China prioritises financial reform

Reform of the financial sector should help bolster China’s domestic demand by aiding its massive rural economy as well as enabling individuals and companies to invest overseas.

Back in 1978, China began its metamorphosis from a state-oriented to a market-based economy. This process continues today, but is still far from complete. Within the more general economic reform programme, financial reform has been a major priority in recent years.

So while most recent comment on China has focused on the astonishing rise of the domestic equity market, the story of financial reform continues, albeit at a gradual pace. Having witnessed the experience of Russia in the 1990s, China has no wish for a Big Bang approach.

Several key financial reforms have been announced so far this year. January saw the launch of the daily Shanghai Inter-bank Offered Rate (Shibor) and the creation of a yield curve from overnight to one year in duration. This has provided money markets with a benchmark for other financial products, which in turn has helped to diversify and deepen these markets. New financial products have been created, including interest rate swaps and forward interest rate agreements.

The revised Regulation on Futures Transactions expanded the futures market into commodity and financial futures, as well as options on futures. This has diversified the product range and offers companies more options in financial risk management.

Chinese policy documents often have long titles, at least in English translation and if you are stuck for a summer holiday reading idea, I can recommend “Opinions of the State Council on Deepening a Fully-fledged Financial Reform to Promote the Sustainable Healthy and Sound Development of the Financial Industry”. This document argues that the flotation experiences of the Industrial and Commercial Bank of China, Bank of China and China Construction Bank will inform plans to reform the one remaining major state controlled bank, the Agricultural Bank of China.

Reform of this institution will help to improve the rural financial system, which is essential if the benefits of economic growth are to spread beyond the cities: China is still less urbanised than Britain was in 1851.

In July 2005, China introduced a major reform to its managed floating exchange rate regime. This allowed the renminbi to float in wider bands, with reference to a basket of currencies. Currency reform has been further enhanced this year, with a relaxation in foreign exchange controls. China has large and growing foreign exchange reserves, which account for almost 70% of China’s external assets.

Overseas investment by individuals and companies remains a tiny proportion of the total. This is in marked contrast to more developed economies where external investment by the private sector plays a key role in balancing the balance of payments.

The experience of other countries suggests that China is about to enter a period of rapid increase in outward investment by the non-government sector, including individuals. In Britain, this is likely to take the form of greater interest in British assets, including bonds, equities, property, art and privately held companies – possibly even football clubs.

Further relaxation of exchange controls is likely as this process begins. The most recent quarterly monetary policy report from the People’s Bank of China states that “it is crucial to encourage enterprises and households to invest abroad”. It could not be any clearer.

Outside the financial sector, there have been other reforms. In January, the National Development and Reform Committee announced the adoption of a new refined oil pricing system and a phasing out of government subsidies.

The reform of the energy sector is important for China and the rest of the world, as artificially low prices in China encourage more consumption and waste. Low energy costs have also had the effect of giving additional stimulus to China’s already booming export economy. The challenge for policy makers will be to control the pace of reform, to take into account the impact of energy price rises on the lives of a population that, on average, remains poor.

The factor that unites all these developments is the growing use of the market mechanism to achieve internal balance within China’s economy and external balance with rest of the world. The Chinese authorities are keen to boost domestic demand, in order to re-orientate the economy away from an emphasis on exports.

China will move at its own pace, however, so it is a major question whether reform can come quickly enough to slow or even reverse the imbalances that have built up within China and between the country and the rest of the world. This is essential if a protectionist backlash in America and elsewhere is to be avoided.