Author Archives: viczhou

Is the Chinese Yuan Becoming More Market-based or Policy-based?

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Recently, the U.S. has been pressuring China on the Chinese yuan’s movement. From the FRED graph above, the yuan was on a steady appreciation path against the dollar until this February, after which it depreciated significantly (down 3% against the dollar) and reached the bottom on March 20. The Treasury Department said that the yuan’s depreciation would “raise serious concerns” if Beijing is moving away from the plan to allow the market force to have a greater impact on the yuan’s exchange rate, especially if Chinese officials are at the same time citing greater flexibility in the currency’s value.

So is the Chinese central bank really altering the path of the yuan’s liberalization? From my perspective, the yuan is still on an upward, market-based trend, in spite of some short-term headwinds that have triggered monetary intervention.

Starting in late February, the Chinese central bank has been engineering the decline in the yuan by instructing state-owned banks to buy dollars. In addition to the government-guided purchase, the daily trading band was widened to allow the yuan to move as much as 2% on either side of the parity rate on a daily basis. The reason behind was to drive out international speculators who had been pouring tremendous capital (“hot potatoes”) into China in anticipation of the endless appreciation of the yuan. The influx of speculative capital made the Chinese government harder to manage its economy, triggering potential housing bubble and inflationary pressure. From the long-run view, the central bank is trying to introduce greater two-way volatility of the yuan before allowing the market force to play a more critical role so as to ensure its stable movement and promote its international use as an important global currency.

Personally, I think the yuan’s decline is also attributed to China’s economic slowdown, signaled by shrinking exports and industrial production, as well as yet-to-stimulate domestic consumption. The country’s GDP is expected to grow by 7% in the first quarter, a level lower than the 7.7% expansion last year, making investors sell the yuan on growth concern.

If we consider the broader picture, the yuan has been appreciating against the dollar for almost 10 years, despite some short-term devaluation. From the FRED graph below, we can see that the yuan was traded against the dollar at a flat rate with almost no change until the de-pegging in June 2005, and then it appreciated significantly for 3 years until the burst of the 2008 global financial crisis. After that, the yuan appreciated at a slower pace and was traded mainly in the range of 6.0 to 6.6.

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Although China is in no hurry to halt the recent slide of the yuan and remains cautious about any potential resurgence in the speculative appetite for the currency, I believe the yuan will resume its appreciation path modestly in the near term because of the Chinese government’s stimulus package for growth, increasing capital inflow into Asia, and political pressure from Washington.

China’s Stimulus Package for Growth

In the past few months, the market focus has been on the Federal Reserve’s exit strategy and a slowdown of China’s economic growth. Regarding the latter one, China’s economy is expected to grow at somewhere around 7% in the first quarter, a level significantly below the double-digit growth many years ago and the 7.7% growth last year.

Since the country has set a target of 7.5% economic expansion for 2014, the first-quarter performance triggered further concern about its growth momentum. In response to that, China’s State Council, the government’s executive body, unveiled Wednesday a stimulus package to boost growth, including additional spending on railways, upgraded housing for low-income households, and tax relief for small businesses.

Although the package is considered as a mini one compared to the four trillion yuan ($650 billion) program rolled out in late 2008 amid the global financial crisis, it would still impact the overall economy in many ways.

Stimulus 1: Additional Spending on Railways

The government would further develop infrastructure through accelerated railway construction, particularly in the nation’s central and western regions, and more aggressive financing. Some operations in the public interest would be subsidized and 150 billion yuan ($24.6 billion) in bonds would be offered by the government to finance construction for the railways. Relatively, the stock prices of companies in the railway sector rallied, as shares of China Railway Group surged 5.1% and China Railway Construction Corporation’s shares jumped 7.2%.

Personally, I think the stimulus will have a double-sided effect. Positively, tremendous infrastructure construction will boost growth effectively, and the emphasis on development in the central and western region will lead to more balanced economic landscape across the country. Negatively, as China is undergoing a significant transition from being overly dependent on investment and export to relying more on domestic consumption, the massive government-led investment project might impede structural reform, and the increasing credit along with financing might pose additional risk in the credit market.

