Sequencing Chinas financial reform: Risks and Options

1
Sequencing Chinas financial reform Risks and
Options

• 
  
  
  
• Yanqing Yang
• Visiting Scholar
• China Studies
• Johns Hopkins University-SAIS
• yanqingyang_at_hotmail.com

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Outline

• Introduction
• NPLs and bank restructuring
• Institutional building
• Domestic financial liberalization
• International financial liberalization
• Concluding remarks

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Introduction

• pro forma economic growth
• Incremental/ Gradualist reform approach
• Pros avoidance of economic turmoil and resultant
  social unrest
• Cons delay of seemingly most difficult reforms,
  the inconsistency of reform paces in different
  sectors, and the incompatibility of different
  aspects of reform
• WTO entry financial system is receiving
  increasing pressure to step up its reform

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Financial reform in China

• most attention has been given to the
  organization-building the process of market
  developmentincluding financial liberalization---
  has received the least attention

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Sequencing matters

• Approach 1 Learning by doing
• Approach2 Get ready then go
• Country experiences highlight the importance of
  addressing early problems in financial system
  soundness
• Interest rate deregulation or NPLs?

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Step1 NPLs and bank restructuring

• Official data average NPL/ Loan portfolio ratio
  of the four SOCBs has been edging down for the
  past two years
• Some argue that the official data is
  underestimated (Lardy, 1998 SP, 2001 Bonin and
  Huang, 2002)
• My estimate system-wide loan losses (ex-AMCs)
  could range 40-44 of 2001 GDP (recovery rate
  15)

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Step1(contd.) contingent liabilities of the
central government

• (Source Huang, 2002 and authors estimation)

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Step1(contd.) Sustainable?

• municipal government debt does not necessarily
  translate into central government debt
• estimated cost of pension funds is not, however,
  a sunk cost
• standard fiscal sustainability conditions
• If Chinas economy can maintaining its growth in
  the future, the ratio of fiscal revenues to GDP
  can very likely maintain its increasing trend.

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Step1(contd.) Growing out ?

• Politically attractive cut NPL ratios by
  2-3ppts every year in the next five years in
  order to lower the average NPL ratio to below 15
  by 2005.
• Dangers delaying the process of strengthening
  banking supervision
• Managers may become very conservative and tend
  to contract loans, a negative impact on banking
  profitability and economic growth.
• Assuming that new NPLs do not emerge in the
  short-run, Managers may tend to increase lending
  to lower NPL ratio, which risks financial
  overheating.

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Step1(contd.) Radical approach full transfer
and recapitalization

• Purchasing the debt
• Convertible bonds
• Printing money
• Sale of Equity in SOE and land use rights or ABS
  (Asset-backed-securitization)
• Strategic investors or IPO
• Capital injection bond-bad-debt swap
• Tier-2 issuance

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Step1(Contd.) Institutional building

• Internal governance and reforms
• Prudential supervision
• Building bank profitability
• Assortative macroeconomic environment
• Legal and accounting reform
• Financial deepening SOE restructuring

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Step2 Domestic financial reform

• Target limit government intervention in the
  determination of interest, reduce barriers to
  competition in the financial sector, scale back
  government ownership of financial intermediaries,
  allow new financial products to appear, etc.
• Major opponents in this paper
• ------Interest rate deregulation
• ------Entry opening

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Step2 (contd.) Big bang vs. Gradualism

• Big bang Chile and New Zealand
• Gradualist approach Malaysia and Korea
• Literatures suggest a gradualist approach because
  the most needed institutional building takes time
  to establish
• Gradualist approach should not take too long
  because the existing beneficiary may permanently
  capture the rent and rent seeking could create
  more distortions

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Step2(Contd.)Preconditions

• Fiscal control
• A minimal system of prudential regulation,
  including enforcement
• Recapitalization of the banking system
• Key monetary control reforms and support for
  changes in the money market
• Reasonably stable macroeconomy
• Checks in place to limit collusive behavior among
  banks in the determination of interest rates

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Step2(Contd.) Koreas is a good model for China

• To ensure the stabilization, Korea liberalized
  loan rates first before embarking on a gradual
  freeing of deposit rates long-term deposit and
  larger deposits were freed, before moving on to
  shorter rates and smaller deposits
• A more harsh condition has been set by Chinas
  commitment to the WTO entry. Thus the sequencing
  and the timing have to be in line with the
  timetable of Chinas financial opening up.

