Dr Fred Hu is Chairman of Greater China at Goldman Sachs. He has advised the Chinese government on financial reform, pension reform andmacroeconomic policies, and has worked closely with China’s leading companies onbusiness strategy, capital raising, and cross-border mergers and acquisitions.
He is a member of the Strategic Development Committee for the Government of Hong Kong Special Administrative Region and the Advisery Committee for the Hong Kong Securities and Futures Commission.
Co-director and professor at the National Center for Economic Research (NCER) at Tsinghua University in Beijing, he teaches a graduate course in international finance and macroeconomics. He has published widely on economics and financial markets. He earned an MS in Engineering Science from Tsinghua University and an MA and PhD in Economics from Harvard University.
The Chinese Economy
The global financial crisis triggered by the US subprime fiasco has sent shock waves throughout the world economy and taken a devastating toll on the global financial system. China’s economy has also been negatively impacted owing to the country’s heavy reliance on exports. Nevertheless China’s financial sector, once considered the weakest link of the country’s otherwise dynamic economy, has escaped the current global crisis largely unscathed and demonstrated remarkable stability. Indeed, a stable and healthy financial sector at the moment has set China apart from United States, Europe, and other leading emerging markets such as Russia.
In contrast to many Western financial institutions battered by toxic assets, liquidity crunch, and capital shortfalls, Chinese banks, insurance companies, and securities firms generally boast strong balance sheets, with adequate capital, good asset quality, and impressive earnings performance. With average loan to deposit ratio at 60%, there is plenty of liquidity and funding in the Chinese banking system. Out of the world’s top 10 largest banks by market capitalization, at least three are now Chinese—ICBC, China Construction Bank, and Bank of China. China Life and Ping An are among the world’s largest insurance companies. ICBC, with net earnings at 110 billion renminbi (US$16.2 billion) for 2008, is easily the world’s most profitable financial institution.
These achievements reflect successful financial reforms undertaken over the past decade, which put China’s ailing banking sector on a much healthier footing. However, there is little cause for China to rest on its laurels. The financial stability China currently enjoys could quickly come under threat if China’s economy should experience a much sharper and more prolonged slowdown. Continuous and steep interest rate cuts by the People’s Bank of China (PBOC), the Chinese central bank, may compress lending margins and cloud outlook for bank earnings. Nonperforming loans, presently at very low levels, may start to rise as numerous export-oriented manufacturing firms experience financial distress in the face of plunging overseas orders and, importantly, China’s once red-hot real estate sector remains sluggish. Chinese insurance companies, securities firms, and fund management companies, once buoyed by a bullish and fast-rising stock market, may be bracing for a tough period ahead if the country’s stock market remains weak and depressed.
China’s Inefficient Financial System
Short-term problems aside, China faces a multitude of medium- to long-term challenges. Despite significant progress in recent years, China’s financial system remains under developed and inefficient. Chinese banks continue to rely mainly on interest income, with little diversification in business lines, assets, and revenues. With few exceptions, large financial institutions (banks, insurance companies, and securities firms) remain under state control. Though the global financial crisis has triggered a tidal wave of nationalization of Western financial institutions, China’s longstanding experience with state controlled financial sector shows that state ownership can be, at best, a mixed blessing. The government, as the majority and controlling shareholder of banks and as regulator, often sets policy objectives at odds with prudent and profit-maximizing banking practices. With the state in firm control of the boards, standards of corporate governance are severely compromised. Senior executives at the largest financial institutions continue to be appointed by the government and the ruling party based primarily on political patronage instead of professional qualifications, and the compensation system for bank managers, undifferentiated from the one designed for public service, does poorly in attracting, motivating and retaining the best talent. As a result, China’s state-controlled financial sector faces an acute shortage of human capital, especially at the senior level. IT infrastructure for China’s finance industry, while fast improving, remains a key bottleneck. There continue to be significant gaps in risk management, internal control, and balance sheet optimization. With regulatory functions and responsibilities divided by four agencies—the PBOC (the central bank), China Banking Regulatory Commission (CBRC), China Securities Regulatory Commission (CSRC), and China Insurance Regulatory Commission (CIRC), China faces its own regulatory fragmentation and coordination problems. While lax regulation and excessive innovation in the West may have been a contributing factor for the current global financial meltdown, most observers would agree that in the case of China, the country clearly suffers too much, not too little, regulation, and that there is too little, not too much, financial innovation.
