1. Cambridge Judge Business School Like dismantling a nuclear bomb: liberalising the Chinese financial system Simon Taylor Director, Cambridge Master of Finance CCBN

2. The message Liberalising a distorted financial system is dangerous China has a very distorted financial system And it is the largest attempted liberalisation in history 2 3. Liberalisation is like un-damming a river 3 4. Financial liberalisation is dangerous Source: IMF Do inflows or outflows dominate? WP 13/189 http://www.imf.org/external/pubs/ft/wp/2013/wp13189.pdf Financial or exchange rate crises following capital flow liberalisation 4 5. The context: rebalancing the Chinese economy Rebalancing needed: From state to private sector From manufacturing to services From investment to consumption Source: IMF Article IV report 2013 http://www.imf.org/external/pubs/ft/scr/2013/cr13211.pdf 5 6. All require (among other things) liberalisation of the financial system 1. Internal: Market based interest rates 2. External: Allowing free capital flows into/out of China (internationalisation of the RMB) 6 7. The government intends to liberalise Since the onset of the new millennium, China has clearly put forward the strategic objective to build a market-oriented and more open economic system. Liu Shiyu, Deputy Governor, Peoples Bank of China, 2013 (*) We need to ensure that the market plays the decisive role in allocating resources and make the government better play its role, vigorously advance reforms conducive to economic structural adjustment, remove constraints on market actors and efficiently allocating factors of production, fully tap the creative potential in society, promote fairness and justice, and enable everyone to share in the fruits of reform and development. Premier Li Keqiang, report to National Peoples Progress, 2014 (*) in Das, Udaibir S.; Fiechter, Jonathan; Sun, Tao (2013). China's Road to Greater Financial Stability: Some Policy Perspectives (IMF) 7 8. People'sBank of China Banks Securities companies Insurancecompanies 8 Chinas financial system is dominated by banks Holdings of financial assets, 2012 Source: PBOC 9. State Council State-owned Assets Supervision and Administration Commission 123 Central State-owned Enterprise Groups National Development and Reform Commission China Banking Regulatory Commission China Insurance Regulatory Commission China Securities Regulatory Commission China Import-Export Bank Agricultural Development Bank of China Administrative reporting line Regulatory reporting line Ownership based on equity investment Ministry of Finance Peoples Bank of China China Investment Corporation Central Huijin Investment Agricultural Bank of China Bank of China China Construction Bank Industrial and Commercial Bank of China China Development Bank Huarong Asset Management Company Orient Asset Management Company Huida Asset Management Company Cinda Asset Management Company Great Wall Asset Management Company SAFE Investment Corporation State control of key banks Source: Walter & Howie (2011) Red Capitalism Appendix 9 10. The economics of liberalisation (1) Interest rate Quantity of lending Demand for loans Supply of funds Market clearing rate r q* 10 11. The economics of liberalisation (2) Interest rate Quantity of lending Demand for loans Supply of funds Market clearing rate r Government set rate g q2q1 Excess demand q2 q1 Results in: 1. SMEs starved of credit 2. Depositors looking for better rates 11 12. Non-bank lending has grown dramatically since the financial crisis Total social financing (RMB trillion) Source: IMF Chinas monetary policy and interest rate liberalisation WP 14/75) http://www.imf.org/external/pubs/ft/wp/2014/wp1475.pdf WMP rates and bank deposit rates 12 13. International capital flows have become less restricted 1997 2010 Source: IMF Effects of capital flow liberalisation WP 12/275 https://www.imf.org/external/pubs/ft/wp/2012/wp12275.pdf 13 14. But not Chinas capital account Source: IMF Do inflows or outflows dominate? WP 13/189 http://www.imf.org/external/pubs/ft/wp/2013/wp13189.pdf 14 15. The restrictions are gradually being lifted Source: IMF Do inflows or outflows dominate? WP 13/189 http://www.imf.org/external/pubs/ft/wp/2013/wp13189.pdf Qualified domestic and foreign institutional investor flows 15 16. Huge FX reserves are evidence of managed exchange rate 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 Chinas foreign exchange reserves (US$ billion) (*) End of Q1 2014 16 17. Liberalising Chinas international capital flows could bring big benefits Effects of liberalising Chinas capital flows (%) Source: IMF Effects of capital flow liberalisation WP 12/275 https://www.imf.org/external/pubs/ft/wp/2012/wp12275.pdf 17 18. China could see 15-20% of GDP worth of outflows Source: IMF Do inflows or outflows dominate? WP 13/189 http://www.imf.org/external/pubs/ft/wp/2013/wp13189.pdf China India Equivalent to: 0-2% of US equities 1-3% of US bonds 4-10% of EM equities & bonds Goldman Sachs estimate $6 trillion of Chinese outflows 18 19. Some things to worry about Mass corporate bankruptcies: higher market interest rates put many highly indebted businesses into crisis Japanese-style bubble and bust: surge in RMB followed by further asset appreciation then collapse Real estate market collapse: sudden portfolio shift from domestic property to foreign assets, causing banking crisis 19 20. Chinas debt is now high for a country of its income per head Source: IMF Article IV Report 2013 20 21. Chinas exceptionally high savings and investment rates Source: IMF Article IV reports 21 22. Household savings and investment Household savings are high: removal of the iron rice-bowl, one child policy Where do you put your savings? Bank low interest rates Stock market not trusted Bond market barely exists Mutual funds invest in the above, not trusted Foreign assets not allowed Real estate yes! So, on top of genuine need for new housing, the Chinese economy is systematically biased towards investing in real estate 22 23. The real estate market: is it a bubble? Peak investment in housingHousing inventory Share of housing stock built before 2000 Breakdown of fixed asset investment 2013 Source: Nomura Asia Insights 14 March 2014 23 24. The Japanese nightmare: index of property prices Commercial Residential Industrial Source: Japanese Real Estate Institute http://www.reinet. or.jp/en/pdf/2013/ Nov2013-Ur- Nationwide.pdf 24 25. Reasons to be hopeful Not going first: China can learn from other countries experience Track record: China dealt effectively with a serious banking problem in the late 1990s Pragmatism: the government will not adopt a big bang approach but steadily move in the right direction 25 26. s.taylor@jbs.cam.ac.uk