China Financial Reforms: In need of further deregulation

Transcription

1 China Financial Reforms: In need of further deregulation Mingchun Sun 1 Summary Over the past decade, the Chinese government has implemented a series of financial reforms and transformed its financial system from one on the verge of collapse to one that is vibrant and profitable. However, beneath its modern appearance, China s financial system is still over-regulated. Rapid economic developments have created new challenges and demand for further deregulation and liberalisation. In this report, we review the major achievements over the past decade and list some areas which are still in need of further deregulation (eg, loan-to-deposit ratio ceiling, securitization of banks loan portfolio, bond market, and entry barriers). We believe a major wave of financial deregulation is needed in the next five years. Over the past decade, Chinese government implemented a series of financial reforms and transformed China s financial system from one on the verge of collapse to one that is vibrant and profitable. Financial repression, the term commonly used to describe China s financial system in 198s-9s, is no longer suitable to describe it today. That said, beneath its modern appearance, China s financial system is still over-regulated. Rapid developments in China s economy have created new challenges and demand for further deregulation. In this report, we summarise first the major achievements in China s financial reforms over the past decade, then go on to discuss the areas where we believe further deregulation is needed. Such deregulation would not only enhance the efficiency of the financial system, but also provide positive catalysts for the overall economy in the coming years. Achievements in the past decade Since the beginning of the 21st century, the government has successfully revamped Chinese financial institutions and laid out the basic structures and foundations of the financial markets. We highlight some of the achievements below. 1 Chief Economist, Asia ex-japan,head of China Research,Daiwa Capital Markets Hong Kong Limited

2 Banking To rescue its state-owned banks from the brink of bankruptcy, the government has embarked on banking reforms via recapitalisation, a clean-up of non-performing loans (NPLs), inviting foreign strategic investors, stock market listings, and improving corporate governance since the late 199s. These measures have brought about dramatic changes in the banking sector, as evidenced by rapid growth in total assets (five-fold over the past 1 years), sharp declines in the NPL ratio, as well as significant improvements in profitability. Total assets of the banking sector (Rmb tn) NPL ratio of the banking sector (Rmb bn) (% ) 1,4 1,2 1, Total NPL (LHS) NPL ratio (RHS) Insurance China s insurance sector experienced very strong growth over the past decade, as evidenced by a 17-fold increase in insurance companies total assets and a 6-fold increase in the density of insurance spending. State-owned insurance companies have been listed, and private (including foreign) capital has been allowed and encouraged to enter this sector.

3 Total assets of the insurance sector (Rmb bn) 7, 6, 5, 4, 3, 2, 1, Insurance density (Rmb/person) Source: 21 Almanac of China s Finance and Banking, Daiwa Brokerage China s brokerage industry experienced difficult times during the first half of the past decade. Due to poor corporate governance and risk control as well as a multi-year bear market, securities companies as a whole suffered four consecutive years of losses during Many of them reached the verge of bankruptcy and some were rescued or recapitalised by the government (and some went insolvent). Starting from 26, the industry turned profitable as the reform of stateowned non-tradable shares triggered a two-year bull market during Securities companies also expanded their business scopes (eg, providing wealth-management products, margin financing and securities lending) and improved their risk control and corporate governance since then.

4 Net profit of securities companies (Rmb bn) (2) Source: CSRC, Daiwa Fund management The fund management industry has also witnessed strong growth in the past decade, boosted by a surge in financial investment demand from households and an increase in the depth and breadth of capital markets. The number of public funds rose from 45 in 2 to 914 in 211, a 2-fold increase in 11 years. Total assets under management (AUM) rose 25-fold over the same period. Total AUM of public funds (Rmb tn) YTD Source: Wind, Daiwa Stock market China s stock market has staged dramatic changes over the past decade. It witnessed a multi-year decline during 21-5 as the overhang of the state-owned non-tradable shares worried investors. As the reforms to address this issue started in 25, the market entered a two-year bull run, which eventually turned into a bubble and ended in tears in 28. Despite a 63% correction in 28, the stock-market capitalisation remained significantly higher in the following years than in 26 and before, reaching Rmb18tn (about 38% of GDP) at the end of 211.

