Abstract: China’s economic growth, in a new stage, will depend more on innovation, which the previous financial model cannot support. Financial innovation, market-oriented reform, financial regulation enforcement, and financial openness will be key components of the transformation of China's financial sector.
Ⅰ. CHINA'S TRADITIONAL FINANCIAL MODEL FACES ADJUSTMENTS IN THE NEW DEVELOPMENT PHASE.
Such a financial model may be problematic now, but for the past few decades, ithad nobig problems supporting economic growth and financial stability. Lately the problems seem to be getting more and more, with complaints getting louder. Financial efficiency is declining, while financial risks are rising.
Why are there problems in this system after 3-decade effective operation since the reform and opening-up? There are many ways to explain it, the most important of which is that the Chinese economy has entered a new stage. When China started the reform and opening-up policy in 1978, its per capita GDP was about US$200, making it one of the poorest nations, but itslow-cost production enabled an extensive factor-input growth. The average annual GDP growth reached 9.8% in the first three decades after the policy was employed.
However, things have gradually changed. China’s per capita GDP exceeded US$12,000 in 2021, one step away from the high-income threshold in the World Bank standard. Chinese people are living richer and better life. At the same time, it also bumped up the production costs, depriving the nation’s advantage, and forcing it to change the growth model from factor-intensive growth to innovation-driven growth. And only by upgrading and improving efficiency through innovation can China maintain its competitiveness, otherwise, economic growth will be difficult to sustain.
When the old financial model ceased to fit with the new economic growth model, problems emerge in the financial system, hence the financial model must change along with the economy. There is much space for China’s financial transformation, which is concentrated on the following four fronts.
1. Financial Innovation
China’s previous extensive and factor-input growth model is barely uncertain, because the products China was producing used to be produced in other countries decades or even hundreds of years ago, whose technology and markets had been highly developed. To win competitiveness in those sectors, you will just need to be cheap enough. Simply put, the uncertainty is relatively low and the risk is relatively small. But such a financial system is not well-positioned to support innovation-driven economic growth.
For example, the Chinese government used to emphasize the issue of SME financing. It is an ingrained headache due to the difficulties in acquiring customers and controlling risks.
First, it is hard for financial institutions to learn the financing needs and provide financial services to SMEs that are large in number but geographically dispersed. A traditional approach is to set up nationwide branches to get close to corporate customers, but doing so is expensive, especially when it is not easy to obtain sufficient returns in many places.
The other obstacle is risk control. For financial institutions, providing financing services for enterprises requires both the ability to lend out money and the ability to get money back, but the latter is a bigger challenge. They need to conduct a comprehensive and rigorous credit risk assessment for SME customers and evaluate the repayment ability and repayment willingness. The traditional approach is based on customers’ financial data and collateral assets, which, unfortunately, are precisely what SMEs lack, so most banks are unwilling to provide financial services for SMEs.
However, as China's economic development has entered a new stage, the difficulty of financing SMEs is no longer a simple financial inclusion problem, but a constraint to the economy, because private enterprisesfeaturing SMEs are the main force of the Chinese economy and play a pivotal role in employment, innovation and economic growth. In other words, one of the great challenges facing innovation lies in whether it can better provide good financial services for SMEs. From this perspective, financial innovation still has a lot of room for development.
First, increase the proportion of direct financing in the financial system. Compared with thebank-dominated financial system, direct financing in the capital market can often better support innovation activities. There are many reasons, including that direct financing can better identify innovative projects and share risks and benefits with start-ups, while you need to repay the principal and interest to banks, which sometimes is pressure on cash flow. Therefore, the capital market has more advantages in serving innovation. China could develop the capital market and increase the proportion of direct financing in the financial system.
