” is a prudent but practical plan to push privatization in state-owned assets in monopoly sectors, including railways, energy, financial, telecoms, education and healthcare.

While the skeptics like to point out that these plans are hardly new, times are changing.

Today the world is curved, lumpy and unpredictable. The Eurozone crisis has barely begun. In the U.S. the economic hangover will hit home after the elections. And money presses will continue to be overheating across the West.

When the world economy was still amidst rapid global growth, local governments and state-owned enterprises (SOEs) had few incentives to privatize.

Today, complacency is no longer an option.

The Great Transition

Despite three decades of success in economic reforms and a decade of rapid achievements in financial reforms, China’s financial system has a long way to go.

True, China’s banking, brokerage, insurance, and asset management industries have enjoyed robust growth and sound profits for more than half a decade. In the process, equity, bond, and currency markets have expanded substantially.

Today, the 75% ceiling for loan-deposit ratio (LDR) continues to constrain commercial banks from growing their lending.

China’s nascent and fragmented bond market remains too small to fulfill the needs of corporate financing.

Commercial banks are coping with increasing capital adequacy pressure and must raise capital frequently. Securitization of loan portfolios could be one way to alleviate such pressures.

China’s financial markets remain relatively closed to most foreign investors and financial institutions. The gradual lowering of entry barriers could support a secure and gradual internationalization of Chinese financial markets, while boosting competition in the system.

In 2012, much of the financial reforms will occur vis-a-vis pilot programs, which herald acceleration in the equity markets in the coming years.

Recently, China's stock exchanges in Shanghai and Shenzhen also moved to allow small firms to sell bonds via private placement, opening another fundraising avenue for the country's cash-strapped small-business sector.

Moreover, China's brokerages will be allowed to take on twice as much debt in relation to their net assets, and will be given easier access to the capital markets. 

As China is stepping up market and financial reforms, it hopes to make Shanghai a key global financial hub by the end of the decade.

Further financial deregulation, gradually

Instead of a rebound, the economic slowdown in China accelerated in April. The policy loosening measures introduced after October 2011 have not yet contained the downtrend. As a result, more policy support is needed to prevent a sharper downturn in the coming months.

As the inflation pressure continues to recede, China can initiate more forceful loosening measures. New reserve requirement ratio cuts are to be expected, along with other similar measures.

The government is also more likely to soften the tightening policies on infrastructure and property investment to prevent a sharper decline in investment growth. 

It would be naive to expect the impending policy shift to translate into a profit bonanza for American banks. Along with real estate, U.S. financial sector played a central role in the global financial crisis in 2008-2009. These highly concentrated, gigantic banks remain “too-big-to-fail.”

Similarly, giant banks in Europe are highly exposed to high-risk regional debt.

It was the gradual approach that made Chinese economic reforms a success. It is that rare combination of ambition and caution that is now needed even more in financial reforms.

China is moving toward financial reforms, decisively – and gradually.

Dan Steinbock is Research Director of International Business at the India, China and America Institute.

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