Stimulus 2: Upgraded Housing for Low-Income Households

The government would also spend more on slum clearance and upgrade of poorer urban areas. It added that the China Development Bank, a lender for key government policy projects, would set up a special arm to issue bonds to support new homes.

I think this measure could be a complement to the railway construction because of its focus on ordinary people’s well-being. It is a tradition that Chinese people care a lot about their housing and treat it as the most important measure of their living standard. Despite that the implementation of housing upgrade is yet to see, this proactive approach could ease social instability and unleash the potential of domestic consumption in the mid- to long-run.

Stimulus 3: Tax Relief for Small Businesses

The government would extend existing tax breaks to small businesses until the end of 2016 and raise the threshold for taxing smaller businesses, which have been struggling as economic growth slows.

Personally, I do believe that small businesses will benefit from decreasing tax burden, but this measure cannot address their problem radically, which is due to the lack of financing. So the government should also accelerate the financial-sector reform by incorporating private capital and diversifying lending channels for small businesses.

Technical Analysis vs. Fundamental Analysis – A Random Walk Down Wall Street

In my previous post, I stressed the importance of diversification in asset allocation. An asset manager has to develop a tailor-made financial solution for a particular client based on the well-rounded mastery of market trends and his/her real needs.

Although there is not a “best” investment portfolio due to different income level and risk tolerance, asset management does call for in-depth analysis for the execution of a balanced solution. In fact, professionals usually consider two methods for stock pitch: technical analysis and fundamental analysis.

Method 1: Technical Analysis

Technical analysis is essentially the making and interpreting of stock charts. Thus its practitioners, a small but abnormally dedicated cult, are called chartists. They study both the movements of common stock prices and the volume of trading for a clue to the direction of future change. Most chartists believe that the market is only 10 percent logical and 90 percent psychological. They generally subscribe to the castle-in-the-air school and view the investment game as one of anticipating how the other players will behave.                                                                                                                                                                                   ——A Random Walk Down Wall Street

Undoubtedly, those chartists are focused on the study of what the others players have been doing in the past, and believe the behaviors would be a reliable source showing what the crowd is likely to do in the future.

To be honest, I am not a big fan of technical analysis. Despite the fact that the capital markets tend to move within a certain range in the long run (i.e. support level & resistance level), a significant drawback of technical analysis is the ignorance of breaking news on market performance. For instance, following Ms. Yellen’s speech last week that interest rate increases might be sooner and more aggressive than expected, the 10-year treasury bills fall drastically in anticipation of lower bond value in the future. However, this sudden move cannot be accurately predicted by chartists because of the lack of historical evidence of Yellen’s statement.

Method 2: Fundamental Analysis

Fundamental analysts take the opposite tack, believing the market to be 90 percent logical and only 10 percent psychological. Caring little about the particular pattern of past price movement, fundamentalists seek to determine an issue’s proper value. Value in this case is related to growth, dividend payout, interest rates, risk, etc. By estimating such factors as growth for each company, the fundamentalist arrives at an estimate of a security’s intrinsic value. If this is above the market price, then the investor is advised to buy. Fundamentalists believe that eventually the market will reflect accurately the security’s real worth.

                                                                                                 ——A Random Walk Down Wall Street

In contrast to chartists, fundamentalists believe the capital markets tend to move in consistent with economic trends and corporate earnings. They usually analyze fundamental factors of economic growth, including GDP, employment, inflation, interest rates, aggregate investment, as well as of corporate earnings, including EPS, cash flow, dividend payout, etc.

Personally, I prefer fundamental analysis over technical analysis because it tends to execute investment decisions based on a broader picture of the overall economy. Regarding the same example above, I believe Yellen’s speech did not surprise fundamentalists because the Fed’s tapering decision is data dependant, and as the U.S. economy had been showing continuous signs of improvement such as rising employment and capital inflow, the Fed would continue to taper and interest rates would go up to prevent overheating of the economy.

