Part I: Challenges in China’s Ongoing Financial Reform

China, the world’s second largest economy, is undergoing a significant transition from being overly dependent on exports and investments to relying more on domestic consumption for sustainable growth. The leadership pledged to allow the market force to play a fundamental role in the overall economy and open closed fields to the private sector and foreign competition. In order to accomplish the structure upgrade, financial reform is indispensable, including liberalization of the interest rate, internationalization of the Chinese yuan, and incorporation of private capital, etc.

In my observation, the country has to deal with four main challenges to realize its ambitious goals mentioned above.

First, the stability of the Chinese yuan has to be improved. The yuan had been on a steady appreciation path until late February, and then the Chinese central bank started to engineer a decline in the yuan by instructing state-owned banks to buy dollars and allowing the yuan to move as much as 2% on either side of the parity rate on a daily basis, leading to a sharp depreciation of 3% against the U.S. dollar. 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 perspective, 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.

However, this move triggered criticism from Washington as the U.S. Treasury Department said that the yuan’s depreciation would “raise serious concerns” if Beijing is moving away from the plan to make the yuan’s exchange rate market-based, especially if Chinese officials are at the same time citing greater flexibility in the currency’s value.

My prediction is the yuan will resume its appreciation path in the near term because of the Chinese government’s stimulus package. Meanwhile, the People’s Bank of China has to intervene in the yuan in a way both effective and also globally acceptable in the future.

Second, credit quality deterioration is emerging. The non-performing ratio of Chinese banks rose to 1% at the end of the fourth quarter from 0.97% at the end of the third quarter last year, which is the highest since the end of 2011. Many loans were made on the expectation of higher growth rate and the slowdown could lead to serious default issues. To make matter worse, the credit concern spread to Hong Kong since the city posted 30% surge in lending to China on tight credit in the mainland and lower interest rates in Hong Kong.