Abstract: China’s policymakers have ten things to do in order to improve the role of finance in serving the “dual circulation” strategy. First, properly understand the role of finance in the new development strategy; second, the supply-side structural reform in the financial sector should continue to play a core role; third, improve the intertemporal design and adjustment of macroeconomic control, better align short-term policy measures with medium-to-long-term strategies; fourth, improve the balance sheets while guarding against the tendency to use the housing market as a means to stimulate the economy in the short term; fifth, institutional opening of the financial sector must be firmly propelled; sixth, implement a negative list approach as it can help consolidate China’s resolution to further open up; seventh, further promote the international use of Renminbi; eighth, improve the institutional setting of China's capital market; ninth, boost equity financing to address the demand of small and micro businesses; tenth, improve supporting mechanisms to spur the development of China’s pension market.
China’s policymakers should pay attention to the following issues to improve the role of finance in serving the “dual circulation” new development pattern.
1. Properly understand the role finance plays in the “dual circulation” new development strategy.
Chinese President Xi Jinping has repeatedly emphasized the close relationship between the prosperity of the economy and the development of finance. I think finance will undoubtedly play an important role in the formation of the “dual circulation”. In other words, the structural reform of the financial sector must focus on resolving the difficulties and pain points in the “dual circulation” development pattern, and on supporting the innovation and development of the real economy. This should be the proper role of finance in the new development pattern.
Internationally, western financial powers like the UK and the US have successfully supported the three industrial revolutions through innovation of the commercial banking system as well as the development of the capital market including investment banking and venture capital, which have thereby laid a solid foundation and provided a sound financial environment for the innovation and development of the real economy. China today can be regarded as a financial giant, in the sense that scale wise, its banking system, credit market and foreign exchange reserves rank the first, and its stock market, bond market and insurance market rank the second in the world. However, there is still a long way to go for China to become a financial power.
The launch of the “dual circulation” strategy has provided an opportunity for the structural reform of China’s financial sector to better serve the high-quality development of the economy and for China to transform into a financial power. Finance is the engine of modern economy, and, to some extent, the efficiency of finance and technological innovation can boost each other, which have already been proved in some developed countries. As is well known, Wall Street and Silicon Valley enjoy a symbiotic relationship that contributes to the success of both.
At a symposium on September 11, President Xi reiterated the importance of science and technology innovation, saying that the modernization of science and technology has always been an important part of China’s modernization efforts. In particular, boosting domestic circulation requires a better supply system. In this process, science and technology innovation play a key role in creating new supply and subsequently new demand. Technology tools are also indispensable in preventing supply chain disruption and enabling free circulation between domestic and international markets. This means that the new round of opening-up and reform of China’s financial sector under the “dual circulation” strategy must aim to accelerate a technology-driven transformation from indirect financing to direct financing. Only when the whole financial system becomes more open and robust, can it provide more targeted and direct financial support for new economy, new technologies and new industries.
2. The supply-side structural reform in the financial sector should continue to play a core role in the new development pattern.
First, the dual-pillar regulatory framework comprising monetary policy and macro-prudential policy should be further improved and monetary policy should be more flexible and moderate.
In particular, under the current situation, the structural monetary policy tools can be improved to strengthen the support of finance for the real economy, particularly for manufacturing, private businesses and small- and micro-sized enterprises, in order to bolster the willingness and capabilityof residents to consume, boost private investment, expand domestic demand and promote the formation of a unified domestic market, and generate demand for the formation of “dual circulation”, particularly the circulation of the domestic market. In the meantime, we should also strengthen regulation, enhance the supervision of systemically important financial institutions, establish counter-cyclical capital buffers and macro-prudential pressure test system, enrich macro-prudential toolkits, and establish mechanisms for the adoption, adjustment and exist of these macro-prudential tools.
