Market Watch
Senior economist argues that China's ongoing financial reform should better serve the real economy and forestall systemic financial risks
China's 14th Five-year Plan (2021-2025) prioritizes reform to the country's financial sector. Huang Yiping, deputy director of the National School of Development, Peking University, believes the objectives are closely linked to China's mode of economic growth.
Ahead of the annual two sessions in early March, Newschina secured an exclusive interview with Huang, who said the previous financial system is unfit for the new economic development mode and that market-orientated reform of the financial sector is the ultimate goal.
Newschina: What are the main tasks for financial reform during the 14th Five-year Plan?
Huang Yipin: The main tasks were already specified in 2013 at the Third Plenary Session of the 18th Central Committee of the Communist Party of China (CPC). A resolution titled “The Decision of the Central Committee of the CPC on Some Major Issues Concerning Comprehensively Continuing the Reform” proposed 11 reform initiatives. In my opinion, there are three main areas.
First, it aimed to develop the multi-level capital market and raise the proportion of direct financing to better serve innovative activities.
Second, it endeavored to deepen market-oriented reform. In a nutshell, the market will play the decisive role in allocation of financial resources and pricing. More importantly, there should be fair competition between different market entities.
Third, it aimed to forestall a systemic financial crisis, which proved to be the bottom line. It is high time to bid farewell to previous risk aversion methods and reduce financial risks with high economic growth which rely on government as a cushion. Efficient regulation will be the way out. While the framework of regulation has been established, it has failed to prevent potential risks.
The reforms have two main objectives: The financial sector should give more support to the real economy and avoid systemic financial failure. However, this is difficult to achieve.
NC: During the 14th Five-year Plan period, which areas are more prone to financial risk?
HY: In the short term, I worry most about smaller banks. Over the past year, China's economy was severely impacted by a number of factors. Growing policy-based lending, coupled with the substantive growth of credit to small and micro businesses, have increased the possibility of a rise in the ratio of non-performing loans. Bond defaults are more likely too.
In 2020, the European Central Bank (ECB) and the US Federal Reserve went back to zero interest rates. Monetary policies were extremely loose and vast amounts of capital flowed into emerging market economies, including China, leading to abundant liquidity, yuan appreciation, dropping interest rates and a thriving capital market.
Once the ECB and the Fed adjust their monetary policies, capital will flow back, interest rates will grow and asset prices will drop, which will give rise to an unstable Chinese financial market. These two risks need to be considered in the next two to three years.
In the long term, risks will occur in financial innovation. It could be under control but despite abundant regulation, there is a lot of room for improvement. In addition, China's real estate market is very unstable. Macroeconomic data shows the market is very risky, but housing prices are still going through the roof in some cities and we are not sure when they will fall. If housing prices plummet, there is likely to be major financial risk.
NC: Market-oriented reform of the financial sector was proposed many years ago, but it has been reiterated in recent years. Why?
HY: Drastic changes in China's economic growth mode have created two problems. First, the current financial system is led by the banks, and China's capital market is relatively weak. Government intervention abounds and regulation is inadequate. Against the backdrop of extensive growth and the advantages of low costs in previous years, risks in products, market and regulation were low. As a result, the previous financial system played a significant role in
bolstering China's economic growth. However, innovation has become increasingly important and whether the financial system will be effective for economic innovation is now an issue.
Second, China is probably the only emerging economy that has not experienced a major financial crisis in the last few decades. Even though there were problems, high growth solved many of them. Nowadays, the mode is unsustainable and regulation is crucial to forestall a systemic financial crisis.
In 2020, the central government proposed three regulations for the capital market: perfecting fundamental systems, non-intervention and zero tolerance for misconduct. Regulations should consider rules more than market prices. If problems occur, regulations should be in place, which is the zero-tolerance element.
NC: China's fintech innovation has developed quickly in the past few years, but regulation seems to lag. Why?
HY: Fintech has solved some problems but also brought about some risks. All financial transactions have some risk, which is an underlying characteristic of finance. This is why financial transactions need supervision.
Regulation has universally lagged behind fintech development. However, that does not mean innovation is independent of regulation. Regulation should apply to all transactions. If it's deemed risky, the transaction shouldn't be approved. Sometimes, relaxed and flexible regulations enable fintech innovators to test new products, services and business models without having to follow the current rules right away. These are called financial sandboxes, and they are widely used in many countries.
In a word, all financial transactions have to be under regulatory supervision whether they use new or traditional technologies.
NC: What does it take to establish a financial regulation mode suited to financial innovation?
HY: Since 1992, China has been working on a complete modern financial regulation system. The framework enables us to assess liquidity and capital adequacy rates and conduct both onsite and offsite supervision. Generally speaking, supervision is weak and many risks are beyond oversight.
For starters, financial regulation reform should have specific goals: maintain fair trade, financial stability and protect consumer rights. Financial regulation is highly specialized work and problems will arise if it unthinkingly follows the baton of macro controls. It's time to streamline regulation objectives and make regulation more professional.
Second, regulatory authorities should have the teeth to penalize violators and maintain financial order after they discovered problems. This is crucial.
Third, accountability should be in place. Nowadays, only those directly responsible for certain financial transgressions are punished and regulatory agencies are rarely held accountable. As a result, these agencies have little incentive or willingness to regulate. In the future, regulatory authorities will be held accountable if they do not perform their duties properly.
NC: What are the main challenges for China to develop a multilevel capital market?
HY: China's financial system is led by the banks and if the capital market is unable to provide effective financial support to enterprises or effective investment channels to the public, then it is far from establishing a multi-level capital market.
The biggest challenge for building a multi-level capital market in China is its ill-suited market mechanism. There are so many retail investors. On the financing side, there are no strong or effective penalties for malpractice such as corporate fraud and financial statement manipulation. China's market mechanism is not properly established.
The central government's three regulation rules on the capital market – perfecting fundamental systems, non-intervention and zero tolerance for misconduct – will provide the backbone for China to establish a sound capital market mechanism.
NC: 2021 is the first year of China's 14th Five-year Plan. What areas should China prioritize for development?
HY: From a government perspective, market-oriented reform of the financial sector and financial regulation reform should be priorities. In 2021, market-oriented reform of the financial sector could start with some practical issues such as risk pricing. Over the past several years, the government required commercial banks to lower loan interest rates for small- and medium-sized enterprises (SMES) each year. It was well-intentioned but not sustainable.
If banks and digital financial institutions want to keep financing large amounts to SMES and private businesses, they have to control the risks and encourage fair competition.
Financial openness is very important. The convertibility of the Chinese yuan and making it a global currency are two major focuses of the 14th Five-year Plan.