IIS Policy Brief, November 17, 2013

Financial Reform May Continue at a Slower Pace

ZHANG Ming

The third plenum was expected to set the direction and principles for financial reform. Defying market expectations, the communique released after the four-day meeting made no direct mention of the subject. 

In the past, China's financial model was a key engine of growth. Interest rate regulation and capital account control channeled funds from the household to the corporate sector. The undervalued exchange rate helped boost export growth. State-owned commercial banks played a central role.

That approach also had costs. Cheap credit fueled over investment and low returns to savers reduced income for households, denting consumption. An undervalued yuan encouraged investment in manufacturing, at the expense of the more job-creating services sector.

To facilitate China's transition to domestic-demand oriented growth, Beijing must accelerate financial sector policy changes. At a minimum that would include liberalization of interest and exchange rates, opening the capital account, and creation of more private financial institutions.

The communique made no specific mention of any of these areas. Instead, it stated the general intention to “strengthen the financial market system” and “achieve the free but orderly flow of factors between domestic and international market.” 

The most likely explanation for the omission is that financial reform had advanced at a satisfactory pace so far, and top leaders deemed it unnecessary to delve into the detail in the communique. Reform will continue, though perhaps at a slower pace owing to the report's emphasis on the coordination and integration of all policy changes.  We can't discount the possibility that financial sector reforms have run into opposition, and the lack of consensus is the reason the communique is short of detail. If this is true, then financial policy change will continue to face opposition, uncertainty, and even stagnation.

If reforms are on track, the first half of 2014 could see a series of new initiatives.

China will still keep a ceiling on benchmark deposit interest rates in the short-term. Policymakers may implement three courses. First, establish a national deposit insurance company, setting the quota for each family at about 500,000 yuan. Second, liberalize longer-term interest rates (more than 5 years). Finally, issue more large-scale certificates of deposit linked to the Chinese currency and allow the market to determine the interest rate.

The People's Bank of China will maintain control of the daily fixing of the yuan exchange rate against the U.S. dollar. It might expand the daily fluctuation band of CNY/USD to plus or minus 2- to 3 percent from plus or minus 1 percent.

The PBOC may publish a timetable by which it will liberalize the capital account by 2015 and completely open it by 2020. After a heated debate between academics and policymakers over whether the central bank should accelerate capital account openness, the PBOC appears to have adopted a gradual and cautious approach. Governor Zhou Xiaochuan has said that even if the capital account is fully open, the PBOC will still monitor and regulate volatile short-term capital flow.

Development of the Shanghai free-trade zone will push forward additional reform. The establishment of the national deposit insurance company would be the prerequisite for the creation of private commercial banks. Dominance by large state-owned commercial banks is unlikely to face strong challenges in the short-term.

Overall, it seems likely that shifts in the financial sector will progress at a slower pace than anticipated before the third plenum. The tapering of U.S. Federal Reserve's quantitative easing program as well as the stress of commercial banks’ balance sheet means additional headwinds to reform.

（IIS简介：国际投资研究系列（International Investment Studies）是中国社会科学院世界经济与政治研究所国际投资研究室的研究成果。该室的主要研究领域包括跨境直接投资、跨境间接投资、外汇储备投资、国家风险、国际收支平衡表与国际投资头寸表等。国际投资室的成员为张明、王永中、张金杰、李众敏、李国学、潘圆圆、韩冰与王碧珺，定期参加国际投资室学术讨论和报告写作的成员还包括姚枝仲、林念、王宇哲、高蓓、陈博、刘洁与徐以升。我们的主要产品包括：中国跨境资本流动季度报告、中国对外投资季度报告、国家风险报告、工作论文与财经评论等。）

【责任条款：本报告非成熟稿件，仅供内部讨论。报告版权为中国社会科学院世界经济与政治研究所国际投资研究室所有。未经许可，不得以任何形式翻版、复制、上网和刊登。本报告仅代表研究人员的个人看法，并不代表作者所在单位的观点。】