Poking Bigger Holes in China's Great Financial Wall

At the third plenary session of China’s 18th Central Committee (the “Third Plenum”) in November 2013, China’s leaders adopted a broad national reform strategy (see here for a scorecard of the economic plans). Included were the liberalization of the country’s government-controlled financial system and the internationalization of its currency, the renminbi (RMB). A year ago, we argued that when it comes to freeing both its domestic and its external finances, China had a long way to go. We also suggested that the pace of liberalization would remain gradual, reflecting policymakers’ gradualist strategy to manage the risks associated with greater financial flexibility.

Well, they still have a long way to go; but the pace of regulatory change has unmistakably quickened. Authorities have been poking bigger and bigger holes in China’s Great Financial Wall. So big, in fact, that it may not be long before the wall is more symbolic than real.

This stepped-up pace of reform seems motivated both by economic and political factors.  A less constrained financial system will almost surely be more effective at allocating resources and supporting economic growth. At the same time, there is a desire for validation of China’s progress – for example, by securing China’s full inclusion in well-known international financial benchmarks, such as the FTSE and MSCI equity indexes and the IMF’s SDR (Special Drawing Rights). Presumably, reformers hope that formal acknowledgment will make liberalization more palatable to those who are less market-friendly.

Because China’s financial system remains subject to many complex controls, the process of liberalization involves hundreds (perhaps thousands) of small steps, each with its own risks.  But there have been some bigger ones in recent months. Here are our top five:

• the partial relaxation of regulatory caps on deposit interest rates (May);
• the authorization for banks to issue large, negotiable certificates of deposit (CDs; announced in June);
• the introduction of deposit insurance (May);
• the simplification of cross-border transactions in domestic stocks (through the Shanghai-Hong Kong Stock Connect system that went live November 2014);
• and the ongoing expansion of quotas and licenses for foreign entities wishing to invest or trade in Chinese financial assets. 

The first three of these are internal, and are driving the liberalization of domestic interest rates. The fourth and fifth have an outward focus, with the objective of making it easier for nonresidents to acquire and trade securities on China’s stock markets in Shanghai and Shenzhen and for residents to access stocks listed in Hong Kong. Let’s have a brief look at each one.

Starting with interest rates, until recently the deposit and lending rates of China’s banks have largely been determined by officials at the central bank (see chart). By allowing the spread of shadow banking after 2008, officials provided savers with market returns on deposit-like “wealth management” and trust accounts. But the easing of restrictions on traditional banking operations remains a work in progress. In 2013, regulators scrapped the floor on bank loan rates, but still provide an official benchmark as a guide. In May 2015, regulators authorized banks to offer deposit rates up to 150% of the official benchmark (which is currently 2% for a one-year deposit), and officials are talking openly about soon ditching the limit altogether.

While the move away from controlled deposit and lending rates is incomplete, it highlights the potential impact of a new market in large negotiable CDs. Over time, the trading of these instruments can provide the basis for a broad money market that includes interbank lending and repurchase agreements. Much as we observed in the United States in the 1970s, interest rates determined in this market would then become the benchmark for retail deposit and lending rates.

China: One-year Official Benchmark Deposit and Lending Rates (set by People’s Bank of China)

Source: IMF IFS through 2014 and author updates.

Turning to the third item on our list, deposit insurance will help underpin confidence in China’s banks when controls on cross-border investments by households eventually are eliminated. Many observers also view the introduction of deposit insurance as a necessary condition for further interest rate liberalization. In this regard, we have our doubts. If anything, deposit insurance is likely to tilt the playing field even further in favor China’s big four banks – already among the world’s largest – adding to the competitive pressure on smaller institutions.

In the United States and many other countries, the introduction of deposit insurance established a safety net and – as an unintended consequence – created the incentive to take on risk at taxpayer expense. This led to heavy regulation of banks. In China, the policy motivation is reversed: deposit insurance appears intended to narrow the existing implicit government guarantee for all bank deposits. Yet, in the absence of serious creditor losses from a future big bank failure, the presumption that China’s behemoths are too-big-to-fail will be difficult to alter.

Our top-five list also highlights policies that directly influence capital inflows and outflows. The Shanghai-Hong Kong Stock Connect system eases trading restrictions on China’s domestic A-shares for licensed nonresident institutional investors with an official quota. In addition to these “northbound” flows, Connect facilitates “southbound” investment by residents of China in Hong Kong-listed stocks. Launched in mid-November 2014, turnover in the new system surpassed RMB150 billion (about $25 billion) in both April and May 2015, but remains subject both to monthly and daily limits. (Foreign investors face no such limits on their investments in China “B” shares, which are denominated in U.S. or Hong Kong dollars, not renminbi).

