Curbing financial risks key to sustainability
Although China has largely contained the COVID-19 pandemic at home, it still faces the daunting task of maintaining steady growth in 2021. One way it could do so — and ensure long-term, healthy development of the real economy — is by optimizing financing and eliminating factors that could trigger financial risks.
To begin with, China should promote financial reform and opening-up to develop a financial cooperation system that is diversified, and improve the risk prevention and control mechanism without relying too much on the indirect financing system.
The development and reform of China’s indirect financing system is in line with its long-term social and cultural development, with banks playing the main guiding role in the entire social credit system. Still, China needs to develop a cross-market and cross-sector financial cooperation system to prevent systemic risks in the financial sector that could trigger an inflation crisis forcing the country into the middle-income trap.
Due to periodic economic structural adjustments and feeble demand caused by a complicated external environment, China faces the risk of deflation. But if the authorities fail to overcome the effects of the short-term economic stimulus policies including over-issuance of money or do not implement effective monetary policy, the country could face inflation in the long run.
For example, Japan’s current development dilemma is related to its relatively underdeveloped direct financing system, which makes it difficult for enterprises to realize longterm “deleveraging ”, and the low interest rate policy, along with the aging population problem, has slowed the country’s growth.
So China should streamline the direct financing system and strengthen the capital supplement mechanism for indirect financing, while promoting the development of diversified financial instruments for direct financing. Shifting focus from the stock market, China should seek to address the financing problems through asset securitization, multi-level equity trading market, convertible capital tools, bond market, and internet finance, which will also help form a sustainable “deleveraging” pattern with Chinese characteristics.
Besides, the authorities should take measures to resolve the contradictions between economic transformation and social transformation, including the widening gap between the rich and the poor, inequitable distribution of social wealth, imbalance in the social security system and the economic development level, dearth of new driving forces for the economy, and the slow pace of industrial upgrading. To resolve these contradictions, China needs to develop a multi-tiered capital market and effectively reduce the debt leverage ratio in the real economy.
China’s financial risks continue to accumulate due not only to its slow economic growth and complex financial market conditions but also its imperfect financial regulatory system, reflecting the inherent defects in the financial regulatory mechanisms, lack of proper coordination among different departments, and lax supervision over financial institutions.
Financial regulation is a global problem. As for the financial regulation system reforms implemented after the 2008 global financial crisis, there are two key problems. The first is how to design a macro-prudential regulatory framework that would improve coordination among different departments, and between central banks, regulatory authorities and insurance companies, so that effective counter-cyclical financial regulatory and monetary policy can be worked out and monetary policy and financial regulation synergized.
The second problem is the relationship between prudential regulation and financial consumer protection. Many countries have separated prudential regulation from behavior supervision, by establishing a separate department for behavior supervision. For example, in accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act, the United States merged the financial consumer protection functions that were originally under multiple departments and created the Consumer Financial Protection Bureau. And the United Kingdom overhauled its financial regulatory system under the Financial Service Act 2012 to establish the Financial Conduct Authority, which is responsible for the conduct of all financial institutions, including the ones in the banking sector.
China, too, should separate regulation from supervision. There are vital differences between commercial banks and investment banks including business model, source of capital and risk-taking. The global financial crisis exposed two major problems of the mixed operation model. One, under the deposit insurance system, banks can use low-cost deposits as capital for high-risk and highly leveraged investment business. This is equivalent to using insurance deposits to provide subsidies for banks’ investment business, which has grave ethnical risks. And two, if investment banks’ problems endanger commercial banks’ basic business such as deposit, remittance, payment and settlement, they could shake the foundation of the financial system.
Therefore, China should strengthen the central bank’s role in macro-prudential regulation and guard against systemic financial risks. Since the central bank can conduct macroeconomic analysis, determine important monetary policy variables such as interest rates and total loan volumes, participate in and understand the capital market and insurance market, act as a lender of last resort, and regulate the payment and clearing system, it should act as the leader of the macro-prudential supervision system. This is common practice around the world.