HOW can China's financial market better integrate into the global financial system? And how can the country's enterprises raise their global profile and rise to challenges in this process?
Many have asked about the benefit of opening up China's financial system, which was among the least impacted during the financial tsunami in 2008. Why bother making it more global?
China's financial market has been stable owing mainly to two factors, which are positive in the short term but negative in the long run. China was insulated from the crisis first because its financial system is largely closed. Any emerging country will be vulnerable to hot money influx if its capital market is totally open.
But since the yuan is not freely convertible, hot money finds few targets in China. Financial crisis is the pandemic of global capital. When capital inflows are restricted, China naturally isn't infected.
Another factor is that even if China isn't an ideal destination for hot money, it is linked to the global economy by trade. Therefore, deteriorating economic fundamentals will result in non-performing bank loans and stock market crashes. Indices on China's bourses plummeted at the beginning of the crisis.
But why didn't the troubles escalate into a crisis? Because China's financial system is one that operates on terms dictated by the government, rather than principally according to market rules. China's banking chiefs are appointed by the state, and view themselves more as officials than bankers. They hew to policies from above on whom to lend to.
These two factors explain why China's finance was resilient during the worst of the crisis, and they also helped the country dodge a bullet when the Asian financial crisis hit in 1997. But the resilience has a price tag. It caused a slowdown in financial reform and skepticism of learning from the United States' financial system. This is a dangerous misunderstanding.
What has insulated us from financial crisis will also bring about long-term risks and pains. A closed financial system will cost Chinese companies more to compete globally.
With an isolated financial system, China has missed out on the benefits of easy access to capital markets. In fact, involving foreign investors as stakeholders in domestic finance can help stabilize China's economy.
But I'm more concerned about another issue. China's economy will be perennially inefficient if its banks continue to make loans by fiat. The cheap credit flowing to large, inefficient firms never dries up, whereas robust private businesses grapple with a credit crunch.
A few months ago, it was reported that banks' profits represent almost half of the earnings of all listed firms in China. This is an indicator of the need for reform.
Opening capital market
A financial system that operates on government orders is wasteful since businesses capable of creating jobs and wealth lack the wherewithal to finance projects.
China's raucous, crude development model has the inherent formula for high growth since the reform and opening up policy took root. Now it is in urgent need of structural overhauls. Otherwise, high growth will be hard to sustain.
Genuine financial openness isn't about free conversion of the yuan only. It means investors can freely invest in China's stock, bond and real estate markets. At present only limited amounts of foreign investments are allowed in Chinese bourses.
The Chinese leadership is of the view that the yuan should achieve a status commensurate with China's growing economic clout, akin to the status enjoyed by dollar, euro and yen. The yuan should become another major reserve currency, they believe.
But to make that happen, they'll have to sacrifice many things. The willingness of global firms, institutions, individuals or even sovereign wealth funds to hold the yuan is a sign of recognition of its coveted status. These entities hold yuan assets not to build factories in China, but to protect and increase value in the belief that the yuan is more valuable than dollars or yen.
How do they profit? Global investors now can only deposit their yuan in banks or invest in the A-share stock market in small quotas specified by QFII (Qualified Foreign Institutional Investor). If the yuan's value depends solely on its appreciation, it'll never become an anchor currency.
So if the yuan is to elevate its global profile, China has to open its capital market to investors, who have little incentive to hold yuan if they cannot cut their share out of China's economic pie.
Zhou Xiaochuan, governor of the People's Bank of China, has set a precondition for the yuan's international heft: maturity of the domestic capital market.
An open capital market will attract enormous money in its A-shares.
But a US crisis will send worldwide bourses tumbling. The US sneezes, and the world catches a cold, so we are told.
It is striking that there is no such volatility in US stocks, although that's where the crisis originated. The US stock market has so matured over the decades that it has developed a self-reinvigorating scheme, whereby investors like Warren Buffet would come to its rescue when it hits the bottom.
By contrast, investors will flee if Chinese bourses suffer devastating losses, contributing to a vicious cycle of capital flight.
All this means if China intends to open to outside investors, it should be able to withstand external shocks, otherwise, the consequences are dire.
Before venturing into the global financial arena, China's mainland has to attain the same levels of maturity as in the US or Hong Kong. Is it mature enough now? I think not.
A mature capital market is one in which whoever wants to launch IPOs is free to do so and can get returns on the initiatives, and market irregularities are rare.
If a fledgling business aspires to an IPO in China, it'll have to wait one or two years for the regulatory authorities to approve its application. And for the application to be successful, it has a lot of lobbying to do. For businesses, opportunities are fleeting. The regulatory paperwork for an IPO, which usually lasts six to eight months, is costing many businesses their opportunities.
Moreover, due to various government restrictions on short-selling and unencumbered issuance of shares, China's capital market is fraught with bubbles. An abnormal phenomenon is that earnings ratios of US- and Hong Kong-listed firms are far lower than on China's mainland, where its stock is experiencing a persistent bearish run.
In these conditions, a stock market cannot play its role of allocating resources. The US stocks were able to gather steam and regain levels before the dotcom bubbles in 2000 and the downturn in 2008. China's retail investors, however, haven't made any money in the last 10 years. The process of ridding the stock market of bubbles is still underway.
The biggest problem confronting the stock market is rampant insider trading and false reporting of corporate earnings. Unless these irregularities are checked, big investors will be left to pocket the funds raised in IPOs. China's securities watchdog is sometimes paternalistic concerning matters of less import, like who is qualified to launch IPOs and how many shares can be floated, while it has failed to bark at the aforementioned excesses.
The US financial crisis was triggered by zero supervision of sub-prime mortgages. Its overall supervision now has appreciably tightened to a degree I think is roughly appropriate. Maybe its regulation of derivatives can be even stricter.
By comparison, the room for China to improve its financial oversight is considerably larger. China's global financial ambition is built on two pillars. One is gradual marketization of financial assets. The other is continued and committed crackdown on irregularities.
For the capital market to perform better, everyone must be treated in the same way before the law. Power and special interests are to be tamed. This will prove a formidable task.
*The author is professor of finance at the China Europe International Business School. The article is adapted from his speech at Shanghai National Accounting Institute on June 9.
By Huang Ming*
28 June 2012