While the authorities continue to expand access, the quotas on nonresident ownership of A-shares remain quite restrictive and have some important implications. For example, they have precluded full inclusion of China’s equity shares in commonly used global equity indices. Without unfettered market access, index-linked equity funds would not be able track emerging market equity indices. In the case of China, this is a very big deal. FTSE Russell estimates that inclusion of China at their full-market weight in the FTSE Emerging Index would result in China A-shares accounting for a whopping 40 percent of the index. By contrast, inclusion based on the level of the current foreign ownership quota reduces that to less than 5 percent.

Overall, where is China’s financial liberalization process headed? Earlier this year, central bank Governor Zhou highlighted the limits: “The capital account convertibility that China is seeking to achieve is not based on the traditional concept of being fully or freely convertible.… China will manage short-term speculative flows when appropriate.” Yet, if policymakers maintain the recent pace of deregulation, within a few years Chinese domestic interest rates will be largely market determined and the cross-border flow of long-term portfolio capital will be largely free of impediment.

As for short-term cross-border flows, policymakers in a number of emerging market countries have soured on these in recent years, and we expect that China’s authorities are no different. But, for those who want to contain short-term capital flows, the question is how? Is there a reliable way to put a brake on short-term flows at the same time that you encourage the long-term ones?

The fact is that a significant reduction of impediments to cross-border money-market flows is already underway in China. Consider the following update of a chart we posted last year. Here, we plot since 2010 the three-month RMB interest rate domestically (CNY) together with the equivalent three-month rate in Hong Kong (CNH). In the period through 2014, Hong Kong RMB rates averaged 275 basis points below “onshore” rates – partly reflecting the desire of RMB holders for the liquidity and safety of the Hong Kong market. Moreover, the two interest rate paths showed no sign of convergence: in fact, the daily correlation was slightly negative.

Since early March, this pattern has changed dramatically. The spread has collapsed to an average of 32 basis points and the daily correlation has soared to +0.96. Our reading of this chart is that the CNY-CNH money market is now significantly (if not fully) integrated. And this level of integration means that shocks to money demand or supply originating on either side of the border are likely to cross over fast.

China RMB Three-Month Deposit Rates: Onshore (CNY) and Offshore (CNH)

Source: Bloomberg indexes CCDRC (CNY) and CGDRC (CNH).

How quickly will China’s ongoing reforms be formally acknowledged internationally? Just this month, index provider MSCI laid out a plan to collaborate with Chinese regulators to address lingering issues of access to China’s domestic equities (“A” shares), including matters related to quotas, capital mobility, and property rights. MSCI “expects to include A-shares in its global benchmarks” without delay once these issues are resolved. With trillions of dollars of asset funds tracking MSCI indexes, this step would almost surely have a meaningful impact on the global allocation of funds and on long-term portfolio flows to and from China.

By contrast, inclusion of the RMB in the IMF’s SDR is more about prestige than economics. A Fund group recently visited China to determine whether the RMB satisfies the SDR inclusion criteria – namely “widely used” and “widely traded.” Like inclusion in the MSCI, inclusion in the SDR is a question of when, not if, the RMB qualifies.

But the real issue is when foreign central banks will begin using the RMB as an important reserve currency – a clear objective of Chinese authorities. While some central banks already own RMB assets, widespread use in reserves requires unimpeded access to the domestic RMB market (which still requires a license and quota) to manage these (primarily fixed-income) holdings. Like private investors, the official sector also cares about their ability to hedge any RMB exposures they might acquire indirectly (say, because they have an SDR-denominated debt to the IMF). It is these market factors – not the IMF’s imprimatur – that will determine if and when the RMB becomes a significant reserve currency.

Finally, keep in mind that financial liberalization is not risk-free. In a previous post, we highlighted the risks from the rise of shadow banks and the rapid increase in real estate and construction lending. Here we note the risks associated with the ongoing evolution of domestic investors’ attitudes toward equities in China and with the expected future inclusion of these equities in global indices. Over the past year, both of these factors have driven up demand, and hence prices, helping to double the capitalization of the Shanghai stock exchange. While some observers view this surge as a welcome result of financial reform, the volatility that accompanies the removal of financial controls is a two-way street: prices that go up can also come down. We have seen this in recent weeks.

That said, our bottom line is simple. Financial liberalization in China – both internal and external – is well worth the risk. It will reward households for saving and firms for using those savings wisely. Reforms also are changing how China’s financial system relates to the global system. As the process continues, we expect widespread international acknowledgement of these advances. But the ever-bigger holes that authorities are poking in the Great Financial Wall are sure to test China’s financial resilience as well as its policymakers’ and investors’ tolerance for risk and volatility.