With commercial banks dominating China’s financial landscape, capital markets play only a secondary role in capital formation and economic growth. China’s domestic stock market capitalization, currently at US$2.2 trillion, accounts for 55% of GDP. The total value of domestic bonds outstanding amounts to US$2.6 trillion, or 68% of GDP. By contrast, China’s outstanding bank assets amount to more than US$8.7 trillion, or 228% of GDP. In 2008, total new corporate equity and bond issuance amounted to US$112 billion (of which, equity financing US$48 billion), which is less than one fifth of the bank credit extended for the year. Even allowing for exceptionally difficult capital market conditions in 2008, bank credit is far more important as a source of financing than equities and bonds in China.
SME Financing Hurdles
Ironically and most worrisome, China’s small and medium-sized enterprises (SMEs), long the most dynamic part of the Chinese economy, and the leading source of job creation, continue to face significant hurdles in accessing capital. China’s rural population of 600 million is also appallingly underserved by the country’s financial system, contributing to widening urban/rural income inequality, a cause of grave concern for a country that puts such a premium on social and political stability. Consumer finance is woefully underdeveloped, which explains the fact that retail banking represents less than one fifth of revenues for the average Chinese bank. Apart from mortgages, which experienced rapid growth over the past decade, Chinese households, even in urban areas, have little access to consumer credit, contributing to China’s persistently sub-par consumption growth. Clearly, it is difficult to revamp China’s investment-led and export-led growth model and rebalance its economy without a major overhaul of the country’s lopsided financial sector.
Developing the Bond and Equity Markets
While continuing to strengthen its banking industry, China should assign a top priority to the development of domestic bond market as well as equity market. Existing listing rules are overly cumbersome and should be streamlined to facilitate more initial public offerings (IPOs) for promising Chinese companies especially fast-growing small and medium-sized enterprises. Chinese regulators should make vigorous efforts to improve liquidity, transparency, and corporate governance to engender investor confidence. Despite the global financial turmoil, China should not unduly delay the planned introduction of new products, such as stock index futures and short selling into the Chinese markets. China’s existing commodities exchanges have failed to keep pace with the demand arising from China’s rapid industrialization and urbanization, and must develop a far greater number and variety of futures contracts, including products designed to promote climate and emission trading, as well as those on traditional agricultural products, crude oil, nonferrous and precious metals.
In light of the massive pool of savings and rapid wealth accumulation in China, investment management is another increasingly important growth segment of China’s financial sector. China’s mutual fund industry has expanded rapidly in recent years, but there is much further to go to achieve world class scale and size in terms of assets under management, as well as in quality and performance. Other institutions, such as sovereign wealth funds including China Investment Corp (CIC), pension funds, insurance, and trust companies are also expected to play a more proactive and significant role in China’s nascent investment management industry. To promote and support entrepreneurial activity, China has now paid growing attention to the development of a domestic private equity/ venture capital (PE/VC) industry that sources yuan-denominated capital primarily from domestic sources, as opposed to sourcing capital mainly from overseas for most existing China-focused PE/VC funds.
Rising to the Challenge
Over the medium term, China will also have to respond to the challenges and opportunities arising from a more open capital account and greater integration with the international financial markets. At the present time, China’s currency, the yuan, is still inconvertible under capital account transactions, which in part explains why the Chinese financial sector has been largely shielded from the US subprime debacle. Understandably, the Chinese authorities have become more cautious towards the financial market opening up in general, and capital account liberalization in particular, in the aftermath of the worst global financial crisis since the Great Depression. But as the world’s third largest economy and a leading trading nation, China is rather unique to continue to maintain extensive and draconian capital control. The exceptional degree of openness of the Chinese economy to international trade, the significant inflows of international capital, the accumulation of massive foreign exchange reserves, the undervalued currency, the build-up in macro imbalances in the economy, and the growing desire of Chinese companies and households to deploy assets abroad and invest in global markets, will exert intensifying pressure on China to open up its capital account. China can have the option to initiate and manage this process in a gradual, orderly and prudent way, not in a rushed, potentially disruptive and destabilizing big bang. But it may not have the luxury to postpone the necessary reform indefinitely.
The ongoing global financial crisis may have created a major opportunity for China. While largely immune to the worst carnage, China can carefully study the current crisis and learn valuable lessons from it. It was after the Asian financial crisis a decade ago that China embarked on a comprehensive banking reform program that has clearly born fruit. The current crisis may well serve as yet another catalyst for China to deepen financial reforms, strengthen risk management, improve regulations and supervisions, and safeguard systemic stability in China’s financial sector.
The next five years will likely be a crucial period for China’s financial development. It will be apparent whether China stands a real chance to emerge as a global financial powerhouse in the same way it has become a global manufacturing juggernaut. If China can harness the numerous opportunities and at the same time effectively overcome the many challenges, China will likely succeed in building a globally competitive, sophisticated and stable financial system that may one day become the envy of the world.