Abstract: In this article, the author examined the two challenges China’s financial sector faces in supporting today’s economic policy. Then he elaborated on the features of the country’s financial system and made clear the pain points, and pointed out the two priorities of financial sector reforms.
I am very happy to share with you today on some economic and financial issues, and I will touch upon my new book The Value of Finance.
I want to start with the just concluded Central Economic Work Conference. We know that the annual Central Economic Work Conference is the most important economic policy meeting which always sets a tone for the economic policy of the second year.
This year's Central Economic Work Conference made a judgment on the current economic situation, which can be summarized in three phrases: demand contraction, supply shocks, and weakening expectations.
We can see from the summary that policy makers are not very optimistic about the current economic situation, so the economic policy guideline for next year is to "prioritize stability while pursuing progress". The meeting also proposed a series of policy priorities concerning macro and micro aspects, and structural adjustment.
As a financial scholar, when I study the policy priorities of the Central Economic Work Conference, one thing that comes to my mind is that finance will play a key role in the next year’s economic strategy.
I would like to start my elaboration with a quote from Nobel Laureate Professor Hicks, who made a famous statement in his review of the economic history of the British Industrial Revolution. He stated that the Industrial Revolution would not have happened without the concurrent development of financial markets.
Why did he say so? We all know that the industrial revolution first occurred in the UK. At that time, the technology of the steam engine had already matured, but the industrial revolution didn’t happen until several decades later. One of the important reasons was that a huge amount of cheap funds need to be invested in economic activities, so that it is possible to turn the steam engine into shipping, railway, and textile industries.
Therefore, I think finance is one of the most important economic inventions in human history. Only with finance can there be the industrial revolution that we see later. More specifically, with the support of finance, economies of scale and division of labor in the economy become possible, and economic development can accelerate its pace. In this sense, China’s economic development next year also requires finance to play a very large role.
I. TWO CHALLENGES CHINA’S FINANCIAL SYSTEM IS FACING
If we look at China's financial system today, we would ask the question whether the system is able to effectively support next year’s policy strategy of "prioritizing stability while pursuing progress"? In fact, there may be some doubts. We do hear some complaints about the financial system at the moment, mainly in two ways:
On the one hand, financial support for the real economy is weakening.
Why is it said that the financial support for the real economy has weakened? I often examine an indicator called marginal capital output ratio, which refers to the number of units of capital input required to produce a unit of GDP. If we look at China's data in the past, the marginal capital output ratio in 2007 was about 3.5, and now it is close to 7, which has doubled. In other words, the financial efficiency does seem to be declining, and financial support for the real economy may be waning.
In real life, we often hear such complaints, such as the difficulty of financing for small and medium-sized enterprises, which is very detrimental to the development of the real economy. We also see that the ordinary people hardly have any good investment channels. Even if people have a lot of money, they don’t have a good place to invest. In the past, when they had savings, they put their money in the bank or bought houses. But now making such investment has become less attractive. However, what other investment channels do we have? For the general public, it is a challenge.
On the other hand, financial risk is rising.
From 2015 to the present, we have seen risks of different scales and frequencies in many financial fields, from the stock market to the bond market, from shadow banking to Internet finance, etc. This is indeed different from the past. In the past, China's financial system was relatively stable, but now the risks have been growing. Therefore, the central government proposes to keep the bottom line of avoiding any systemic financial risks.
The combination of the weakening financial support for the real economy and the rising fianncial risks reflects the huge challenges China’s financial system is facing. This is why I have doubts about whether the financial system can really support the economic policies in the next year.
II. FOUR CHARACTERISTICS OF CHINA’S FINANCIAL SYSTEM
How does this happen? We can look back at what has happened to the Chinese financial system over the past 40 years.
China started to implement the reform and opening up policy at the Third Plenary Session of the Eleventh Central Committee in December 1978. At that time, China’s financial system was dominated by a financial institution (the People's Bank of China), and its financial assets accounted for about 93% of the country's total. It was because China had adopted a planned economy before 1978, at which time allocation of funds was mainly realized through central planning, so the demand for financial intermediaries was relatively small.
But starting with the economic reforms in December 1978, the focus of Chinese government shifted from class conflict to economic development, and the need for financial intermediation arose. China has actually started the process of rebuilding a financial system since 1978.
Looking at China’s financial system after 40 years’ development, we can see the following features:
First, large scale.
The amount of financial assets is huge. For example, the ratio of money supply to GDP has far exceeded 200%, which is relatively high in the world. Our banking system is very large, and China’s four largest banks are basically the top four in the world.
Even the capital markets that are considered to be small compared to the banking sector, including the stock market and bond market, are now probably the second largest in the world in terms of market value.
In 1978, we had only one financial institution. Today the number of financial institutions is huge, with more than 4,000 banks in the banking sector alone.
Second, excessive control.
The government still has a lot of intervention in the financial system. Specifically, all kinds of guidance on interest rate, exchange rate, capital allocation, cross-border capital flow are still common. We once constructed a "financial repression index" using the underlying data from the World Bank. The financial repression index is a concept proposed by Prof. McKinnon, which refers to the degree of government intervention in the financial system. We construct an index from 0-1, with 0 indicating a complete market economy and 1 indicating complete control by the government. We have seen that in the past 40 years, China's financial repression index has dropped from 1 in 1980 to 0.6 in 2018, indicating that the past 40 years have indeed followed the path of market-oriented reform. But at the same time, we can also see that in 2018, among the total of 130 countries in the database, China ranks the 14th, which means even after 40 years’ development, government intervention in the financial system is too much.
