Tag Archives: Structure Upgrade

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.

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.