Diversification for Asset Allocation – A Random Walk Down Wall Street

After reading the book “A Random Walk Down Wall Street”, I came to realize that investment is a lifelong lesson. Either you are an individual investor or an asset manager, the central goal of investment is to optimize the risk-return payoff through well-structured asset allocation. Since investors have different income level and risk tolerance, there is not a so-called “best” portfolio that fits everyone’s needs. Nevertheless, one concept is set in stone for asset management: diversification is the key to any investment portfolio.

So here comes the question: how to diversify a portfolio appropriately? In my view, it has to do with your understanding on the market reality, as well as on yourself.

Principle 1: History shows that risk and return are related.

Common stocks have clearly provided very generous long-run rates of return. It has been estimated that if George Washington had put just one dollar aside from his first presidential salary and invested it at the rate of return earned by common stocks, his heirs would have been millionaires more than seven times over by 1999. Roger Ibbotson estimates that stocks have provided a compounded rate of return of more than 8 percent per year since 1790. But this return came only at substantial risk to investors. Total returns were negative in about three years out of ten. So as you reach for higher returns, never forget that “There ain’t no such thing as a free lunch.” Higher risk is the price one pays for more generous returns.                                                                                                                                                                           ——A Random Walk Down Wall Street

I believe almost every investor has heard of this oldest theory in investment. The table below summarizes the risk-return relations for five major asset classes in the past century, in which small growth stocks have the highest, and U.S. Treasury bills have the lowest. The distinctive features of different asset classes make U.S. Treasuries the “safe-haven asset”, so investors usually pour a significant portion of funds into it for lower risk exposure when there are huge uncertainties in economic situation and market trend (i.e. Fiscal Cliff in 2013 & Yellen’s Speech last week).

                                                        Average Return       Average Risk Index

Small-company common stocks        12.7%                      33.9%

Common stocks in general                  11.0%                      20.3%

Long-term bonds                                   5.7%                        8.7%

U.S. Treasury bills                                 3.8%                        3.2%

Inflation rate 3.1

Source: Ibbotson Associates, Stocks, Bonds, Bills, and Inflation: 1997 Yearbook.

Nevertheless, a pure focus on low-risk assets such as treasury bills and long-term bonds tends to offer lower expected return. So the incorporation of stocks and derivatives is essential for capital growth.

Therefore, a good question to ask is “what is the percentage of each asset class in a diversified portfolio?” Let’s think about principle 2.

Principle 2: You must distinguish between your attitude toward and your capacity for risk.

The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income. Your earning ability outside your investments, and thus your capacity for risk, is usually related to your age.

                                                                                                 ——A Random Walk Down Wall Street

As I mentioned above, there is not a “best” portfolio for everyone. A responsible asset manager has to execute investment decisions for a particular client based on the well-rounded mastery of his/her financial situation and beyond.

Personally, I interned at AIA Hong Kong office as a financial planner last summer. One of the tasks I accomplished was “financial health check interview”. The goal of the interview was to understand the financial status of clients and ensure their benefits from total protection. In the fact-finding stage of the interview, I collected financial facts, including income level, family expenses, aggregate debt, and investment style, as well as non-financial facts, including age, family status, diagnosed illness, and smoking & drinking habits. Through the integration of all these facts, I collaborated with my colleagues to develop a tailor-made financial solution spanning insurance, savings, and investment for each client.

In conclusion, a truly diversified and well-structured portfolio is not the result of a random selection from various asset classes in the market. Instead, it is derived from in-depth analysis on their features, as well as on your earning power and risk appetite.

London: Next Stop for the RMB Internationalization

The Chinese yuan, or RMB, has been on its path to internationalization in the past few years, and is finally expanding to the West. Under a preliminary agreement between the Bank of England and the People’s Bank of China, London will be the first Western city offering offshore clearing service for the yuan. The official memorandum will be signed on Monday to cover how the two central banks will share in the operations, with a clearing bank to be named after.

This move is considered as a win-win game for both the UK and China.

From the standpoint of the UK, the establishment of an official clearer for the Chinese currency will facilitate trade, financing, and investment in the yuan, boosting London’s status as one of the most influential global financial centers.

