Reforming financial market

Authorities will push for greater access for private and foreign capital while keeping proper capital account regulations

The history of the global economy shows that emerging countries need sound and comprehensive financial markets if they are to escape the "middle income trap" and realize their economic transformation from a factors-driven to an efficiency-driven growth model.

As an emerging nation with a per capita GDP that exceeds $5,000, China has been working to build such a financial market over the past two decades and has made remarkable progress in this endeavor.

China has made noticeable steps toward marketizing the exchange rate of the yuan, which has risen considerably in value against the US dollar, and in its real effective exchange rate since the reform of its exchange rate formation mechanism was launched in July 2005. Yet judging from the ratio of China's current account balance to its GDP, the yuan is close to its equilibrium exchange rate. The plus or minus 1 percent margin the yuan is allowed to fluctuate is expected to further widen in the future.

Since September, China's central bank has reduced its interventions into the yuan's central parity interest rate, which has led to its exchange rate against the dollar continually touching its daily upper ceiling. This has to some extent changed market expectations for China's central bank interventions into the yuan's exchange rate. It is expected that the yuan will face wider exchange rate fluctuations in the future, but the pace of its average yearly appreciation against the dollar will slow.

However, compared with its exchange rate, the marketization of the yuan's interest rate regime has encountered obstructions from interest groups. The Chinese government has adopted a gradual approach to this, maintaining the yuan's benchmark interest rates intact while trying to pursue a marketized interest rate policy for its currency, inter-bank lending and bond markets. At the same time, the government has given a green light to experimental financial reforms in Wenzhou, Zhejiang province, in a move to include the city's grey financial sector into a legal framework. The move is also aimed at monitoring and guiding non-governmental borrowing and lending rates in the financially booming region and pushing for indirect interest rate marketization.

So far, China has adopted a market-based interest rate policy for all financial transactions except for banks' benchmark interest rates. This, together with the float margin allowed for domestic banks' benchmark interest rates adopted earlier this year, is a forcible example of China's remarkable progress in financial marketization. It is expected that the country's monetary authorities will further widen the float margin for banks' benchmark interest rates in the future and finally suspend such control. Open operations are likely to be used in the monetary market as a replacement to indirectly influence the financing costs of the domestic banking system.

China has also accomplished huge progress in changing the financing structure of its financial market, with the proportion of its bank credit to the country's whole financing volumes declining from 90 percent a decade ago to the current 60 percent. Such financing channels as entrusted loans and cooperation between banks and trust companies have also played an increasingly important role.

Remarkable progress has also been achieved in China's bid to push for diversification of its financial market players since its entry into the World Trade Organization. However, the country's financial market is more open to foreign capital than to domestic non-governmental capital. Foreign capital is now allowed to hold shares in China's insurance sector and the upper ceiling for their shareholding in the domestic banking and securities sectors has been raised by a large margin. Compared with the raised shareholding ceiling of qualified foreign institutional investors in 2012, China's private capital still faces numerous restrictions in access to the domestic financial market, as indicated by the lack of essential progress in the push for the establishment of more flexible township banks and small-amount lending institutions.

For the sake of long-term and sustainable development of its financial market, China should open its financial market to domestic private capital before foreign capital, a move that will prevent its fledging and less powerful non-governmental capital from being squeezed jointly by State-owned financial bodies and foreign giants. Compared with their State-owned counterparts, non-governmental financial bodies are usually more motivated to follow the rhythms of the market and improve their efficiency through innovation. The government should not only open its financial sector to private capital, but should also take essential measures to reduce hidden obstacles, such as the "glass door" that private financial bodies now face. Continuing efforts to push for structural reforms in China's financial market will also facilitate the transformation of its economic growth model.

Before fully opening the financial market to private capital, it is necessary for China to maintain appropriate capital account regulations as an effective firewall to ward off the impacts of external financial risks on the national economy. At a time when monetary easing has been embraced by developed countries the Chinese authorities should keep a particularly cautious attitude toward calls for accelerated steps to open its capital accounts in order to prevent the possible large-scale influx and outflow of short-term capital from having unwanted repercussions on the domestic financial market.

The author is a researcher with the Institute of World Economics and Politics under the Chinese Academy of Social Sciences.