Third, weak regulation.
China has a large and complete regulatory system, with established agencies, adequate staffing and measures in place, but the role of this system in identifying and resolving risks remains limited. China is the only major emerging market economy that has managed to prevent large financial crises over the past four decades, which is commendable. However, it has ensured financial stability not by proper regulation, but by having government as the last resort in case of crises, and by maintaining high economic growth so that it can keep new risks under control while working on existing ones bit by bit.
But as the economy grows larger, with an increasingly sophisticated and diverse financial system, it’s impossible to protect financial stability by seeking help from the government each time there is a risk. Regulation must take on a bigger role.
Fourth, bank dominance.
There are typically two kinds of financial systems: market-led systems, and bank-led ones. In a market-led system, the capital market (the stock market, the bond market, etc.) dominates, taking up an overwhelming proportion among all financial intermediaries. Examples of market-led financial systems are those of the United Kingdom and the United States. In comparison, in a bank-led system, banks play the dominant role among all financial intermediaries, like the situation in Germany and Japan. As of today, China has had a bank-led financial system.
In summary, China has spent 40 years to rebuild its financial system, one that features a large scale, heavy intervention, weak regulation and bank dominance.
III. TWO FOCUSES OF FUTURE FINANCIAL REFORM IN CHINA
But why are we having so many complaints of the financial system today, such as those of its low efficiency and high risk as mentioned above? In fact, over the first three decades of reform and opening-up, the financial system in China in general served its purpose very well, remaining highly stable and sustaining an average annual GDP growth of 9.8%. Its effectiveness in promoting stability and growth in the past is beyond doubt.
But why is it becoming less and less efficient? Our empirical and quantitative analyses show that government intervention in the financial system played a positive role promoting economic growth in the first decades of reform and opening-up in China, but is having increasing negative impacts in recent years.
The ongoing transformation in the growth paradigm from factor-driven to innovation-led is putting up new requirements for the financial system in China. That partly explains why the once-efficient system is becoming less so with more problems. This has to be put in the context that the Chinese economy is entering a new phase of development, where the changing growth model has to be echoed by corresponding update in the financial system.
Going forward, China should continue to press ahead with market-oriented reform. Let the market play a bigger role in the resource allocation of the financial system, instead of relying on government intervention.
Specifically, we need to move forward at two fronts: financial innovation and financial supervision.
1. Financial innovation
The extensive growth model that once drove China’s economic development is out of date. The focus now is to spur economic innovation. But a large financial system characterized by heavy intervention, weak regulation and bank dominance cannot serve that purpose. That’s why financial innovation is critical. For finance to better support economic innovation, we could take three measures:
First, boost the capital market, and increase the share of direct financing in financial intermediation.
Second, stimulate bank innovations. Banks will remain major players in the financial system in China at least in the foreseeable future, and they need to change and innovate in order to fulfill their due roles in supporting economic growth. They need to explore new business models to fit into an innovation-driven economy.
Third, encourage digital finance innovations, including those with mobile payment and big-tech lending, so that we could fully tap into digital technologies and big data to assess credit risks and step up financing support for businesses. This is a novel change, and China is at the moment taking the lead.
A roadblock standing in the way of financial innovation is the financing of small- and medium-sized enterprises (SMEs). The traditional financial system catered more to big companies, where credit risk analysis was conducted based on past financial performance and the availability of mortgage assets, but SMEs are poor in both.
SME financing has always been a problem, and is becoming an increasingly acute one. The private economy represented by SMEs has emerged as an important pillar sustaining the Chinese economy, contributing to half, if not more, of tax revenue, GDP growth, urban employment and innovation. However, the innovation, jobs and sustainable growth powered by SMEs will face great headwinds without a financial sector that can serve them well. Thus, the underlying goal of financial innovation is to promote economic innovation and sustainable growth, and an important part of the effort is to support the innovation-driven SMEs.
2. Financial regulation
As said above, in the past, China relied heavily on the government as the last resort to protect financial stability; but this is not a sustainable solution, and it also brings potential moral hazards and adds to the aggregate financial risk. That’s why China needs to step up and build a complete and sound framework for financial regulation.
To this end, first, we need to set three clear policy goals: creating a level playing field, protecting consumer interests, and maintaining financial stability. All financial policies should be oriented toward these goals, and other policy objectives might as well be left to other sectors and departments to serve.
Second, regulators should be given enough authority, tools and motivation to see to it that these policies are fully implemented.
Third, it’s important to ensure accountability. In the past, we have seen many policies that failed to deliver, out of many reasons, even if they have all the necessary inputs: executive agencies, people and rules. It’s important to recognize the progress, but it’s equally important to hold regulators accountable for what they have failed to achieve. Only in this way can future regulatory policies be implemented to the full.
Over the past four decades of reform and opening-up, China has established a huge financial system, and this process has been filled with both laudable achievements and frustrating challenges. And a reason why we find ourselves amidst many new hurdles today is because our economy has entered a new stage of development.
In the short-term view, some of the problems we face now have special reasons behind. As proposed at the Central Economic Work Conference, China is having a sluggish demand, supply-side shocks, and weakening expectations; in addition, there are changes in the international market and blows from the COVID-19 pandemic except for the economic transformation at large mentioned above. But no matter which stance we take to examine this issue, if China is to achieve the policy goal of prioritizing stability while pursuing progress, financial policy has an indispensable role to play.