Currently, London has to rely on Hong Kong for RMB liquidity and clearing services due to strict foreign exchange control by the Chinese government. But with this clearing initiative, yuan transactions will be allowed to proceed in the UK capital, instead of going through agent banks in mainland China or the Bank of China in Hong Kong. Considering UK’s proximity to the European continent and the fact that there has been a huge demand for yuan trading in Europe, including yuan-related bond issuance and investment products, London can leverage the clearing service to strengthen its impact on the capital markets with higher trading volume and revenue.

Furthermore, since the UK set up an official currency swap line with China in last October, making it the first member of Group of Seven leading economies with such a swap with China, and letting UK fund managers invest directly in China’s heavily restricted domestic stock and bond markets, this initiative is expected to help London emerge as another offshore RMB trading center, following Hong Kong in 2009.

From the standpoint of China, this is definitely a critical move to promote the international use of the yuan and its status as a major reserve currency in the long run.

The yuan has been ranking up the currency chart rapidly in recent years. It is now the ninth-most-traded currency in the world, according to the Bank for International Settlements’ latest benchmark report on overall foreign-exchange turnover, which was published in September.

At this point, the Chinese government is committed to strong-than-ever financial reform by accelerating the liberalization of its capital and foreign exchange markets. Domestically, the financial sector will be gradually open to private capital and foreign banks. Internationally, with an offshore clearing partner in London, the trading potential for the yuan will be unleashed.

What Is the Fed Trying to Tell Us?

Janet Yellen held her first meeting as Federal Reserve Chairwoman last Wednesday and released several important updates on the Fed’s exit strategy, prompting significant market reactions.

Update 1: Tapering

The Fed decided to scale back its monthly bond purchases to $55 billion from the current level of $65 billion. The $10 reduction was evenly distributed to mortgage-backed securities and longer-term treasury bonds, with $5 billion in each. Unlike the central bank’s moves in late 2013, this round of tapering was in close line with market’s expectation, given that the U.S economy has shown continuous signs of improvement.

Update 2: Unemployment rate

The Fed once claimed that it would not consider interest-rate increases as long as the unemployment rate was above 6.5%. As the indicator was approaching the threshold (6.7% in February), the central bank altered its guidance about the likely path of short-term interest rates by lessening the weight on the unemployment rate as a signpost for when rate increases will start.

Specifically, Ms. Yellen argued that the Fed would look at a broad range of economic indicators for tapering down the line, including the share of workers who have been unemployed for six months or more, the share of adults who are holding or seeking jobs, the portion of workers who hold part-time jobs but say they would rather have full-time occupations and the rate at which people are quitting jobs.

From my perspective, I think the unemployment rate alone simplifies the reality of the job market due to the ignorance of issues mentioned above. In particular, the retirement of “The Post-World War II baby boom” significantly decrease the pressure of employment, which should also be taken into account when considering labor market policy in the future.

Update 3: Interest Rates

The Fed sent mixed signals on the outlook of interest rates.

In terms of the long-term interest rate, the Fed is committed to keeping it low even after inflation and unemployment return to their normal levels. Since the major goal of the Quantitative Easing was to bring down long-term interest rates so as to stimulate investment, spending, and hiring, I think the Fed should be more prudent in its further tapering decision by adjusting the magnitude of reduction in consistent with economic situations and market trends.

However, the movement of the short-term interest rate triggered instability in the market. Ms. Yellen suggested that interest-rate increases might come about six months after the bond-buying program ends—a conclusion that could come this fall. Consequently, there was a drastic sell-off in the 10-year treasury bonds in anticipation that rate increases might be sooner and more aggressive than expected.

(Revised) A Critical Move in China’s Financial Reform

China, the global growth engine, is undergoing a significant transition as the new administration is committed to structural reform in its overall economy. Undoubtedly, financial innovation is on the to-do list, and top officials confirmed an initiative this week: liberalization of the deposit rate.

Specifically, the country’s top central banker reaffirmed their commitment to liberalizing interest rates on bank deposits within two years, an unprecedented move that would force the nation’s lenders to compete for customers by offering the best terms.