Second, develop multi-layered capital markets, with a particular focus on cultivating innovation-friendly equity financing and securities market, and establish reinforcement among technology, modern finance and the real economy; strive to develop supply chain finance and strengthen the integration and coordination between finance and supply chains. Meanwhile, while providing support to the development of strategic industries, the financial sector also needs to serve the upgrade of traditional manufacturing industries because only in this way can an efficient and complete production and supply system be built to support the formation of “dual circulation”, especially domestic circulation.
Third, gradually promote Renminbi internationalization. During this process, it is particularly important to promote the use of Renminbi in cross-border trade, investment and the pricing of bulk commodities. On the one hand, the use of Renminbi can be expanded through such mechanisms as bilateral currency swaps, foreign aids and foreign concessional loans; on the other hand, the development of cross-border payment infrastructure, for example the Cross-border Interbank Payment System (CIPS), should be strengthened to improve the efficiency of Renminbi clearing and settlement, gradually reduce Chinese financial institutions’ reliance on SWIFT and safeguard the capability of finance in supporting Chinese businesses in participating in international economic circulation.
3. Improve the intertemporal design and adjustment of macroeconomic control, better align short-term macroeconomic measures with medium-to-long-term development strategies, and adopt policies of proper intensity and pace in the short term to leave policy room for the structural reform in the medium to long term.
President Xi has pointed out that “Although Chinese economy is facing huge pressure, domestic economic fundamentals are stable overall. The economy is still characterized by ample potential, strong resilience, large maneuver room and sufficient policy instruments.” Under the impact of the COVID-19, China has adopted strong counter-cyclical adjustment policies which have played an important role in supporting the rapid recovery of the economy. However, in order to prevent potential side-effects brought by excessive stimulus, the policy focus has been placed on pandemic control and helping businesses resume work and production. As a result, both fiscal and monetary stimulus have remained relatively moderate and the leverage ratio of the government sector has remained controllable.
Regarding monetary policy, compared with other developed economies, the expansion of the balance sheet of the People’s Bank of China (PBC) has been relatively mild, and there is still room for further rate cuts. This means that compared with most of other major economies, there are still sufficient policy instruments at disposal to respond to possible shocks in the future. However, the sharp increase of new credit and social financing can still drive up the leverage level of the economy. According to the quarterly report on macro leverage ratio released by the Chinese Academy of Social Sciences, the ratio increased by 21 percentage points in the first half of this year, from 245.4% at the end of last year to 266.4%. Such a situation requires the easy credit policies to be more targeted in the future, which means that while helping small- and medium-sized enterprises (SMEs) overcome the difficulties, the government should also prevent a large amount of newly created liquidity from flowing into the stock and housing markets which could drive up asset prices and cause risks to accumulate. In particular, actions should be taken to prevent capital idling and arbitrage as such practice will push up the financing costs of the real economy.
4. Pay attention to the repair of the balance sheets while guarding against the tendency to use the housing market as a mean to stimulate the economy in the short term.
First, what should be particularly noted is that it takes time for the balance sheets of the government, non-financial business and residential sectors to be repaired. The pandemic shock is somewhat asymmetrical with the balance sheet of SMEs having suffered more damage. Correspondingly, the government’s relief policies so far have mainly targeted the cash flow challenges facing these enterprises. How quickly their balance sheets can improve will be constrained by the recovery speed of the effective demand.
Second, the tendency to use the housing market as a mean to stimulate economic growth still exists. The rise of the Chinese economy to a large extent has been driven by investment. In recent years, the proportion of fixed asset investment in GDP has reached 70%-80%, of which a large portion is investment in the real estate industry. In fact, the housing industry in China had already shown signs of overheating before the COVID-19 outbreak, with the proportion of real estate investment in GDP reaching 13% in 2018. Meanwhile, there has been a severe imbalance in the prices and supply-demand relationship across different regions. More alarmingly, the excessive concentration of financial resources in real estate-related industries has led to economic distortion and severe crowd-out of consumption.