5 Jan- Aug- Mar-1 Oct-1 May-2 Dec-2 Jul-3 Feb-4 Sep-4 Apr-5 Nov-5 Jun-6 Jan-7 Aug-7 Mar-8 Oct-8 May-9 Dec-9 Jul-1 Feb-11 Sep-11 Shanghai Stock Exchange Index (Index ) 6, 5, 4, 3, 2, 1, Total stock-market capitalisation (Rmb bn) 35, 3, 25, 2, 15, 1, 5, Source: Bloomberg, Daiwa The stock market has also increased in depth and breadth due to continued liberalisation and innovation. In late 22, China opened up its stock market to foreign investors on a quota basis, allowing qualified foreign institutional investors (QFII) to invest in the domestic stock market. Starting from 25, qualified domestic institutional investors (QDII) were allowed to invest in overseas securities markets. As of March 212, total quotas approved reached US$25bn for QFII programmes and US$75bn for QDII programmes. Regulators also expanded the scope of the stock market by launching new trading platforms. In May 25, the Shenzhen Stock Exchange launched a SME board to list and trade small- and medium-sized companies. In October 29, a new board called ChiNext was launched to list and trade high-growth enterprises (similar to the Growth Enterprise Market (GEM) or second board). In April 21, trading of Stock Index Futures was launched, giving investors a tool to short the market for the first time since stock exchanges were launched in China in 199.

6 Jun-3 Nov-3 Apr-4 Sep-4 Feb-5 Jul-5 Dec-5 May-6 Oct-6 Mar-7 Aug-7 Jan-8 Jun-8 Nov-8 Apr-9 Sep-9 Feb-1 Jul-1 Dec-1 May-11 Oct-11 Approved investment quotas for QFIIs and QDIIs (US$m) 8, 7, 6, 5, 4, 3, 2, 1, QFII QDII As of February 212, a total of 978 stocks were listed on the Shanghai Securities Exchange and 1,472 stocks were listed on the Shenzhen Securities Exchange (including both A-share and B- share). As at the same date, 655 companies were listed on the SME board and 291 were listed on the ChiNext board. Total number of listed companies on the SME board (Unit) Interest rate liberalisation Before the mid-199s, almost all interest rates in China were strictly regulated and determined by the central bank. Since the late 199s, the People s Bank of China (PBoC) has embarked on interest rate liberalisation, via a step-by-step approach. For example, it liberalised inter-bank interest rates in 1996, allowed banks to adjust their lending rates within a small band in 1998, and then widened the band significantly in 24. Starting from 2, banks were gradually allowed to decide interest rates on almost all types of foreign currency loans and deposits by themselves. As of today, almost all types of interest rates are liberalised, except that the PBoC still sets a ceiling for banks Renminbi deposit rates and a floor for Renminbi lending rates. The purpose of setting the ceiling and the floor is to prohibit aggressive pricing competition among banks, which could potentially squeeze interest-rate margins to zero. However, most banks have tried, and

7 Jan- Aug- Mar-1 Oct-1 May-2 Dec-2 Jul-3 Feb-4 Sep-4 Apr-5 Nov-5 Jun-6 Jan-7 Aug-7 Mar-8 Oct-8 May-9 Dec-9 Jul-1 Feb-11 Sep-11 Oct-6 Jan-7 Apr-7 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Jan-9 Apr-9 Jul-9 Oct-9 Jan-1 Apr-1 Jul-1 Oct-1 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 have been allowed, to circumvent these constraints via offering wealth-management products to individual customers at interest rates well above the official deposit rates. 3-month SHIBOR (% pa) year bank lending and deposit rates (% pa) year lending rate 1-year deposit rate Currency reforms In July 25, China gave up its fixed exchange rate regime and adopted a so-called managed floating regime. Though the new regime is essentially a crawling peg against the US dollar with the exchange rate being heavily influenced by the PBoC in the foreign exchange market, it is nevertheless a significant improvement over the former regime. In fact, since the de-pegging in July 25, the Renminbi has appreciated by a total of 3% against the US dollar.

