China: Ex-regulator calls for market reforms
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China: Ex-regulator calls for market reforms

Gao urges SOE defaults; financial reform should precede capital liberalization.


Gao Xiqing says: 'I am hoping the government will allow some SOEs to go bankrupt. That will send a shock-wave throughout the country'

Reformists, bruised by the Chinese government’s mishandling of the summer stock-market rout, are calling on Beijing to modernise the domestic financial system – despite the up-front economic and political costs – to facilitate an orderly liberalization of the capital account. 

However, growth-minded local government agencies and powerful officials at Beijing’s planning agency, the National Development and Reform Commission (NDRC), are resisting calls from the finance ministry, and others, to embark on a root-and-branch reform. The latter want to see the monopolistic power of state-owned enterprises (SOEs) undercut and bankruptcies at private- and government-backed companies permitted.

Key officials are cool on reforms, according to minutes of a September meeting of NDRC officials, obtained by the Wall Street Journal. One attendee said: “Reform itself faces huge problems,” adding: “It’s doubtful that any reform dividends can be translated into economic growth in the foreseeable future.”

But in a wide-ranging interview with Euromoney, Gao Xiqing, former vice-chairman of the China Securities Regulatory Commission, says Beijing should bite the bullet to boost the efficiency of credit-allocation, with non-financial corporate debt rising from 98% of GDP in 1998 to 149%, as of end-2014.

“I am hoping the government will allow some SOEs to go bankrupt,” he says. “That will send a shock-wave throughout the country and many people who bought their bonds will be nervous but I think this would be a great thing [in order to reduce moral hazard in the financial system] because the government will be unable to sustain this system in the long-term.”


Gao expresses regret over Beijing’s handling of the summer stock-market meltdown when the government subsidized margin financing to brokers, articulated an index-level target for the Shanghai exchange and aggressively pursued short-sellers. The moves failed and the Shanghai bourse lost $2 trillion in one month alone. These moves underscore Beijing’s discomfort with free-market forces and undermine the spirit of its liberalization efforts, more generally. 

“Over the past year or so, the regulators and government were very gungho about the market,” says Gao. “They encouraged the rank-and-file to invest in the rising market. The problem I see in the long-term is the government role in regulating the market. Of course, all regulators seek to secure stability but there are principles one needs to abide by. This includes the principle the regulator should not set a certain level in the market; their role is to catch the bad guys, and ensure an orderly capital flow in the market.”

Gao, who was instrumental in the establishment of the Shanghai and Shenzhen stock exchanges in the 1990s, says there needs to be an “independent” investigation to study the causes behind the crash, including the role of leverage, market-makers, and speculators, to reform the market structure. 

The Shanghai Free Trade Zone (SFTZ) provides an experimental avenue for financial reform but, over the past six months, there has been a lack of guidance from Beijing about how it will work in practice. The government is considering creating a single mega-regulator to oversee the financial operations of the SFTZ, a departure from the current structure of four separate bodies, which, if successful, would be established nationally, according to Credit Suisse. Gao says, in principle, the creation of a mega-regulator could aid policy co-ordination, which was found wanting in the build-up to the summer market crash that saw shadow lenders provide excess margin financing.

Lack of clarity

The negative market reaction to the yuan’s August devaluation also underscored the volatility of markets, and fears over the health of China’s economy, given the pace of capital outflows. Aside from stock market reforms, and an improvement to the regulatory architecture, analysts say there is a lack of clarity about the time-line for domestic financial reforms, which include fostering competition between lenders and financial players, more generally, and the full freeing of interest rates, which in the short-term could expose politically-connected borrowers to insolvency. 

Barry Eichengreen, economics professor at University of California, Berkeley, in an interview with Goldman Sachs analysts, advocates a prudent pace of liberalization, when asked about the most appropriate sequencing of reforms in the capital account, FX regime and the financial sector.

“History is littered with the corpses of countries that opened their capital account prematurely,” he says. “The record shows clearly that you should first upgrade financial regulation, deepen financial markets, enhance financial transparency, strengthen policy, and reform institutions – for example, make the central bank and financial regulators independent of politics – before fully opening the capital account. To be sure, as you undertake these changes, the capital account begins to open spontaneously. More sophisticated markets and institutions find more ways around. But domestic reform first and capital account opening second is still the right sequencing.”

He adds: “China’s gradual opening of more of its markets to foreign investors over time, with the Qualified Foreign Institutional Investor schemes and the Hong Kong-Shanghai Stock Connect, has basically been the right approach. But my worry for a while now has been that they’re moving a little too fast on capital account liberalization relative to domestic financial reform. I’m reassured by the elimination of the ceiling on deposit rates that was recently announced. But I would personally prefer to see them move a little more gradually on the external opening and more swiftly on domestic financial development and reform.”

In other comments, Gao, a veteran official, latterly president of the China Investment Corporation, China’s sovereign wealth fund, says capital-account liberalization – which would enhance the efficiency of capital-allocation, and returns from China’s excess savings – is unlikely to unleash large net outflows given foreign demand and the current ability for Chinese corporates and rich individuals to invest abroad.

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