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Economy

Opening and Reform of China’s Financial Sector: the Time is Now

Dec 12 , 2019

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Throughout the year, officials in Beijing have made encouraging announcements regarding the opening of China’s financial sector. Most notably, regulators will remove the limits on foreign ownership of fund management, insurance, and securities firms throughout 2020, one year ahead of schedule. This is a positive development for many foreign firms who have visions of establishing or expanding their operations in China. American and European firms such as Goldman Sachs, JP Morgan, UBS, and others are considering renegotiating their existing joint ventures with their local Chinese partners to take a larger ownership stake or possibly full ownership of their local operations.

Yet, as important as these announcements are, the greater significance and long-term impact of these regulatory changes is that they are in best interest of China itself. The time for bold modernization of the financial sector is now. Opening and reform stimulates financial efficiency of enterprises, creates product innovation from which both companies and the public can benefit, and protects the financial sector system-wide.

A main argument for continued reform of the financial sector is that it will accelerate financial innovation. Development of new financial products should continue to be a priority for China’s financial markets, as they provide additional opportunities for companies to receive improved and timely market signals and deploy newly-fashioned instruments (including derivatives) when necessary. Treasury departments at companies can expand their menu of financial engineering methods to include greater adoption of currency forwards, credit, interest rates, collateral swaps, and other products to improve forecasts and gauge their liquidity needs. In addition, monitoring the inherent maturity mismatch in short-term liabilities funding longer-term assets, as well as hedging exposures to interest rate movements and foreign exchange fluctuations becomes easier to manage. 

Equally important are the benefits that the public – meaning Chinese retail investors – will gain from financial innovation. As WMPs (wealth management products) with implicit guarantees and nested, opaque structures begin to decline, the industry will continue a gradual shift from a “quasi asset management” model to a more traditional asset management structure, more akin to that of other parts of the world. Shifting from WMPs, asset management firms can develop different styles of mutual funds: ETFs (exchange traded funds), target funds (funds with specific retirement dates), sector-focused funds, broader variety of active vs. passively managed funds, index funds, commodity funds, quant/algo funds, and other fund structures. Additional choice of financial products will allow investors to better mitigate market risk and manage their wealth. Over time, with the increasing adoption of these products, Chinese retail investors will become more knowledgeable of the mechanics driving capital markets, and their greater level of investment sophistication will change the current short-term trading mentality to a longer-term investment outlook that reduces market volatility and helps to stabilize the market. These developments will spur additional waves of financial innovation as newer products are demanded and eventually created by traditional financial institutions and fintech companies.

Financial innovation and opening also serves to identify and mitigate risks earlier on due to the introduction of more advanced risk management techniques. For example, Chinese banks can develop customized early warning indicators to better identify and monitor risks on their books caused by idiosyncratic or systemic events and subsequently take appropriate measures. As China’s banks have gone global to support business activities of outbound local firms, it becomes increasingly challenging to have an accurate and timely read on the whole enterprise. This is understandable. In today’s environment, how does a treasurer coordinate even basic functions such as funding needs, cashflow forecasting, and intraday liquidity requirements across various treasury centers spanning the globe? Typically, those decisions are made in a silo without a comprehensive view of the larger corporate need. There is no magic button that a Treasurer or a CFO can press to answer this question across all the business lines, legal entities, and geographies. However, financial innovation – increased adoption of financial technology, plus deployment of more advanced hedging instruments (e.g. derivatives) and macroprudential tools (e.g. haircuts on assets, reserve requirements, and liquidity ratios), all of which are spurred by financial innovation – can result in enhanced vigilance and create a more robust control environment for Chinese firms. Partnerships with foreign financial institutions, which can share the best practices used and lessons learned during the financial crisis of 2008 and were mandated by subsequent regulations in the U.S. (such as Dodd Frank) and Europe, serve to strengthen institutional resiliency system-wide, one of the primary goals of the CBRC (China Banking and Regulatory Commission). On a system-wide basis, bolder financial reform is needed to continue deleveraging efforts and curtail the shadow banking sector that has roared back to life and is now worth about $8.4 trillion USD. 

Opening the financial sector brings numerous benefits for China at both the institutional and retail levels. But in the current context of the ongoing trade war between China and the United States, financial reform should not be politicized by either party and used as a bargaining chip.  Furthermore, given the slowdown of the Chinese economy due to the late stage of a global economic cycle coupled with the effects of the ongoing trade war, opening the financial sector is conducive to long-term economic growth by fostering better allocation of capital and removing information asymmetries that hamper companies in developing nations. As this essay makes the case, the greater significance and long-term impact of these regulatory changes is that they are in best interest of China itself. Modernization of the financial sector stimulates capital efficiency of enterprises and creates financial innovation from which both companies and the public can benefit. The time for bold reforms to continue is now.

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