8 Feb-4 Jul-4 Dec-4 May-5 Oct-5 Mar-6 Aug-6 Jan-7 Jun-7 Nov-7 Apr-8 Sep-8 Feb-9 Jul-9 Dec-9 May-1 Oct-1 Mar-11 Aug-11 Jan-12 Mar-1 Jun-1 Sep-1 Dec-1 Mar-11 Jun-11 Sep-11 Dec-11 Jan- Aug- Mar-1 Oct-1 May-2 Dec-2 Jul-3 Feb-4 Sep-4 Apr-5 Nov-5 Jun-6 Jan-7 Aug-7 Mar-8 Oct-8 May-9 Dec-9 Jul-1 Feb-11 Sep-11 Rmb:US$ exchange rate (Rmb/US$) As China has now become the world s No. 1 exporter and No. 2 importer and the Renminbi continues to appreciate, the country s trade partners are increasingly interested in using the Renminbi as a trade-settlement currency. To satisfy such demand, the PBoC has gradually allowed Chinese exporters and importers to use Renminbi for trade settlement. To facilitate the process, the mainland government has also encouraged Hong Kong to develop itself into an offshore centre for Renminbi business. These policies have led to rapid growth in Renminbidenominated trade settlements as well as Renminbi deposits in Hong Kong over the past two years. In fact, in 211, the amount of exports and imports settled in Reminbi accounted for 8.9% of China s total foreign trade, up from nearly zero in 29. Renminbi trade settlement amounts (Rmb bn) Renminbi deposits in Hong Kong (Rmb bn)

9 France Germany Korea UK Singapore US Taiwan Japan China Areas for further deregulation While China s financial system looks quite modern today, it is still over-regulated, in our view. Visible and invisible entry barriers, prohibitions and restrictions on financial practices still exist for both Chinese and foreign financial institutions, investors, businesses and households. Some standard practices in other countries are still prohibited in China, which distorts resource allocation and reduces the efficiency of the financial market and the overall economy. In this report, we identify some potential areas, among many others, for further deregulation. Loan-to-deposit ratio (LDR) Chinese regulators have been requiring commercial banks not to lend more than 75% of the deposits they have received from their clients since the mid-199s, in order to avoid excessive lending practice. Imposing such a ceiling on the LDR is quite subjective as there is no international standard or requirement on the LDR. In fact, a comparison of LDRs across countries shows that Chinese banks are clearly the least leveraged, due partly to the LDR ceiling. International comparison of LDRs: January 212 (% ) In recent years, the 75% LDR ceiling has increasingly become a binding constraint for many commercial banks to grow their lending businesses, mainly because more and more banks are relying on wholesale channels for funding (eg, bond issuance, inter-bank borrowing), rather than on retail deposits as most banks did in 199s. The constraint is greater for smaller, local (or regional), and foreign-funded banks as they have much smaller deposit bases than the big stateowned (SOE) banks. In our view, one or more of the following options could be taken to address the issue: 1. Raise the LDR ceiling from 75% to a higher ceiling (say, 8%) across the board; 2. Impose different LDR ceilings for different types of banks (eg, based on size, shareholder structure, or systemic importance); 3. Change the definition of deposits (eg, to include inter-bank deposits);