What does that mean? Let’s think about this from the standpoint of China’s state-owned banks.

On the borrowing side, they have been soaking up piles of money at a relatively low cost. The Chinese central bank maintains a cap on the rate banks can pay depositors, a system that has left Chinese households poorly compensated, because deposit rates often fall short of the rate of inflation. At present, inflation is running at about 2.5%, while a one-year deposit can pay no more than 3.3%—a level China’s big banks rarely reach. However, most Chinese people still overwhelmingly allocate their assets in savings due to limited investment channels available in the country. As a result, those state-owned banks have no incentive to compete for deposits and make huge profits through the cheap funding.

But with the reform of deposit rate liberalization, they have to improve operations and manage risks more prudently so as to offer the best possible rates in the deposit competition. Who is the winner? Savers! They are highly likely to obtain higher pay on their deposit under the fierce race.

On the lending side, China’s banking sector is well known for the so-called shadow banking system. State-owned banks mainly make loans to state-owned enterprises and many small and medium enterprises (SMEs) are struggling with financing. Furthermore, state-owned banks bypassed the savings restriction by offering wealth management products. The seemingly fancy name of “wealth management” is just another channel of financing. Basically, banks offer higher-than-deposit rates on financial products sold to the general public and then charge even higher rates on lending to government-led investment projects. In this scenario, banks and the government are both winners because they could easily pocket the difference between cost and return, but savers might be the loser since the mismatch of short-term maturity of products and long-term investment projects could trigger serious defaults.

However, I have got a concern here: there is a possibility that those state-owned banks might become even more reluctant to offer loans to SMEs under the pressure of higher borrowing cost. As lenders, what they really care about is borrowers’ credibility, which is usually measured by collateral size, company revenue, track record of investment projects. Consequently, those national lenders might still be skeptical about SMEs’ repayment ability and therefore fund state-owned enterprises, a continuation of what they have been doing for years.

Fortunately, the Chinese government shows its ambition for reform as Beijing advanced a pilot program of private banks at the same time, including two of the country’s Internet giants, Alibaba and Tencent.

For clarification, “Private Bank” here does not refer to the Swiss-style private banking division, which is focused on wealth management business for high-net-worth individuals and families. Instead, it is a new form of banking managed by the private sector, in contrast to those lumbering, state-owned banks.

From my perspective, this initiative would complement the deposit rate liberalization by breaking the state-dominated banking monopoly and addressing the financing problem of SMEs effectively. For instance, let’s think about Alibaba, a selected player in the private-bank trial. The company dominates China’s e-commerce market, which by one measure is now the biggest in the world. Its biggest website, Taobao, is mostly for small merchants and has developed into an online business powerhouse with about 760 million product listings from 7 million sellers. The bond between Alibaba and SMEs has been strengthened through the development of the company’s another affiliate of Small and Micro Lending Group, as well as the enhancement in the so-called Alipay, which is a electronic payment system that protects buyers if sellers don’t deliver. Therefore, the company’s well-developed understanding on SMEs and significant capital advantage tend to prompt financing for SMEs, an action partly motivated by another prospective boom of e-commerce as SMEs progress.

In conclusion, I think the liberalization of deposit rate, as well as the creation of private banks, both call for a stronger regulatory framework, as a significant portion of liquidity in those state banks and in money-market funds offered by Alibaba are flowed into unregulated and untested investments. Therefore, regulators have to develop advanced risk management and consolidation skills to integrate all players into a uniform system for sustainable growth in the financial markets.

Alibaba: Countdown to U.S. IPO

Alibaba Group Holding Ltd, China’s Internet giant, has decided to launch its IPO in the U.S. rather than in Hong Kong. The company is expected to raise as much as $15 billion in the listing, making it one of the largest ever in the U.S.

Currently, the two major U.S. stock exchanges, NYSE and Nasdaq, are competing for the high-profile listing by offering discounts on certain fees and increasing visibility. It is widely believed that the exchange that “wins Alibaba will have bragging rights and momentum” for other technology IPOs, leading to greater financial impact and trading revenues.