Second, commercial banks are encouraged to increase innovation. The bank-led financial structure in China will not change much in the short term, but innovations in the business model are always needed. Banks must find ways to support innovation activities. Globally, financial systems can be roughly divided into two categories: one is a market-led financial system, represented by the United States and the United Kingdom; the other is a bank-led financial system, represented by Germany andJapan. Although the UK and the US are relatively more active in technological innovation, Germany and Japan are also world leaders in economic development and technological innovation. China should learn from the countries with bank-led financial systems, encourage commercial banks to innovate in business models, and actively support innovation activities. There is a lot to do in this regard.
Third, vigorously develop digital finance. Digital finance can better serve SMEs and innovative activities, which is the direction of future work. Big tech credit is an area of concern at present, which can help the financial sector to better serve SMEs as it can use digital technology to overcome difficulties of customer acquisition and risk control. In the past, traditional financial institutions needed to set up branches all over the country to be close to users, which is expensive and not practical. However, digital technology and big technology platforms, such as WeChat and Alipay among other platforms with over one billion daily active users, have actually reached a large number of customers at relatively little cost. These platforms can acquire customers quickly with extremely low marginal costs, partly solving the difficulty of customer acquisition. Meanwhile, customers' activities on the platform, including social networking, shopping and payments will leave a digital footprint. The platform can use big data accumulated by the digital footprint to conduct credit risk assessment, so as to assess the default probability of the borrower. According to research, big data-facilitated credit risk assessment of small and micro enterprises is relatively reliable. This shows that digital technology innovation can help clear up many problems the financial system in the past could not resolve. Of course, digital economy is only one aspect of financial innovation, and innovation in markets and banks is also important.
2. Market-oriented Reform
The Financial Repression Index of China has dropped from 1 to 0.6 since the adoption of reform and opening policy, but it is still at a very high level. Whether state-owned enterprises and private enterprises can truly stand on the same starting line when financial resource allocation and credit decisions are made is an important issue of market-oriented reform. Meanwhile, efforts should be made to realize truly market-based risk pricing. For example, the determination of loan interest rate is the core of market-based risk pricing. A high market risk should correspond to a high loan interest rate, because the cost must cover potential risk, otherwise banks may suffer huge losses in the future, which is the basic requirement of market-based risk pricing. However, in the past few years, the regulatory authorities kept urging banks to reduce the financing costs of SMEs. This practice of using administrative means to lower interest rates for corporate loan may be effective in the short term, but in the long run, banks may be less willing and capable of providing loans to SMEs.
SMEs have indeed suffered financing difficulties, but the financing environment for SMEs in China has been greatly improved in recent years. This can be illustrated with two sets of data. The first is the share of SMEs in total bank loans. According to data released by the OECD, the proportion of Chinese SME loans in total loans has reached 65%, the highest proportion in countries other than South Korea and Japan. This shows the great achievements brought by the hard work in over a decade. The second data is the asset-liability ratio of private enterprises. After the global financial crisis, the problem of financing difficulties for private enterprises has become more prominent, and the tendency to deleverage is obvious, while the asset-liability ratio of state-owned enterprises is relatively stable. However, by the end of 2021, the asset-liability ratio of China’s private enterprises has surpassed that of state-owned ones, behind which the reasons are complex. One thing to note is that private enterprises are not limited to small and medium-sized enterprises, and there are large ones as well. From these two sets of data, it can be seen that the financing environment faced by the small and medium-sized enterprises in China has been greatly improved.
However, this leads to a key question: how are these improvements achieved? At present, using administrative means to solve problems is still very common in China. Despite the contribution made by financial institutions, such as digital financial innovations, administrative regulatory requirements still have more weight in the process. The basic content of these regulatory requirements is that commercial banks must have their annual loans to SMEs and the proportion of SME loans in a bank’s total loans increase from the previous year, otherwise they will be subject to regulatory accountability.
Now, these highly administrative requirements have indeed increased loans to SMEs, but there is an important challenge here. Is the risk controllable? Arethe loans profitable? If these two targets are not met, even if the policy goals are achieved in the short term, it will be difficult to sustain in the long run, and even cause many new problems. Being profitable means that the cost is lower than possible return; being risk controllable means that the bank must have the ability of customer acquisition and risk control.
