China domestic reform: do or die

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China is pushing ahead with capital account reforms but it needs to make sure its own house is in order first.

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From South Korea, Indonesia, Malaysia to Thailand, recent Asian history is littered with disastrous tales of countries liberalizing their capital accounts in haste. The lessons of the 1997 regional storm have not been lost on China. 

Yet even as China focuses on stabilizing jittery markets in the near-term while boosting economic growth amid deflationary pressures, it is pushing ahead with capital account reforms, which entail near-term economic costs. Reforms include permitting greater cross-border securities trading, while easing RMB convertibility offshore. The latter is key to China’s bid to position itself as an economic and political power on the international stage. China could achieve full FX and capital-account liberalization within two years, some analysts suggest. 

In public, Beijing is sanguine about the execution risks, stating the near-term costs of opening up are offset by the medium-term benefits. The latter includes boosting the returns on China’s savings and enhancing the efficiency of credit allocation. 

Reformists caution that market education, FX hedging and some micro reforms, for example, in the bond market, still need to be pursued in earnest. 

But even with these caveats, liberalization aficionados are still worryingly complacent. From exchange rate, monetary to regulatory policies, China needs domestic reforms on steroids before portfolio money flows freely across its borders. Indeed, it took Japan almost 40 years to fully complete its liberalization process. 

By contrast, China has a breathtaking number of hurdles to jump since its financial market has scant experience of allocating capital and yields in the formal banking system, let alone setting a price-discovery mechanism in a liberalized money-market system or derivatives. 

According to the World Bank, Beijing retains 65% ownership of commercial banks and controls most of their assets. Interest rates have yet to be fully liberalized. Bond market defaults are rarely permitted. A mark-to-market for securities trading is virtually nonexistent. Secondary market liquidity is weak. The deposit insurance system has yet to be tested. A macro-prudential role for monetary policy has yet to be discussed. Regulation of the shadow-banking system is famously lax. And a mega-regulator for the formal banking and capital-market system has yet to be established. 

What’s more, even with new rules to boost competition in the SOE sector, the 2009 fiscal stimulus programme only served to enhance the political power of state-owned enterprises.

Recent market developments are cause for concern too. The summer equity-market rout exposed Beijing’s hostility to free-market forces and the politicization of regulators. The late-November news that China busted an underground banking ring, which had transferred the equivalent of $125 billion out of the country, also demonstrates how regulatory oversight of China’s shadow banking market has been found wanting in recent years.

Chinese capital-account liberalization, when it comes, will no doubt be accompanied with heavy de facto controls. But the ambitious time-frame gives Beijing little room to delay domestic financial reforms while a premature freeing of controls – necessary to heal macro imbalances in the medium-term – could lead to disaster.