The economic data for the first seven months this year show that real estate development and investment has remained resilient, taking lead in returning to positive growth with a rate of 3.4%, which no doubt contributed to China’s economic recovery. At the same time, however, housing prices in some cities have been picking up rapidly despite the shock of COVID-19. Some funds have been directed into the housing market in violation of regulations. Such phenomenon will not only destabilize the housing market, but also increase risks in the financial system and bring negative impact on the recovery of domestic demand, particularly consumer spending and manufacturing investment which is the most productive part of fixed asset investment.
5. Institutional opening of the financial sector must be firmly propelled. Despite the anti-globalization trend, international connectivity and communication is still essential to the development of global economy.
Reform and opening-up is China’s fundamental policy and an important driver of the sustainable development of its economy. While the liberalization of flows of goods and production factors in China has achieved satisfactory progress, little substantive headway has so far been made in terms of institutional opening. There’s still a huge gap between the level of China’s financial opening and international norms.
At the Central Economic Working Conference held at the end of 2018, Chinese leaders proposed that the country should fully understand and adapt to the new situation, and the opening process should move from enabling free flow of goods and production factors to rule-based institutional opening which, at core, is promoting market- and law-based opening while actively learning and participating in international rule-making. This means there’s still a long way to go for China’s financial opening. Currently, foreign investment accounts for less than 5% in China’s stock market, and less than 4% in China’s bond market. Meanwhile, the share of Renminbi in global foreign exchange reserve is less than 3%, and the share of foreign capital in China’s banking industry is less than 2%. Hence, China’s financial sector has huge room for further opening-up in the future.
6. A negative list approach can help consolidate China’s resolution to further open up.
Under the “dual circulation” pattern, the promotion of capital account liberalization and Renminbi internationalization must follow the government’s guidance on optimizing the market-based allocation of production factors and improving the system of socialist market economy in the new era. When designing the path for rule- and law-based opening, policymakers must avoid judging the progress of opening by the level of freedom given to capital flow, and institutional arrangement should not be used as a means of managing fluctuations in capital movement.
As per international standards, a negative list approach is often adopted in regulating currency convertibility and internationalization, because under this approach, opened-up items are the norm while restricted items are the exceptions. A negative list is irreversible in the sense that to open up wider, we can only remove items from the list, but not adding new ones onto it. Only institutional opening based on the negative list approach can provide the support necessary for a currency to become a global safe-haven currency. China’s capital account would be considered highly convertible when evaluated against the positive list since only five or six of the forty plus items are non-convertible. However, if we apply the negative list, only seven or eight items are totally convertible, with all the other items subject to capital controls to various extent. Thus applying the two standards can produce very different results.
7. Promoting international use of Renminbi will help stimulate the “dual circulation”.
Since the PBC started to test with settlements in Renminbi in cross-border transactions in July 2009, China gradually eased the restrictions on the use of its currency in cross-border trade and investment. Over the past decade or so, the ability of Renminbi in assuming the functions of an international currency in payment, investment, financing, pricing and acting as a reserve asset has all improved. Now it is the second most used currency in cross-border payment, the fifth largest for international payment, the fifth largest international reserve currency, the third largest currency for trade financing, and the eighth largest for foreign exchange transactions. Its use in pricing has also been significantly improved.
Promoting the use of Renminbi in international transactions is becoming increasingly important against the current backdrop. This is mainly due to the fact that non-market factors play a bigger role in the choice of cross-border currencies in a world seeing constant changes in the international political and economic landscape, with rising geopolitical risks, prevailing unilateralism and trade protectionism, and increasing politicization of economic and trade issues. What used to be considered trivial factors due to trading inertia and path dependence have become more important.