The big technology platform uses big data to replace collateral for credit risk assessment, and the effect is good so far. For example, the average non-performing rate of WeBank and MYBank is much lower than that of loans lent by traditional commercial banks, indicating that big data-enabled credit risk management is fairly effective.
Therefore, although the current financing environment for SMEs has been improved, if policymakers continue to use administrative requirements to force commercial banks to provide loans to SMEs, it will eventually lead to serious financial risks and financial consequences. In this sense, China must further promote market-oriented reforms and solve problems with market means, including realizing market-based risk pricing and further reducing the Financial Repression Index. The core is to rely on financial innovation itself, which is the general direction of future development.
3. Financial regulation must be put in place.
The fact that China has boasted financial stability over the past three decades without major risks was not a result of effective regulation, but more of the government's role of providing compensation and sustained high economic growth. Now this model is found difficult to sustain in the long term. On the one hand, as China’s financial system grows in size and complexity, it is unrealistic for the government to resolve the problems as soon as they arise. On the other hand, economic growth in China is declining. The Bank for International Settlements has pointed out that financial risks have risen in many countries after the financial crisis, and summed it up as a risk triangle: rising leverage, falling productivity and shrinking policy space. Under this situation, it is difficult for China to rely on the old financial model to support economic growth.
In terms of regulation, China has a lot of room for improvement. In the past, despite a regulatory framework, personnel, tools, and goals, implementation of regulatory rules in many fields were absent in practice. In the past two years, small and medium-sized banks started to confront problems, which was largely due to the absence of the implementation of regulatory rules. For example, illegal operation of major shareholders is expressly prohibited by rules, but it has become a relatively common phenomenon. This shows that China must further improve its regulatory system. Specifically, there are three important directions:
One is the goal. The most important goal of regulation is to ensure adequate competition, prevent monopoly, protect the interests of consumers, and the ultimate goal is to maintain financial stability. At present, regulatory objectives in China are very complex, and the objectives are not completely consistent. For example, industry regulation and financial regulation are inherently contradictory to each other. The second is authority. With regulatory goals being determined, the regulatory authorities should be given corresponding powers to decide what measures to take and the time to take measures. The third is accountability. In the past, the law was not enforced when everyone was an offender. When everyone does wrong, no one can be blamed. Therefore, there is a need to enforce regulatory accountability. After more than 40 years of financial reform, a regulatory framework has been established in China, but practical implementation of the regulatory policies need to be secured in the future.
4. Financial Opening Up
The opening of China’s financial sector is significantly important, and must be realized in a steady way. Some countries rashly promoted the opening of capital accounts and the financial sector before conditions became ripe, which eventually led to large financial crises. Therefore, it is necessary to strike a balance between improving financial efficiency and maintaining financial stability.
To sum up, as Chinese economy has entered a new stage of development, the old financial system is not able to serve the new economy efficiently and changes must take place. Changes may touch upon the following: encouraging financial innovation, promoting market-oriented reforms, implementing financial regulation, and steadily promoting financial opening. The direction of China’s financial reform is rather clear, which is to embark on the path of a capital market, carry forward market-oriented reform and accelerate internationalization.
II. PRAGMATIC REFORM WILL REMAIN THE BASIC FEATURE OF CHINA'S FINANCIAL REFORM IN THE FUTURE
Although the general direction of financial reform is clear, how the financial model will evolve in the future remains a question. There is still a lot of room for discussion. Will it become a bank-led financial system like Germany and Japan, or a market-led financial model like Britain and the United States? Can marketization reach a high level? How to improve the regulatory framework? Answers to these questions are related to the basic characteristics of China's financial reform.