So here comes the question: Who is Alibaba?

The company is like as a mix of Amazon, eBay and PayPal, with a dash of Google thrown in, all with some uniquely Chinese characteristics.

Phase 1 – The Legendary Inception

Alibaba was created in 1999 by Jack Ma, an English teacher in the eastern Chinese city of Hangzhou. Internet was like a UFO to most Chinese at that time, so when Jack tried to promote Alibaba.com, a trading website that connected Chinese manufacturers with overseas buyers, many people considered him as a fraud. “How can you sell things in the virtual world of Internet? That is impossible!” Jack was rejected repeatedly. Instead of giving up, he was persistent and embraced a breakthrough by obtaining funds from Softbank, a major angel investor in Japan. Through Jack’s continuous concept pitch of Internet and online business, the company achieved profitability in late 2001.

Phase 2 – The Era of E-Commerce

Initially, Alibaba was focused on the B2B marketplace (Businesses to Businesses). Starting 2003, the company began to diversify its portfolio by creating Taobao.com, a C2C marketplace (Consumers to Consumers), and Tmall.com, a B2C marketplace (Businesses to Consumers).

Taobao is mostly for small businesses, on which they don’t pay to sell products. Instead, they pay Alibaba for advertising and other services to allow them to stand out from the crowd. Comparatively, Tmall was designed for bigger merchants, including many well-known brands such as Nike and Apple, on which they have to pay a deposit and an annual fee, as well as a commission on each transaction, for sales.

In 2012, the combined transaction volume of Taobao and Tmall topped one trillion yuan ($163 billion), more than Amazon and eBay combined.

Phase 3 – Go Beyond: A Conglomerate across Various Sectors

Alibaba’s huge success in e-commerce allowed it to break into sectors other than Internet for even larger impact on China’s economy.

1) Logistics

The company claimed that Taobao and Tmall account for more than half of all parcel deliveries in China. Following that, Jack has integrated the company’s advantage in transaction volume, data mining, and extensive networks to create a logistics firm called Cainiao. The vision is to facilitate infrastructure development by teaming up with other major players in the private sector as well as the Chinese government for more efficient online orderings and parcel deliveries.

2) Finance

One of the key determinants for the company’s success is the initiative of Alipay, an electronic payment system that protects buyers if sellers don’t deliver. This effective tool has been leveraged for the development of lending and financial products. On one hand, the company created an affiliate called Small and Micro Lending Group to address the financing problem facing China’s small and medium businesses. On the other hand, it launched a money-market fund for the general public, which became one of the world’s largest in just eight months. Furthermore, Alibaba was selected as one of the five private banks in a pilot program aimed at breaking the state-dominated banking monopoly in the country. As a result, the Internet giant will be capable of running businesses of corporate finance, investment management, venture capital, and even more.

Probably no one can accurately predict the size of Alibaba in the future, but what we can say for sure is, its magic will continue.

Are We Heading to a More Stable Business Environment?

In the past few months, the Fed’s exit strategy has been dominating the headline. Fortunately, the tapering process went from the nontransparent phase in the fourth quarter of 2013, during which time the market was struggling with prospective liquidity squeeze, to the more transparent, understandable period in early 2014, as the decrease in monthly purchases of longer-term government bonds and mortgage-backed securities were getting closer to market forecasts.

So can we say that we are heading to a more stable business environment?

Apparently, the answer is no because the Ukraine Crisis has triggered concern on geopolitical instability.

Last Sunday, Crimean voters overwhelmingly approved a referendum to secede from Ukraine and join Russia. Following that, the Obama administration Monday enacted what it called the most comprehensive sanctions to punish Russia since the end of the Cold War. It targeted 11 Russian and Ukrainian officials, including some of Mr. Putin’s top advisers and the ousted former president of Ukraine, Viktor Yanukovych, a close Kremlin ally. Similarly, the European Union blacklisted 21 individuals, despite its deeper business ties with Russia.