10 Change the frequency of LDR monitoring from daily average to month-end or quarter-end monitoring; 5. Simply drop the LDR ceiling. Securitisation of bank loans Securitisation of loan portfolios is a common practice for commercial banks in developed economies. Banks originate loans (eg, mortgages, credit-card loans), securitise them, and then sell them to potential buyers such as insurance companies and pension funds. Outstanding mortgage-backed securities in the US (US$bn) 5, 4,5 4, 3,5 3, 2,5 2, 1,5 1, 5 In contrast, securitisation is prohibited in China. Though the PBoC approved a few pilot programmes on asset-backed securities in 25-7, the efforts were interrupted by the US subprime crisis in 28 as regulators were concerned about the risks involved. Since then, no securitisation programme has been approved in China. Unable to securitise part of their loan portfolios, Chinese commercial banks have accumulated almost all of the loans they originated on their balance sheets. With average loan growth of 21% YoY over the past five years, outstanding bank loans more than doubled to Rmb55tn in 211 from Rmb23tn in 26. Such strong growth in loan assets has exerted great pressure on banks capital adequacy, forcing them to raise capital almost every 3-4 years. Securitisation should help to alleviate such pressure, as securitised loans are taken off banks balance sheets and become the assets of the buyers (such as insurance companies and pension funds). In this process, banks become pure service providers for insurance companies and pension funds via loan origination and securitisation. As a financial innovation that became popular over the past two decades, securitisation offers a division of labour among different types of financial institutions. For example, banks are typically short-term funded, but they give out loans with long maturities (especially for mortgage loans). On the other hand, insurance companies and pension funds have long-duration liabilities and need to invest in assets with similar maturity structures, but are not able to make the lending directly themselves. In this case, securitisation (eg, mortgage-backed securities) can help solve the duration-mismatching problems for both types of financial institutions.

11 Meanwhile, as banks charge fees to buyers (instead of receiving interest from borrowers) through this process, securitisation essentially changes the lending business into a fee business, which should help enhance banks return on equity and reduce their capital requirements. Due to these benefits, Chinese regulators are bringing securitisation back onto their agenda. According to a report in the 21st Century Economic Herald on 17 February 212, the PBoC plans to re-introduce a pilot programme of securitisation this year. The pilot programme may amount to Rmb5bn in 212 and the loans to be securitised may include mortgages, credit-card loans, local government financing vehicle (LGFV) loans and loans to SMEs. Bond market development Despite substantial bond issuance over the past decade, China s bond markets have still lagged behind the country s overall economic development. We see three main problems. First, the overall bond market is still too small to satisfy corporate financing needs. Therefore, business entities still rely heavily on bank loans for funding. This is reflected in the ratio of outstanding bank loans to outstanding corporate bonds, which stood at 11 times for China as at the end of September 211 (versus 5 times in Japan and 1.8 times in South Korea). Ratio of outstanding bank loans to corporate bonds (September 211) (% ) 1,2 1, China Hong Kong Japan Singapore Korea Shares of new bank loans and bond issuance in social financing aggregate (% ) New bank loan Bond issuance

12 From the macro perspective, the advantage of financing via bond issuance (which is a type of direct financing ) over bank loans (a type of indirect financing ) is that the former does not create new money but the latter does. This is because new loans always create new deposits, hence they increase the money supply (eg, M2, which is the sum of cash in circulation and bank deposits). In contrast, bond issuance only shifts deposits from one account to another (as long as the buyers of bonds are not deposit-taking financial institutions). Therefore, other things (eg, GDP growth) being equal, M2 growth should generally be higher in an economy where bank loans (or indirect financing) play a larger role in social financing than bond issuance (or direct financing). This is one of the reasons why China s M2 growth has been high over the past decades. For this reason, developing the bond market and increasing the share of bond issuance in the social financing aggregate should help bring down M2 growth in China. International comparison of M2 growth (% YoY) China Japan Korea US Second, China s bond markets are fragmented as three government agencies regulate different types of corporate bonds. The China Securities Regulatory Commission (CSRC) is in charge of bond issuance by listed companies. These bonds are called company bonds and are traded on the Shanghai and Shenzhen Securities Exchanges. The PBoC is in charge of the issuance of short-term financing bills (less than one year in maturity), medium-term notes (5-1 years in maturity, mostly for big SOEs), and collective notes (for SMEs to issue bonds collectively) by non-financial companies. These bonds (notes or bills) are issued and traded on the inter-bank bond market. The National Development and Reform Commission (NDRC) is in charge of bond issuance by non-listed companies (mostly SOEs). These bonds are called enterprise bonds, which can be traded on either the inter-bank bond market or the Securities Exchanges. The fragmentation of the bond markets as well as the regulatory authorities has not only created confusion for bond issuers and purchasers, but has also meant a lack of a consistent criterion for bond issuance.

