Manuel Sánchez: Deepening financial reform in China
Remarks by Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the China
Financial Summit 2014, Beijing, 14 May 2014.
* * *
I am extremely pleased to be back in this beautiful, captivating land to participate in the
China Financial Summit 2014, devoted to the theme of financial reform and economic
growth. I would like to thank our hosts for the honor of accompanying such distinguished
speakers and sharing some views with you on the implications of financial reform.
China's economic miracle
For more than three decades, China has experienced a remarkable increase in income and
living standards. Average annual GDP growth has been about 10 percent, and since 2010
China has become the second-largest economy in the world.
This progress has had a global impact. Many nations have benefited from China's
momentum, through the effects of greater international trade and investment. Also, world
economic growth has been enhanced, and per capita income disparities have substantially
narrowed.1
China's outstanding economic performance has been the result of sweeping reforms starting
in the late 1970s. Transformations have included property rights granted to farmers, the
opening of many economic sectors to foreign direct investment (FDI), the ability to run a
private business, the privatization of some state-owned enterprises, the liberalization of
goods prices, and the reduction of barriers to international trade.
Tremendous output expansion has gone hand in hand with urbanization, as well as
augmented employment and investment. But most notably, it has been backed by
consistently growing total factor productivity. Efficiency has benefited greatly from the
adoption of technologies and know-how from leading advanced economies.2
As occurs in any economic development process, China may be facing diminishing returns
from already implemented liberalization policies. Unexploited opportunities are suggested by
the relatively low size of consumption and the service sector in China's economy in
comparison with many nations.
Hence, the sustainability of high growth rates and further widening of benefits to society
would seem to require more structural changes. In particular, inefficiencies prevailing in
several markets may be too costly to allow for continued high rates of economic expansion.
To take hold of these opportunities, the plan for reform announced by China's government
last November aims to make the economy more efficient and market oriented. The reform
agenda is ambitious, involving a great number of issues. The following are just a few that
stand out: the protection of property rights, the deregulation of non-public enterprises, further
liberalization of prices, financial reform, a revision of government's role in the economy,
urban and rural development, and additional areas opened to FDI.
The potential for success is high in light of China's proven ability to implement necessary and
difficult reforms in the past. Given China's importance to the global economy, the world is
following this process with fixed attention.
The implications of financial development
The incorporation of financial reform in China's transformation plan is highly appropriate
considering its potential benefits. China can take further advantage of common knowledge
regarding financial development, such as the following points, which can be gleaned from
years of world experience.
First, functioning financial markets are a necessary condition for a prosperous economy.
Many studies based on cross-country, individual-country, and industry levels confirm that
greater financial deepening tends to bring about higher rates of economic expansion.3
Second, the market is a cost-effective mechanism for channeling savings to financing.
Market functioning, in turn, requires competition, with the free entry and exit of for-profit
players, as well as the possibility of the failure of institutions which are no longer viable,
provided that the stability of the financial system is preserved. Markets also require flexible
prices, which of course, include interest and exchange rates.4
Third, productivity may be enhanced by opening an economy to foreign investment and the
free movement of capital. It is better for financial institutions to be well-developed and
adequately regulated and supervised before the capital account is fully freed.
Flexible exchange rates and currency convertibility allow for independent monetary policy.
Furthermore, economies with flexible interest and exchange rates are able to accommodate
external shocks more easily than those under rigid price regimes, where adjustment relies
heavily on quantity changes, including higher unemployment.
Fourth, financial markets frequently suffer from imperfections, such as asymmetric
information, adverse selection, and moral hazard, which can translate into negative
externalities to the rest of the economy. The financial system is based on trust and the
management of risk. When risk is not appropriately priced, contagion may arise and trust
may be jeopardized.
These limitations make adequate regulation and supervision absolutely necessary. While the
rules of the game should provide the correct incentives to market participants, by reducing
moral hazard for example, prudential policies should aim at preventing systemic crises.
Fifth, we are continually learning about how financial systems should best develop.
Specifically, successful financial liberalization depends greatly on how well and in what order
it is implemented. Neither can it be considered a panacea. History teaches us that financial
crises have been recurrent, and that many of them have resulted from poor policies, a fact to
which the recent global financial debacle bears witness.
China's financial challenges
China has made significant progress in fostering its financial system. Key advances include
bank restructuring, increased foreign participation in financial institutions, the listing of banks
on domestic and foreign stock markets, the development of debt, stock, and derivatives
markets, the liberalization of lending interest rates, the initial opening of the capital account,
and a stronger regulatory and supervisory framework.
These measures have allowed China's financial system to become one of the largest in the
world. This is reflected by indicators such as the ratio of financial assets relative to GDP, the
number of financial intermediaries, the capitalization value of the stock markets, and the fact
that some of the major banks in the world in terms of market value are Chinese.5
This advancement is obviously impressive, especially given the daunting complexity of the
system. The next step is to increase quality and efficiency. Indeed, China's financial system
could yield greater benefits by becoming more market oriented, in the spirit of the reform
plan.
Well-known avenues for transformation would include further interest rate liberalization,
credit allocation according to business criteria, transparent local government finances,
competitive capital markets, currency convertibility, flexible exchange rates, and additional
opening of the capital account. These reforms can enhance long-term economic potential.
In the short term, China faces significant challenges to sustained economic momentum,
given the presence of apparent financial imbalances, which, to a large extent, stem from
stimulus policies implemented in the aftermath of the global crisis.
In particular, during recent years, credit has been growing rapidly, financing significant
investment projects. The unregulated shadow-banking sector has been taking on a growing
role. With rapid credit growth since 2008, China's total financing stock relative to GDP has
risen about 70 percentage points, to reach approximately 200 percent in 2013.6
Credit and debt trends may need to slow, and some deleveraging and cooling in certain
sectors of the economy may be unavoidable, as for example, in the real-estate market.