In the past, businesses mainly considered market factors when choosing a currency for cross-border settlement, such as exchange rate risk, currency conversion costs and financing cost. Renminbi as a currency with high interest rates is attractive to foreign investors as China opens up its financial market wider, but in global trade, its costs are higher compared with the US dollar, the Euro or the Japanese yen. However, concerned with the possibility that settlement in US dollar could be arrested by the United States’ financial sanctions and long-arm jurisdiction, more businesses are turning to Renminbi in their cross-border transactions.
In fact, the habitual dependence upon the US dollar system for settlement could also be reduced through refined management. Most countries adopt the netting model when settling in US dollars, which means that banks in one country will finish domestic intra-bank and inter-bank settlements before they settle abroad. In contrast, most Chinese banks choose the gross settlement system. Their headquarters, branches or overseas branches complete the settlement directly through SWIFT and CHIPS. According to statistics, under the gross settlement system, the daily average amount of settlement in China stands at around two to three trillion yuan, but the number would only be about one-tenths of this amount if netting settlement is applied. The gross settlement system has not only incurred higher service charges, but also increased Chinese businesses’ reliance on the American payment settlement system. Under the “dual circulation” strategy, it’s important for China to widely promote the use of netting settlement.
8. Improving the institutions and systems for China’s capital market will boost sound development.
The institutional arrangement for a capital market determines the latter’s quality of development. Under the “dual circulation” strategy, it’s more important to utilize global financial resources to promote the high-quality development and modernization of the Chinese economy through institutional reforms in the financial sector than to blindly spread China’s financial resources to other countries in an ill-organized manner. Stepping up the opening of China’s capital market can not only attract high-quality resources from abroad and boost in-depth institutional reform of the market, but also introduce mature market rules and investment philosophies by engaging more foreign investors. This will improve the ability of the Chinese capital market in allocating global resources.
Opening up the capital market does not only mean to remove the restrictions on foreign investors; more importantly, it seeks to integrate and better align the Chinese market with the international market. The rules applied in the Chinese market are very different from those in developed economies, and its current systems for information disclosure, delisting, short-selling and investor protection, among others, all need improvement. Foreign investors unfamiliar with China’s investment environment tend to be more risk-averse and prefer short-term investments. To level up its financial opening, China needs to promote the registration-based IPO reform grounded on information disclosure, improve the delisting mechanism and prevent against excessive administrative intervention, enhance investor protection, so as to create a level playing field and align the financial market with international standards. Only in this way can the capital market play a pivotal role in enhancing China’s competitiveness.
9. Boosting equity financing to address the demand of small and micro businesses by implementing the pilot program for equity investments by commercial banks.
From the perspective of business cycles, what small and micro businesses need the most in their start-up and growth periods are equity investment rather than loan credit. Data show that VC investment in China has undergone big adjustments since 2019, with the total volume publicly disclosed at only 40.5 billion yuan in 2020, a quarter of the amount in 2019; besides, small and micro businesses were not especially favored by venture capital, either.
If deep-pocketed commercial banks are allowed to make equity investment, they will empower small and micro businesses and better serve the real economy. The investments by commercial banks usually have a longer time horizon compared with the short-term and profit-driven nature of social capital. So they can sustain businesses to grow steadily over the long run. What’s more, equity investments backed by the financial prowess of commercial banks will attract more loans and double the funds available to businesses in need. Meanwhile, banks are better at integrating their resources with which they can build comprehensive service platforms for businesses and introduce support from industrial investors, consultancy agencies, factors and insurance companies. In this way, they can help businesses improve financial management and corporate governance, foster more competitive businesses that have the potential to go public, and support the high-quality development of the Chinese economy.
Thus, to promote “dual circulation”, China should fully implement the Guiding Opinions of the China Banking Regulatory Commission, the Ministry of Science and Technology and the People’s Bank of China on Supporting Banking Financial Institutions in Intensifying Innovation and Implementing the Pilot Program of Debt-Equity Combination Financing for Scientific and Technological Innovation Enterprises (No. 14 [2016]. CBRC).