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Step2(contd.) A dilemma

• Empirical evidence has shown that interest rate
  liberalization combined with entry requirement
  relaxation can be a deadly dose resulting in bank
  failures and possible systemic crisis

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Step2(contd.)Two possible timings

• Timing1 Free Rmb loan interest rates before 2004
  and free deposit interest rate before 2006
• Timing2 (second best, but more likely) a
  gradualist foreign entry under some implementing
  rules that does not conflict with WTO spirit,
  with a combination of restriction on domestic
  entry, which will help to maintain the franchise
  value

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Step3 International financial reform

• Target capital account liberalization and
  exchange rate regime choice.
• A liberalized or open capital market is defined
  as one in which individuals and firms can access
  international financial markets freely, not just
  one in which the government intermediates between
  international capital flows to balance
  differences in private savings and investment

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Step3(contd.)Costs and Benefits

• Costs capital outflows reduce policy
  effectiveness (Mundell, 1968)
• Benefit capital inflow and larger capital stock
  fiscal policy more effective beneficial to
  individuals
• Empirical results the ambiguous nexus between
  economic growth and free capital flows
• Empirical results controversial conclusions on
  the link between capital account openness and
  crises

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Step3(contd.) Sequencing

• Conventional view follow the opening of the
  current account and the domestic financial system
  (McKinnon, 1973, and 1991 Frenkel,1982and
  Edwards, 1984)
• Simultaneous liberalization of the current and
  capital account (Little, Scitovsky, and Scott,
  1970 Michaely, 1986 and Krueger, 1984)
• Endogenous view capital account
  liberalization could precede domestic financial
  market liberalization

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Step3(contd.)Country experiences

• Chile and Korea a gradual approach, financial
  sector reforms tended to precede capital account
  liberalization,
• Indonesia liberalized capital outflows early in
  the reform process quickly, capital account
  opening helped to promote restructuring and to
  improve the competitiveness of the domestic
  financial system.
• Thailand opened its economy to capital inflows,
  especially portfolio investment inflows much more
  rapidly than other countries

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Step3(contd.) Chinas story

• Sizeable dollar deposits
• Foreign currency liquidity flows
• Significant leakage in foreign exchange
  (illustrated by errors and omissions in Chinas
  balance of payments )
• Increasing cross-border capital flows after the
  WTO

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Step3(cont.) Preconditions for China

• Stable macroeconomy, a sound fiscal position and
  current account surplus or ample foreign exchange
  reserves
• Reformed and healthy real sector
• Significant domestic financial reform after NPLs
  problems have been solved and strengthened
  financial supervision
• Well-structured money market and indirect
  monetary instruments
• More flexible exchange rate regime

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Step3(contd.) Chinas sequencing

• Japans gradualist approach in opening the
  capital account is a good example for China. The
  sequence has been generally from long-term
  investment to short-term investment, from direct
  investment to indirect investment, and from
  portfolio investment to bank transactions

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Step3(Contd.) Timetable

• Emphasis should be stressed on its coordination
  with domestic reform, particularly domestic
  financial liberalization
• it is more likely that domestic financial reform/
  interest rate liberalization will start around
  2006. In this case, capital account
  liberalization should begin around 2008-2010,
  when Chinas economy is more integrated into the
  world economy and capital mobility has increased

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Step3(contd.) Some issues on Capital account
convertibility

• Temporary and selective capital account controls
  still in place
• Precautions should be taken to monitor
  short-term capital (capital inflows may be
  managed or channeled with measures like the
  Chilean reserve requirements against short-term
  flows).

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Conclusions

• Step1 NPLs resolution and institutional building
• Step2 Domestic financial reform
• Step3 International financial reform