Economic measures such as tightening financial conditions may facilitate the adjustment.
Furthermore, non-traditional finance could pose a systemic threat to financial stability in part
because banks remain closely linked to the shadow-banking sector. Prudential policies may
be called for.
China's authorities are conscious of these and other short- and long-term financial
challenges, as shown by efforts to adjust to recent economic developments. In the past,
reforms have been gradual and ordered, and results have been encouraging. This feature
does not need to be changed. Smooth implementation and adequate sequencing of reforms
will continue to be essential for China to gain further from financial modernization.
The Mexican experience
I would now like to comment on experiences from my own country, Mexico. The health of the
Mexican financial system seems to be largely a result of policies inspired by the hardship and
trauma caused by domestic financial crises. Specifically, the disarray that emerged in 1982
and in 1995 due to a perverse mix of fiscal, monetary, and bank policies, led the country to
implement corrective measures to achieve sustainable financial growth.
The Mexican financial system is bank centric. Most of its assets are owned by banks that
compete among themselves and exhibit strong balance sheets by international standards.
The system also includes other intermediaries, such as mutual funds, pension funds,
insurance companies and nonbank banks, as well as efficient bond and equity markets for
government and private issuers.7
Several sound policies have led to financial improvement in Mexico. First and foremost, we
learned the hard way that no financial system functions properly within an unstable nominal
framework characterized by high inflation and weak public finances.
Mexico's central bank has had autonomy for 20 years. Monetary policy adheres to an
inflation-targeting regime and uses an interest rate as its key policy instrument. The control of
inflation at low levels for more than a decade has been backed by stable and well-managed
public debt.
The credibility of monetary and fiscal policies, in turn, helps explain the rapid formation of a
complete yield curve for sovereign bonds in local currency during the first years of this
century, and issuances of public debt in international markets for maturities as long as
100 years.
Second, the modernization of bank regulation and supervision has been a continuous work in
progress. We lifted restrictions on deposit terms, amounts, and interest rates, and eliminated
both mandatory credit allocation and deposit reserve requirements in the late 1980s and
early 1990s.
Unfortunately, this was done without first imposing more adequate bank regulations amid all
these changes, along with appropriate supervision. Financial liberalization triggered the
beginning of excessive, low-quality credit growth. Also, after a 10-year period of bank
nationalization, the banks were reprivatized, further inflating the credit boom.
Third, the need to recapitalize the banks after the ensuing credit bust in the mid-1990s led to
the abolition of restrictions on FDI in the banking sector. At the same time, a deposit
insurance corporation was founded to provide deposit insurance to savers up to a certain
limit.
Accounting, disclosure, corporate governance, capital, currency mismatch regulations, and
provisioning requirements were further enhanced in the second half of the 1990s. Moreover,
in the early years of this millennium, the legal framework for protecting creditor property
rights was strengthened and credit bureaus were formed.
Banks' business models have also become more suitable in the wake of the lessons learned
by managers from crises and the transfer of technical skills from other countries. Prudential
regulation has received a careful overhaul based on experience from the most recent global
turmoil.
Fourth, the public defined-benefit pension system was replaced by a privately funded
defined-contribution system, in which workers hold individual retirement accounts operated
by specialized private asset managers. This has had the double effect of nourishing deeper
capital markets while making the pension system sustainable in the long run.
Fifth, the lack of obstacles to free international capital movement, especially since the early
1990s, has been combined since 1995 with a flexible exchange rate regime, which has
served as a buffer in turbulent times. Indeed, the resilience of the Mexican financial system
was tested by the recent global crisis. Despite real and financial shocks to the economy,
financial markets operated with no disruptions and with sufficient liquidity during the most
volatile period, while banks remained solvent.
Furthermore, the international financial bonanza since 2010 resulted in substantial portfolio
capital inflows directed to Mexico's equity and fixed-income assets. Especially noteworthy
have been increasing holdings of peso-denominated government bonds by non-residents, a
trend that has only recently slowed.
Given the possibility of future bouts of heightened global risk aversion, sudden stops or even
reversals of capital flows cannot be ruled out. The authorities remain vigilant to the need for
measures to make the Mexican financial system more resilient in such an event.
In the long run, Mexico faces two significant and interrelated challenges to financial
development: greater deepening and wider inclusion. Mexico is one of the emerging
economies with the lowest ratios of credit to the private sector relative to GDP, and with less
favorable coverage of financial services geographically and across different income strata.
The relatively compact Mexican financial system finds its roots in previous domestic crises
and a history of high and volatile inflation and financial repression. Fortunately, the
deepening process was renewed during the last decade, as a result of a sounder policy
framework.
To further facilitate this process, the authorities have allowed new forms of bank delivery
channels such as retail commission agents, and simplified the requirements for opening bank
deposit and phone banking accounts. Finally, Mexico's ongoing, multi-tiered financial reform
includes measures to tackle some obstacles to competition and permit the more expedient
repossession of loan collateral. Financial expansion will necessarily take time if it is to be
sustainable.8
Final remarks
China's decades-long reform program has been responsible for nothing short of an economic
miracle, which has improved living conditions not only for the country itself, but to a large
degree the world over.
Where China's financial development is concerned, reforms with the potential to fuel growth
for many years have recently been outlined. The importance of structural reforms that
undergird a solid financial system cannot be understated for any country. In China's case,
the order in which measures are implemented is of key significance, as is facing short-term
challenges, and devising a well-thought-out medium-term plan.
Without a doubt, China is pursuing these objectives with innovative and timely solutions, as
the nation has done for many years. This course of action should allow its citizens to look
forward to greater standards of living, and future generations to enjoy more prosperous lives.