The Financial Reforms in China - Case Study Example

Task: The Financial Reforms in China Table of Contents Introduction 3 The financial reform 3 Capitalism with Chinese Features 4 The beginning of the reform (1978-1990) 5 The Era of Jiang-Zhu (1991-2005) 6 The diminishing effort to the financial reforms (2005-2013) 8 The current condition of the financial market in China 8 The potential of Chinese Currency (Renminbi) to be an International Currency 10 The new leadership reform agenda (2012-2022) 11 Conclusion 12 Works Cited 13 Introduction Chinese economy is flourishing due to the strategies adopted to revamp and improve the overall economic performance. Various Chinese economic sectors have emerged and aggregately lead to China being the fastest growing country in terms of the economic performance. However, the preceding statement is not true concerning the country’s financial sector. Chinese financial sector is considered the weakest among all other sectors, as is has been observed by various Chinese economic analysts. The weakness in the financial sector becomes easily noticed when comparing China with another emerging economy, say, India. Some critics assert that the weakness in Chinese financial sector is a major hindrance to the country’s continued economic growth. Thus, it is expected that the gap will pose various challenges to China’s economy. This paper seeks to discuss China’s financial reform (Hess 1-2). The financial reform The journey of economic reform in China begun in 1978, during the third general assembly when the Chinese Communist Party held the 11th Party Congress. During the meeting, the struggle for class was strongly condemned by one of the members, Deng Xiaoping. The member, instead, urged other members to focus more energy and resources toward the pursuit of China’s economic development. That meeting, to most economist, marked the beginning of China’s financial reform. Ever since, the Chinese economy has been in hitting headlines as one of the fastest growing in the world (Hess 2-3). China was ranked number two world’s largest and vibrant economy due to the double growth rate that the country exhibited. Even though, the thriving economic performance of China has been backed by the financial system, which has also experienced some major reorganization, the level of financial reform achievement is unstable when compared to the economic transformations. Various economic and financial analysts from China and the western countries have branded China’s financial sector as both fluctuating and delicate. Fortunately, China has made the same observations and plans to develop a financial market. The need to achieve the global economic crisis has driven the objective. During the crisis, China was forced to seek for funds (USD) borrowed from the international monetary system (Hess 3-4). Capitalism with Chinese Features In China, the formulation and implementation of the economic policies and strategies are not the responsibility of the government or the state, but, of the ruling party. The Chinese Communist Party is in charge of all the economic activities, rules the economy and assures economic development. According to Deng and other top leaders of the Chinese Communist party, the restoration of the party’s political powers was and still is the ultimate goal of a stable economy. That was the basis of all the transformations in China, especially after the mass protests witnessed in 1989. That explains why the financial sector in China is entrenched in the political economy (Hess 3-4). That association gave rise to the development of a unique form of system of capitalism referred to by Walter and Howie (2012), quoted in Hess (4) as the “red capitalism” (Hess 4). On the other hand, refers to this system “capitalism with Chinese characteristics”. The system was developed to conform to the goal of the ruling party (Chinese Communist Party), which was to introduce Chinese features in a socialist country. Deng’s understanding of the importance of developing a healthy economy to support the ruling party was based on the mentioned ideology (Hess 4). Currently, the Chinese Communist Party rests its legitimacy on performance (output legitimacy), as opposed to ideas used in the past. The authority has been stable for a while. It is important to notice that the upcoming Chinese middle class has confidence in the Chinese Communist Party to facilitate the economic development and guarantee growth and improved living standards. However, it should be noted that the confidence can be cut in the event the country experiences an anticipated economic collapse. For this reason, the people’s trust and party authority can only be maintained by ensuring that the double-digit economic growth rate is achieved (Hess 5). The journey of Chinese economic restructuring can be divided into three sections. That is, the beginning stage of 1978 to 1990, the Jiang-Zhu era until 2005, and the current phase (the fading reforms stage) (Hess 5). The beginning of the reform (1978-1990) Ten years from 1978 was marked by an influx of the financial institutions. During the period, the central bank and other major banks were created. In addition, other financial institutions were set up at various levels such as the central, the provincial and the municipal. During the period, several credit cooperatives and approximately 745 trust and investment companies were founded. Notably, an eventful year was 1983. During the period, the responsibilities of the central bank were assumed by the People’s Bank of China (PBoC). Thereafter, its functions as a commercial bank were shared among four banks: the Agricultural Bank of China, the newly established Industrial and Commercial Bank of China, the Bank of China, and the People’s Construction Bank of China (Hess 5). The ineffectiveness of the mentioned financial institutions was noticeable towards the end of the decade to 1990. The primary reason for the shortcomings is the organization structure of the banks, which was directly influenced by both party and government officials. For instance, the branch managers of the financial institutions were being selected by the local party committees. The primary reason for such alignment is to ease the access of funds (loans from banks) to finance development projects. The rate of borrowing by both the party and government officials led to an increase