Jury still out on China’s commitment to liberalization of financial system

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The Shanghai free-trade zone (FTZ), China’s grand experiment with liberalizing interest rates and opening its capital account, has only a short window of opportunity to convince the markets that the Communist Party is serious about reform.

Beginning with the now-famous Shenzhen special economic zone (SEZ) in 1979, SEZs have a played a key role in the development of China’s market economy as incubators for policies that are then adopted countrywide.

However, the Shanghai FTZ was launched on September 30 not so much with a bang as a whimper. No high-ranking government officials showed up for the launch – not even its champion, the country’s pro-economic reform premier Li Keqiang.

It was the same story with the central bank and the big three regulators, which were represented only by deputies.

What appears to be verging on a boycott by top officials from Beijing is just one of a number of questions surrounding the zone and its true significance. 

The ambivalence toward what was billed as a showcase for China’s future financial system could simply reflect internal tensions between reformers and conservatives ahead of November’s Communist Party plenum.

With a broader reform agenda set to be thrashed out and unveiled after this event, Li is determined to secure long-awaited economic reforms, and what better way than this to demonstrate that his vision is not theoretical but a practical reality.

Loan-to-deposit ratios and rules on cross-border bank financing will be relaxed within the zone and tight restrictions on capital flows eased.

Currently, inward and outward portfolio investment is subject to quotas and available only to foreign and domestic institutions that have obtained special qualified status from the China Securities Regulatory Commission. Foreign and Chinese investors-only access to cross-border investments is through funds managed by these reportedly qualified institutions.

The Shanghai FTZ extends the right to make direct cross-border investment to all organizations registered in the zone and individuals, both Chinese and foreign.

Liberalizing the financial sector is a vital step in China’s goal to make Shanghai a global financial centre by 2020 by opening up its burgeoning services sector to foreign competition.

In addition to offering health insurance and leasing, foreign banks will be permitted to issue domestic bonds. Other sectors opening for investment in the zone range from manufacturing and sales of video game consoles to legal services and investment management to entertainment.

So far, the zone, located in the north-east of the city, appears to be long on ambition and short on specifics, save for a very long list of what’s not allowed – more than 1,000 sectors. This might explain its lukewarm reception.

Around 35 companies have reportedly been approved to start operations in the zone, including 11 financial firms, eight of which are Chinese state-owned banks and only two the China subsidiaries of leading foreign banks.

Rules surrounding the mechanism by which banks will be able to set interest rates distinct from those in the rest of the country and exactly how the promised yuan convertibility would work have not been detailed.

More importantly, there’s no timetable for implementation of these initiatives other than the government saying most will be introduced in the next three years.

“The content of what appears to be there is good in that the really key reforms of interest rate liberalization and capital flows are both there,’’ says Lombard Street Research’s Hong Kong-based economist Freya Beamish.

“But the language is quite cautious, effectively saying that as long as everything remains controllable and as long as it doesn’t go haywire, you’ll have this set of reforms.

“The problem then becomes: is this them setting themselves up so that if it does all fail they can just retract it and say it’s just a silly western idea that hasn’t worked for China and it was only a trial anyway?”

She adds: “What they really need to do is do it now. They’ve been talking about it for more than a decade and now's the crunch time because there’s only a very small window of opportunity to make those liberalization reforms of interest rates and capital flows, and turn the banking system into a real market-orientated system.”

Beamish says the main criterion is the extent to which the government has the capacity to take over bad debt within the economy. 

“By our calculations, total debt in the economy and space nominally on the government balance sheet is still sufficient to be able to absorb even the pretty stellar amount of debt that has been built up, particularly over the past few years, but also over many previous rounds of failed clean-ups,” she says. 

“They do still have that scope, but the bad news is that if they’re still tinkering around with a test run, that window of opportunity is closing fast.”

The best-case scenario is a rapid transition between try-out and incorporation into the broader financial system. Alternatively, working directly with the Shanghai government could be a bid by premier Li to bypass old-guard elements of the party to implement wider reforms more quickly.

The zone is supposed to be sealed off from the financial system to keep hot money from escaping into the wider economy, exacerbating China’s credit-fuelled investment boom, and vice-versa. But with leakage inevitable, loopholes will arise and it will become, effectively, a hole in China’s capital controls.

“We’ve got to see the Shanghai free trade zone as an experiment, as a seed being planted to see what sort of plant it grows into,” says Andrew Milligan, head of global strategy at Standard Life Investments.

“The authorities can obviously control the flow of capital, say via the regulator instructing the banks about specific rules, but there is sizable free-flow of capital already that takes place formally or informally.”

He adds: “I don’t think the authorities are worried about capital leaving the country – they worry about the extent of capital leaving the country in any period of time and this zone therefore will be a way for them to monitor this situation.

“If there was a giant sucking sound in the banking system and it looked like it was becoming problematic, would they react? Absolutely.”

He continues: “It’s a fascinating situation, mixing both stability and experiments. But the aim of this experimentation is to move to another stable situation through controlled reform in different areas of the country, but not across the whole economy all at once.

“The watchwords of the administration at the moment are very much ‘stability’ and ‘controlled reform’.”