It is worth pointing out that despite the mentioned models out there, China never has a definite target model to learn from. China’s financial and economic reform has never had a clear blueprint or target model from the start. This can be attributed to two reasons. The first reason is that when the reform and opening-up policy was formulated in 1978, it was actually difficult to figure out what changes would take place in the next few decades, and more importantly, the political environment at that time did not allow the explicit expression of radical ideas. For example, the concept of a socialist market economy was not put forward until fifteen years later. The second reason is that China’s economic reforms, including financial reforms, are very pragmatic. The purpose of implementing reform policies is to solve problems, because of which the ultimate goal might be ignored even though the direction is rather clear.
It is concluded that pragmatic financial reforms have the following two characteristics: First, any reform policy must be feasible. Some policies sound good, but cannot be implemented. Such policies don’t have much value. For example, requiring the establishment of a huge capital market tomorrow is not practical as this is not something that can be accomplished overnight. In addition, political feasibility is equally important, because China’s reform is characterized by gradual progress and dual tracks. An important manifestation of pragmatism is to solve practical problems on the premise of feasibility.
Second, the determination and evaluation of reform measures are generally result-oriented. That is to say, each step of the reform must be based on actual results. If the effect is good, the reform can move forward, otherwise it must take a step back. This is consistent with Deng Xiaoping's quotes "crossing the river by touching the stones" and "black cat or white cat, if it can catch mice, it’s a good cat." Though there are issues remaining to be dealt with, the financial reform in the past over 40 years has seen good results. Meanwhile, we also have to admit that this pragmatic approach to reform sometimes raises new problems. Without thorough reforms, new interest groups can arise, and are likely to hinder future reforms in the new stage. Therefore, the continuous advancement of reform is an important condition for the success of pragmatic reform.
The direction for China’s financial reform is clear: higher level of marketization, and internationalization, stronger role of the capital market, and more effective regulation. But meanwhile, China will continue to take a pragmatic approach to the reform for a long time and move forward step by step.
First, although direct financing will gradually account for a larger share of China’s capital market, it is unlikely to reach the level of the UK and US very soon. Many factors determine whether a country’s financial system is dominated by banks or capital market, including the legal system, cultural background, and political system. Therefore, even if China will rely more on direct financing from the capital market, in the foreseeable future, banks remain the main financing channel in the country.
Second, though China will move towards financial mixed operation, whether it can directly transition from separate to mixed operation depends on the prerequisite whether it can control risks. Mixed operation can bring huge returns and better efficiency, but risk control and identification also become more complicated. Therefore, it will be a gradual process to transfer from separate to mixed operation.
Third, market-oriented reform is a multi-step progress. Although China’s Financial Repression Index might keep decreasing, in the current context, the government will still play an important role in the financial system. As long as administrative intervention is beneficial, China will continue to take the approach.
Fourth, how the regulatory model will evolve is uncertain at the moment. Currently, China adopts a specialized regulation model. Yet it is not clear whether different regulators will be integrated into a comprehensive service institution or divided into prudential and conduct regulation authorities.
In summary, by 1978, China hadn’t established a complete financial system, and the so-called financial model at that time was solely based on one exclusive authority — the PBOC; after 40 years of market-based reform, China’s current financial model shows four main features: large scale, strong intervention, weak regulation, and bank dominance. However, under the present market condition, the system that used to work is becoming less effective. In the future, China will move towards a larger share of direct financing, higher level of marketization and internationalization, and more effective regulation. Though the general direction is clear, we should still take a “pragmatic” approach. This means, in the foreseeable future, the proportion of direct financing from the capital market will increase, but will not reach the level of the UK and US; though China’s financial system will become more market-oriented and the pricing of financial assets and allocation of financial resources will rely more on market-based approach, the government may still play a big role in the operation of the financial system; in addition, it also takes time to achieve competitive neutrality to level the playing field between SOEs and privately owned enterprises.
Yet if we stick to the principle of “pragmatism” by stressing feasibility and being result-oriented, it is highly possible that the reform can be advanced steadily. The future financial model should better support economic growth in the new development era. Meanwhile, we should also be mentally prepared for the potential financial risks and turmoil in the future.