in spending as several major projects were undertaken. The rate of expenditure rose among the Chinese, which created higher demand than supply of the local products. Eventually, local the prices of domestic goods increased, thus, causing inflation (Hess 5). The dramatic events of Tian’anmen of June 1989 were sparked by the long-stretched increase in inflation between 1987 to 1988 together with the exploitation and bad leadership. One year after the end of the inflation period, the China was pushed to make a decision to create a formal stock market. The primary reason for creating the stock market was to curb social unrest and boost state-owned enterprises (SOEs) performance. For that reason, the operation of Shanghai and Shenzhen stock exchange commenced in December 1990 and July 1991 respectively (Hess 5). The Era of Jiang-Zhu (1991-2005) Jiang Zemin and his premier, Zhu Rongji, set the second stage’s event into motion of the financial reorganization, which lasted until the year 2005. Both Jiang and Zhu Rongji served as vice-premier since 1991. In addition, between July 1993 and June 1995, they both served as Governor of the PBoC. In March 1998, Zhu joined efforts with Jiang, and they both focused more on reform strategy. Concerning the financial reorganization, Zhou Xiaochuan, who served as China Construction Bank president between 1998 and 2000 was Zhu’s chief architect. Zhou Xiaochuan also served as the chairman of the Chinese securities regulator between 2000 and 2002 and PBoC Governor since December 2002. A reform aimed at strengthening the regulatory functions of the central bank and reducing the authority of the provincial Party chiefs and their control in decision-making such as Zhu and Zhou implemented the lending decision. They achieved the objective by putting nine regional branches in place of the provincial PBoC (Hess 6). In January 1999, an event that threatened the performance of the financial industry in China and shook the confidence in China occurred. A major bank in China, Guangdong International Trust & Investment Corporation (GITIC) became solvent. The news quickly spread and others misconceived the collapse to be a financial crisis. The response from Zhu Rongji after the fall of GITIC was to close trust companies and urban credit cooperative in the tune of hundreds and thousands respectively. From a different approach, the recapitalization of the four banks (the Agricultural Bank of China, the newly established Industrial and Commercial Bank of China, the Bank of China, and the People’s Construction Bank of China) was initiated by Zhu. In addition, the establishment of Asset Management entities (AMCs) was done. The primary task of the AMCs was to manage the non-performing of the collapsed bank (Hess 7). The process of reorganizing the financial institutions in China led to need to publicize the big four (the Agricultural Bank of China, the newly established Industrial and Commercial Bank of China, the Bank of China, and the People’s Construction Bank of China) by requiring the banks to issue IPO on the stock market (sell the company’s ownership to the public). Other critical restructuring activities involved the establishment of a national social security fund. Other activities included the creation of the Chinese bond and stock markets. In addition, in 2001, China became a member of the World Trade Organization (WTO). The membership of the WTO was much needed to exert force on China to continue with and complete the critical reforms (Hess 8). The diminishing effort to the financial reforms (2005-2013) This stage of the economic reform, specifically in 2005, marked the beginning of fading of the reforms. The state Council began the withdrawal of focus on the implementation of reform programs that were jointly formulated and implemented by Zhou and Zhu. Under the new leadership of Hu-Wen, the conservatives in the Chinese Communist Party gained more power. The conservatives blamed the Zhu-Zhou reform programs for further increasing the gap between the rich and the poor (causing more income disparities) to unbearable levels (Hess 8-9). In addition, the Zhu-Zhou reforms were criticized for allowing the ownership of a local institution by a foreign body. For instance, the modification made it possible for the Singaporean sovereign wealth fund Temasek and the Bank of America to buy shares in China Construction Bank. The conservatives based their criticism on the fact that the authorization of such trading activities leads to the transfer of valuable state assets to the foreigners. Walter and Howie 2012, cited in ……8 assert that Zhou Xiaochuan infringed various norms. Among them included the encroachment of other institutions territories. Such institutions are the Ministry of Finance (MoF) and the National Development and Reform Commission (NDRC). After the reform attack, its implementation started to wane (Hess 8-9). The current condition of the financial market in China Due to the incomplete implementation of economic reforms in the Jiang-Zhu era, the following are the features of China’s current financial system. First, the economic system is bank-based. That implies that a greater portion of the corporate and household savings are done in large banks by what the financial risks of the depositors are concentrated on the banks financial statement (balance sheet). Second, the state owns most of the banks and majority shares in others. For this reason, the economic system in China is primarily state-owned. Third, the Chinese capital markets are not entirely developed. For that reason, government bonds and central bank bills are dominant in the bond market. These bonds can be purchased only by the banks owned by the state. Consequently, a greater portion of the bonds are long held by banks, which leads to a decrease in the trading activities (Hess 10). Fourth, like the country, the financial system in China is managed by the Chinese Communist Party or few individuals at the top of the party leadership. The Chinese Communist Party, through it agency, the Central Organization Department, selects the controllers of the financial system together with leaders of the major State Owned Enterprises. Fifth, the system discriminates the idea of lending to the state sector in order to stimulate the economic performance of the state-owned enterprises. The discrimination hampers the economic