China must let go of its capital strings

The announcement of China’s new economic team this week will open a window for serious financial liberalisation – and poses an early test of President Xi Jinping's commitment to reforms essential to the country’s growth prospects.

China is well-positioned to draw on the rich precedent of 1990s reforms, particularly to its banking system. And today Beijing has every incentive to change if it is to meet rapidly rising public expectations that the government will adopt a new and fairer economic model.

Why are the 1990s relevant? There are two main reasons. First, some of that decade’s reforms were prompted by the 1997-98 Asian financial crisis. China could not then wall itself off from volatility beyond its borders – and this is even harder to imagine today. Its $8 trillion-plus economy cannot remain immune to fiscal and growth problems afflicting the combined $35 trillion economies of the US, Europe and Japan.

Second, with Beijing facing a crisis of credibility in the 1990s following several political crises in the 1980s, public expectations were sky-high. And they are high once again, partly because, for all China’s successes, a rising middle class faces diminishing returns on the current growth model.

Whoever ends up in which chair, senior officials with whom I have worked for decades, such as central bank governor Zhou Xiaochuan, understand the pivotal role financial reforms must play in transforming a nation of savers into a nation of investors. China’s leaders will probably retain or promote Zhou and other reformers such as Lou Jiwei of the China Investment Corporation; Xiao Gang of the Bank of China; and Jiang Jianqing of Industrial and Commercial Bank of China.

The lack of investment options for ordinary citizens, coupled with inflation (now at a 10-month high) and low interest rates on deposit accounts, means the return on their savings is negative. Meanwhile, Chinese companies, especially state-owned enterprises, can gain access to cash at below-market rates.

This oversupply of low-cost capital removes market discipline necessary for the long-term competitiveness of these companies. It also undermines the efficiency of the economy by steering capital away from more productive investments in private companies, which fuel innovation and represent the nation’s economic future. Current global challenges, not least austerity in Europe and US fiscal problems, demonstrate China’s need for bolder financial reforms such as liberalising foreign capital flows and assuring greater flexibility in the exchange rate.

To its credit, Beijing has made significant progress, from bank restructuring to developing domestic debt and equity markets, asset managers and a regulatory system. It is committed to currency reform, too, because it recognises capital markets will not otherwise function efficiently.

But the global turmoil of recent years should make financial reforms more, not less, urgent. In the aftermath of Beijing’s $586 billion bank-lending stimulus in 2009, the country faces difficult side-effects. These are hard to deal with for two reasons. First, with official intervention leading to a weakened currency, the central bank has been denied a useful monetary tool to fight inflation. Second, without sufficient oversight of non-bank or “shadow” lending, it is more difficult for policy makers effectively to tighten liquidity. Shadow lending is also problematic because it is not transparent, and generates credit risks and, potentially, bubbles.

This new team will face early tests, and three reforms will be critical. The first is interest-rate liberalisation. This is essential to promote the efficient allocation of capital – and ensure lending is directed to a dynamic private sector that has been starved of capital.

Second, China must reform municipal finance because ballooning local debt will hinder its ambition to make urbanisation the main growth driver for a more consumption-driven economy. A legitimate local government bond market, decentralisation of budget authority, and a more equitable division of tax revenue are needed.

But having spent most of my career in financial services and capital markets, I believe that the essential ingredient of reform is opening up to foreign competition. I know of no nation that has competitive capital markets yet does not allow the world’s best-in-class financial institutions to compete on a level playing field.

Joint ventures yield suboptimal results so it is in China’s best interest to eliminate requirements for foreign financial firms to operate on this basis. It should also do away with remaining restrictions on where these firms can operate and allow them to function as they do in other leading financial centres, subject to domestic regulations.

Reform will pose political and economic risks. But I believe the country’s underlying development challenges cannot be met without deepening and restructuring capital markets. Acting too slowly poses a greater risk than many in China believe. The new economic team must draw on the lessons of the 1990s, seize this moment of opportunity and take bold action.

The writer is chairman of The Paulson Institute. He served as US Treasury secretary from 2006 to 2009, and was previously Goldman Sachs chairman and chief executive.

Copyright The Financial Times 2013.