13 Third, the issuance of company bonds and enterprise bonds needs prior approval by the CSRC and NDRC, respectively. The requirement for approval has made the bond issuance process inefficient and opaque. In fact, the majority of private enterprises and SMEs were denied access to the corporate bond market due to these approval procedures until the PBoC allowed SMEs to issue collective bonds on the inter-bank bond market in 21. In contrast, the issuance of short-term bills, medium-term notes and collective notes on the interbank market does not require PBoC approval. The issuer only needs to register with China Interbank Traders Association. Possibly because of this convenience, bond issuance on the inter-bank market has been rising much faster than the issuance of enterprise and company bonds (labelled as corporate bond in the following chart) over the past five years. Annual bond issuance by category: 25 versus 211 (Rmb bn) Mid-term note Short-term financing bill Corporate bond Collective note However, because buyers on the inter-bank bond market are banks and other financial institutions, bond issuance on this market still creates money (M2). In other words, bond issuance on the inter-bank market is still indirect financing, as banks are mostly using the deposits they collected to fund the bond purchases. For all these reasons, Chinese regulators have decided to consolidate and develop further the bond markets in China. Early this year, the three regulators (CSRC, PBoC and NDRC) formed a joint task team on this project. One of the tasks on the agenda for this year is to develop a highyield bond market to give individual SMEs access to raise funds on the bond market (which should be expanded to cover property developers in the coming years). Entry barriers for foreign entities China s financial markets are still quite closed to foreign investors and financial institutions. For example, despite the launch of QFII programmes since 22, foreign investors still find it extremely difficult to get access to the A-share market because the QFII quota is too small compared to both the demand from overseas investors and the size of the A-share market. As of today, the total QFII quota only represents about.7% of China s stock-market capitalisation.

14 Foreign financial institutions also find it hard to set up joint ventures or subsidiaries in China, especially in the brokerage business. Though Chinese regulators have allowed some foreign banks, insurance companies, securities companies and asset management companies to set up joint ventures or wholly-owned subsidiaries in China, the approval procedures are slow, uncertain and lack transparency. As at the end of 21, only 22 foreign commercial banks (including both wholly-owned and joint ventures), 1 insurance companies, and one financial services company had local licences in China. As at the end of 211, only 1 joint-venture securities companies have obtained local licenses. Even for those foreign financial institutions that have succeeded in obtaining local licences, they have found many regulations too restrictive for them to grow their businesses in China. For example, most joint ventures in the brokerage business have only been given licences to conduct a much smaller scope of business activities than their local competitors. Foreign companies are also denied access to China s domestic bond and equity markets to raise funds. Even foreign-funded companies and joint ventures cannot raise funds on domestic capital markets to finance their local operations in China. In light of all these restrictions, Chinese regulators are considering opening up further the domestic capital markets to foreign entities. For example, regulators have accelerated the approval of QFII quotas at the beginning of 212. In the first two weeks of March 212, a total quota of US$2.1bn was approved, which was more than the total quotas approved for the whole of 211. Such acceleration aligns well with the government s near-term goal to boost investor confidence in domestic equity markets. Conclusion We believe that 212 will mark the beginning of the next round of financial reforms in China, most likely a year of pilot programmes. According to China s gradualism approach to reforms, almost no major reforms in China will be rolled out until they have proved successful in pilot programmes. Given that 212 is the political transition year during which the new generation of political leaders will take power, we believe no major reforms are likely to be introduced this year. However, the timing of the leadership transition does make 212 a perfect year for economic experiment and pilot programmes, in our view, as the new leaders, who are already part of the existing leadership team, are eager to test ideas and prepare the reform agenda for the next decade. These reforms, be they new pilot programmes or further expansion of existing programmes, should provide positive catalysts for the overall economy because most of them should reduce transaction costs and enhance the efficiency of corporate and financial sectors.