performance and growth of the small and medium enterprises (SMEs) (Hess 10). Sixth, the approach to setting the interest rates is administrative. The primary reason for adopting such approach is to improve the banking industry’s profitability. The industry intends to gain control of the financial resources. The strict interest rate control is favorable for the borrowers to whom the cost of finance is hardly above that of inflation. The approach leads to a substantial relocation of assets to the rest of the economy from the depositors. The process is referred to as the financial repression (Hess 11). Seventh, the financial system is characterized by shadow banking. The shadow banking sector include the following products and activities: bank acceptance bill, underground lending activities, micro loans, entrusted loans, leasing activities and trust product. These activities are worth approximately 30 trillion RMB, which is 57% of the country’s 2012 gross domestic product. These goods and activities have been determined to pose a potential danger to the financial stability of China. Such risks include the liquidity risks, credit risks, moral hazard, the rise in off-balance sheet risks and transparency issues (Hess 11). Last, the Chinese currency is not fully convertible. The financial crises that have occurred in the past have induced the decision to keep the financial market in China closed (Hess 12). The potential of Chinese Currency (Renminbi) to be an International Currency As mentioned earlier, Chinese economy is among the fastest growing in the world. The trading of Renminbi (RMB) has risen in the past few years to a share of close to 10%. In addition, the use of RMB has increased both as a financing and investment currency. These developments have been set into motion by the policies formulated and implemented by local authorities to facilitate the settlement of current accounts and financial investments. In addition, the developments were boosted by the adoption of the concept of international business by the Chinese Banks. The fact that the Chinese banks increased their activities in the global market, merged, acquired or were purchased by the foreign firms created the need to trade the Chinese currency in the foreign exchange market (Hess 16). From another point of view, China has demonstrated its capability and the determination to keep the inflation rate low. The CPI inflation in China, on average, has been stable at 1.92%. The rate has never gone beyond 5%, which proves the country’s commitment to controlling the inflation rate low. When the inflation rate is high, it means that the demand for local products is greater than supply, leading to high product prices. High inflation rates reduce the value of the local currency against the foreign. China’s inflation rate has been low for an extended period, which indicates the stability of the currency. For that reason, the confidence and the interest of foreign investors have been earned. For this reason, there is a possibility of a rise in the demand for the Chinese currency (Hess 16). However, the foreign investor confidence faces some risks such as the excess levels of the country’s financial stability. Upon occurrence, the China’s economic performance could be significantly affected, same applies to the levels of the foreign currency reserve (Hess 16). The new leadership reform agenda (2012-2022) The document, jointly compiled and released by the people’s Bank of China, the three regulatory commissions, and the State Administration of Foreign Exchange on the 17 September 2012 stressed on three issues. They are the unstable state of the exchange rate, the rise in foreign reserve diversification, and the liberalization of the capital account as the anticipated course the financial reforms would follow during between 2011 and 2015. Some critical economic reforms such as the elimination of the controls put on the lending rate were removed when the leadership changed hands to Xi and Li at the 18th Party Assembly held (Hess 17). The reforms sparked by the report and the change in leadership includes the increase in the strictness of the regulatory and supervisory activities, the liberalization of the exchange and the interest rate (relinquishing control and regulation of both the exchange and interest rate to the forces of demand and supply), and the gradual opening of the capital market. These are primarily aimed at improving resource distribution using the market-based pricing approach, minimize supervisory arbitrage, and eradicate the implicit-asset-guaranteed-by-the-state moral hazard. The agenda digests the core of the issues that pose a significant challenge to the financial system in China. Te only question without an answer is the extent to which the new program for reform will be implemented by the fresh leadership of Xi and Li. The subtleness of the issue is reflected in the June 2013 tension experienced in the money market. Li Keqiang is sending a mixed signal, but it is anticipated that in the future, he will follow in Zhu Rongji footsteps and continue the implementation of the bold reform (Hess 18). Conclusion The financial sector and the currency performance is still behind the international standards. The primary reason for that is the fact that China’s financial sector is under the control of the Chinese Communist Party. The only way the Chinese financial markets can live up to the international standards is through the liberalization of the financial markets (allowing the pricing of both capital and risk to be market-based). The mentioned strategy together with the creation of a liquid market for trading bonds and stocks with the primary aim of maximizing the returns on investments as opposed to financing the state-owned projects would indeed increase the probability of trading RMB in the foreign exchange market. The leadership of Li Keqiang and Xi Jinping shows the signs of continuing the work started by Zhou and Zhu. However, it is unclear what direction the conservative’s reaction to such reforms will take. In addition, what will prove to be most difficult task is the breaking up the State Owned Enterprise monopolies created by individuals with bestowed interests. Works Cited Hess, Patrick 2014, China’s Financial System: Past Reforms, Future Ambitions and Current State. PDF file. 12 Feb. 2015. http://www.springer.com Read More