First, China should allow pilot banks to establish domestic investment subsidiaries and expand pilot cities to cover those with a high concentration of technological start-ups such as Shenzhen and Xi’an.
Second, banks with adequate capital should be allowed to put some of its money in equity investments, and their performance could be monitored by calculating the risk rating ratios on a regular basis. For example, drawing on the calculation method of risk rating ratios in debt-to-equity conversions, commercial banks could be allowed to assign low risk weighting to their equity investments in strategic emerging industries for the first two to three years to smooth out fluctuations in their capital input over the investment period.
Third, give full play to the incubation and exit mechanisms of the STAR market. Relevant government departments could use fiscal resources to establish private equity funds or funds of funds targeting SMEs, to provide financing for enterprises in their start-up stage. These funds should be managed by banks, and this will be an important way to deliver tangible results of debt-equity combination financing. Meanwhile, the PBC and other regulatory agencies could jointly set up a service center for financial inclusion that coordinates efforts to remove barriers to inclusive finance practices, bolster up the new pilot programs for innovation in supply chain finance, and boost the development of digital and inclusive finance. This will help stimulate the domestic circulation.
10. Improve supporting mechanisms to spur the development of China’s third-pillar pension market.
The sound development of pension finance in China will be important for pressing ahead with the “dual circulation” strategy, and it is a crucial way to facilitate the formation of long-term capital. In some senses, the third-pillar pension market, which is vital to supporting the huge group of aged people across the country in the future, holds the key to addressing some tricky issues, including improvement of the financing structure, restructuring of the financial system, long-term capital formation and reduction of macroeconomic leverage, among others.
It’s widely known that the savings rate in China is high. But in the past, a large proportion of the savings translated into net outbound investments in the form of net exports. Under the “dual circulation” strategy, Chinese businesses will enhance their own R&D capacity or carry out long-term investment. To support these drives, China needs to address the lack of long-term capital formation. That is to say, changes in the macro environment calls for a revamp of the pension financing system.
Compared with the mature and successful pension systems elsewhere in the world, the major obstacles stemming the development of the third-pillar of pension in China include insufficient tax preferences, cumbersome taxation procedures, and inadequate incentives for the Chinese people to participate, etc. Meanwhile, neither economies of scale nor institutional investors are developed enough, and there is a lack of synergy between the pension system and the capital market. To overcome these barriers, tax policies need to be improved, while financial institutions should play a bigger role. I believe that as the Chinese population continues to age, China will have to replace the current DB pension scheme with a DC scheme.
First, establishing the third-pillar pension market will allow short-term savings of the household sector to be turned into long-term capital, which will promote the development of the direct financing market and step up the deleveraging drive. According to official estimates, China’s GDP in 2020 is expected to reach 100 trillion yuan, while the amount of household financial assets will climb up to around 200 trillion yuan. On the balance sheet of the Chinese household sector, 30% of the assets at a total of around 60 trillion yuan are put aside for old-age care, 40 trillion of which are kept in the third-pillar pension account. If 20% of the money is handed over to professional asset managers, the amount of funds available for equity financing will be as high as 8 trillion yuan; once these funds are managed in a scientific and careful manner, they will become long-term capital and used to meet businesses’ demand, which will be a major drive for deleveraging in the business sector.
Meanwhile, building up the third-pillar pension market will also help foster more competitive institutional investors and buttress financial stability. China’s capital market has long featured a large number of individual investors, high volatility and prevailing speculations, making it less attractive and incapable of serving the real economy. In comparison, institutional investors, large in scale, well-informed, equipped with professional and scientific models for investment decision-making, behave more closely to “rational agents” under the efficient market hypothesis. Therefore, the financial market will develop more sturdily when institutional investors play a bigger role.
To realize the above-mentioned structural changes in the financial sector, we have to keep an open mind and work to deliver tangible outcomes. This will be an important prerequisite for China to foster a new development pattern featuring the “dual circulation”.