At this point, the sanctions seem weak because those selected politicians are widely believed to have no overseas assets that could be targeted. However, the magnitude of sanctions could increase as President Obama prepares to launch a much-broader financial war with Moscow in the coming months, depending on Kremlin’s next step.

Regardless of the prospective shape of the Crisis, it is certainly creating global ripples, given the fact of turbulence in Russia’s financial markets and in the global commodity markets.

But do we have any good news? Yes we do.

First, the uncertainty about economic policy is decreasing. As shown by the graph above, the Economic Policy Uncertainty Index has dropped to levels not seen since the earliest days of the 2008 recession.

The index surged in late 2012 just before lawmakers finally compromised to reach a deal to avert automatic tax increases and spending cuts, known as the fiscal cliff. Currently, recent budget deals and distance from last year’s spending cuts and government shutdown, along with the manageable tapering process, have sharply diminished the fear of more curveballs from Washington.

Second, companies are taking advantage of advanced data analytics to manage their business on everything from hiring and supply chains to shipment orders and routing.

Data allows businesses to “sync up supply and demand as never before,” said Paul Ballew, chief data and analytic officer at Dun & Bradstreet. Market research decades ago involved considerable “trial and error,” Mr. Ballew said. “Now there is far more science in it.”

As a result, companies could execute decisions more effectively based on more accurate forecasts and useful information about the past performances of themselves and others.

In conclusion, I believe we are indeed heading to a more stable business environment because of policy stability and technological progress, despite some short-term headwinds due to geopolitical issues.

The Inception of Private Banks in China’s Banking System

In my previous post, I focused my analysis on a critical move in China’s financial reform: liberalization of the deposit rate. The major goal of this free-up is to increase returns for Chinese savors and promote stronger risk management in state-owned banks, since they have to compete for customers by offering the best terms.

However, I have got a concern regarding this initiative: there is a possibility that those state-owned banks might become even more reluctant to offer loans to small and medium enterprises (SMEs) under the pressure of higher borrowing cost. As lenders, what they really care about is borrowers’ credibility, which is usually measured by collateral, company revenue, track record of investment projects. Consequently, those national lenders might still be skeptical about SMEs’ repayment ability and primarily fund state-owned enterprises, a continuation of what they have been doing for years.

Fortunately, the Chinese government shows its ambition for reform as Beijing advanced a pilot program of private banks, including two of the country’s Internet giants, Alibaba and Tencent.

For clarification, “Private Bank” here does not refer to the Swiss-style private banking division, which is focused on wealth management business for high-net-worth individuals and families. Instead, it is a new form of banking managed by the private sector, in contrast to those lumbering, state-owned banks.

So what motivated the authorities to launch the trial? From my perspective, it is due to two key reasons.

First, the incorporation of private capital could address the financing problem of SMEs by breaking the state-dominated banking monopoly. As mentioned above, many SMEs are struggling with funding because national lenders are more willing to offer loans to state borrowers. Comparatively, private banks run by the private sector are more capable of doing smaller-sized lending. For instance, let’s think about Alibaba, a selected player in the private-bank trial. The company dominates China’s e-commerce market, which by one measure is now the biggest in the world. Its biggest website, Taobao, is mostly for small merchants and has developed into an online business powerhouse with about 760 million product listings from 7 million sellers. The bond between Alibaba and SMEs has been intensified through the development of the company’s another affiliate of Small and Micro Lending Group, as well as the enhancement in the so-called Alipay, which is a payment system that protects buyers if sellers don’t deliver. Therefore, the company’s well-developed understanding on SMEs and significant capital advantage tend to allow it to finance SMEs, an action partly motivated by another prospective boom of e-commerce as SMEs progress.

Second, the private-bank trial could lead to an integrated framework for regulation. China’s banking sector has been in chaos in some sense, as state-owned banks are offering various wealth management products and privately owned companies are catching up by offering money-market funds, many of which are flowed into unregulated and untested investments. The creation of private banks, along with tightening control on the wealth management products offered by traditional banks, tends to integrate all players into a uniform system for regulation. Meanwhile, it also calls for stronger risk management and consolidation skills from regulators.