China may be about to tick another box on its lengthy to-do list for financial reform. In late May media reports claimed that the People’s Bank of China plans to allow banks to issue certificates of deposit to ordinary bank customers this year, another encouraging stride toward interest rate liberalization and a baby step in overall financial reform.
A list of the tasks that China needs to undertake to remake its financial system is readily available. In fact, there are several versions. Each related ministry and regulator has its own index for the next step in opening up. The securities commission, for example, is trying to wipe the domestic stock market clean of fraud and false reporting while also creating investment opportunities for foreigners. The State Administration of Foreign Exchange is ever so slowly allowing the yuan to trade more freely. The central bank itself may have the longest list. PBOC is the trailblazer of financial reform, if not announcing changes to the system then pushing others to do so. It’s often hard to keep up.
In mid-March People’s Bank chairman Zhou Xiaochuan set a new pace for change. In perhaps the biggest announcement on financial reform in years, Zhou said China could fully liberalize interest rates by 2016.
Ending state control over the interest rate paid on bank deposits is the final step China must take in interest rate liberalization. The cap on the rate, currently set at 3%, has kept the cost of lending artificially low during the last two decades of relentless development. That ceiling, along with a floor on borrowing costs that was scrapped nearly a year ago, gave state banks ample room to lend the deposits of the masses to state-owned firms and local governments at below market prices. Without reform, China faces the risk of an increasingly high debt to GDP ratio while the return on its investments grows smaller and smaller.
Allowing certificates of deposit for the public, which give qualified bank customers a slightly higher return on deposits, would show the central bank’s determination to meet Zhou’s tight two-year deadline on interest rate reform.
But this 2016 date is a single point on a timeline that stretches far beyond the horizon. Which reforms happen before or after that date are debatable, even contested. That’s because a change in one area of China’s fragile financial structure could, at least in the short term, undermine another reform somewhere else in the system.
Freeing interest rates is just one of four major financial reform initiatives. The other three are liberalizing exchange rates, reforming capital markets and opening China’s capital account. None of these takes priority over another. As the People’s Bank pushes forward, not only must it consider the pace at which other financial players are crossing items off their lists, it must be sure the entire economy, down to the level of property developers and regional governments, is on board. However, in local authorities far from Beijing, some cadre may not have received the checklist for reform yet.
How to stall forex reform
Two years is a blink of an eye in China’s overall reform, and the new timeline has found critics. Just a month after Zhou’s announcement on uncapping deposit rates, another top financial regulator put forward his own version of how reform would sweep the financial sector.
Yi Gang (see box), the chairman of the State Administration for Foreign Exchange and one of five PBOC deputy governors, said the exchange rate should be liberalized before interest rates can be fully freed. This has caused some commotion among analysts, most of whom have long viewed foreign exchange reform as a far more distant goal than interest rate liberalization.
“Yi Gang’s concern is perhaps that interest rate liberalization is likely to result in higher interest rates and attract more speculative inflows, making it harder for foreign exchange reform,” said Wang Qinwei, an economist at research firm Capital Economics in London.
Nixing the cap on deposit rates would shake China’s growth model to its core. The cost of borrowing would rise as banks start to compete for deposits by paying higher interest. That in turn could give rise to a new wave of arbitrage on the yuan.
With a currency seeming set only on an upward trajectory, those with the means have borrowed dollars offshore, exchanged them for renminbi on the mainland and invested in places such as money market funds. The primary culprits in this “carry trade” are traders. As the cost of borrowing rises, so do the yields on money market funds, making them an increasingly attractive investment option. It could also stall foreign exchange reform.
Carry trade has wreaked havoc on reformers and customs officials alike. For years, it has warped China’s export data. In an attempt to halt the practice, PBOC began pushing the value of the yuan lower in February. In response traders halted the arbitrage and exports fell by 15% year-on-year in March.
The practice also artificially drives up demand for the yuan and could make the currency appreciate further than the Chinese government would like. Yi’s worry is that hot inflows of cash attracted by interest rate liberalization would make exchange reform unruly and potentially destabilizing.
“What factors could slow the foreign exchange reforms?” asks Alex Fuste Mozo, chief economist at Andorra-based Andbank. “Crystal clear: Their own Chinese companies engaging again in speculative activity.”
Fuste Mozo has pointed out that the biggest risks lie in the slow pace of foreign exchange reform. As more and more trade is conducted in renminbi, the demand for convertibility increases. Slower changes to the forex scheme could spell out overall delays in the grand prize of financial reform: The opening of the capital account.
All arrows point out
Hot inflows of cash are one thing; a massive outflow of capital is another – perhaps a far greater threat of destabilization to the Chinese economy. That prospect has bound policymakers such as SAFE and the China Securities Regulatory Commission in a struggle to safely open markets to the outside world.
China’s capital account is still largely closed, preventing any sudden surge of cash in or out of the country but also keeping much-needed foreign capital at the doorstep. In 2003, the CSRC and the central bank began slowly opening the domestic equity market with programs that allot quotas to foreign institutional investors. A similar outbound program opened in 2006 allows domestic institutional investors to invest in capital markets abroad. A system for investing offshore yuan back onto the mainland also exists.
These experiments for opening the capital account have grown rapidly since 2011 and quotas for the inbound program, the Qualified Foreign Institutional Investor scheme, or QFII, have quintupled from US$30 billion then to US$150 billion today. A major breakthrough came this March when the CSRC and Hong Kong’s securities regulator announced that qualified investors in Shanghai would soon be given a quota of US$40 billion to invest in the Hong Kong stock market. A similar cohort in Hong Kong would be allowed up to US$48 billion to invest in the Shanghai stock market.
This most recent step in capital account reform, called the Shanghai-Hong Kong Connect, was applauded by analysts but it reveals, yet again, another serious problem in the sequencing in overall financial reform, namely a lag in reinventing China’s domestic capital market.