Part II: Challenges in China’s Ongoing Financial Reform

In my previous post, I introduced two of the four main challenges facing China as the country is set to optimize its financial system. In this post, I will discuss the rest two—the inflationary pressure and the effective use of private capital.

Apparently, inflation should not be an issue for the country, given the fact that its economy is slowing down, and the Federal Reserve had started to scale back the massive bond purchase program, leading to significant capital outflows from emerging markets. However, there is not a definite link between inflation and money supply. Instead, inflation has a lot more to do with the level of economic activities. In spite of a slowdown in terms of growth rate, China’s economy is still growing rapidly at around 7.5% with increasing number of the middle class, pushing up inflationary pressure naturally. The concern was somewhat eased as China’s Consumer Price Index rose 2.5% in January from a year earlier mainly due to muted food prices. According to estimates by J.P. Morgan, the index might pick up later this year, averaging 3% in 2014. The expected level is still below the government’s stated tolerance of 3.5% but implies another worry for growth, which is weaker domestic consumption. So the government has to face a continuous trade-off between inflation and domestic consumption for sustainable development.

Regarding the incorporation of private capital, it is a welcome trend that would inject vigor to the lumbering, state-dominated banking sector, but a stronger framework of regulations has to be developed to ensure fair play in the capital markets. For instance, Alibaba, China’s Internet giant, recently broke into asset management business by launching a money-market fund called Yu’e Bao. The fund initially offered super appealing returns of around 6.8%, which was much higher than those of traditional bank deposits, but then slid to around 5.5% in anticipation of declining interest rates. In addition, there are concerns that a significant portion of the fund flows into untested and unregulated investments eventually, threatening the stability of the overall financial system. People’s Bank of China Governor Zhou Xiaochuan said recently that while the central bank wouldn’t crack down on the products, it would improve regulations. But how to regulate those private players while offering ordinary Chinese people as many money-making channels as possible remains unclear.

In conclusion, I am bullish about the country’s financial reform as long as the four challenges above could be managed effectively. In particular, the leadership has to deal with existing interest groups wisely to reduce resistance and share growth dividends nationwide.