By Sun Lijian

Since Shanghai launched its effort to build itself into an international financial center in 1992, it has made significant achievements despite all the pressures and difficulties of the process.

Shanghai has yet to gain a more substantial position in the global financial network, however. And more challenges can be expected in the coming days.

While Shanghai spends a huge amount of resources on building an international financial centre, many regions around the world are making similar efforts by offering open market and high-end financial services. Would Shanghai gain an upper hand in the competition? Would its efforts attract the target clients successfully?

Before trying to find conclusive answers to these questions, it is reasonable to review a theoretical starting point.

An international financial centre can only be forged by the market. The government can facilitate the process by offering better administrative mechanisms, rather than trying to influence or even control the process that should be dominated by the market. Otherwise, it would only destroy the evolution of the centre.

A global financial center serves as a hub where financial resources can be reallocated with high efficiency. All Shanghai's efforts should be aimed at assisting the financial resource reallocation, no matter how many challenges it faces.

In the 1930s, Irving Fisher, one of the pioneers of modern financial thought, pointed out in his famous Fisher Separation Theorem that a price system reflecting the real situation of financial resource allocation is the best guideline for the financial resource holders to make investments and finance decisions that could maximize social wealth.

Under this theoretical framework, a precondition for establishing a global financial centre is a price system reflecting the real supply and demand of the financial assets at this moment as well as in the future, like free interest and exchange rates.

However, in the later development of financial theory and practice, Fisher's conclusion was proven to be defective. As a result, the goal of a global financial centre becomes more demanding and challenging to attain.

First of all, financial assets are circulated based on the involved parties' common assumptions regarding the future. Such assumptions are usually accompanied with high uncertainty, which could not be fully indicated in the pricing system Fisher described.

Hence, it is important to develop necessary financial services that could diversify the risks brought by the uncertainty. It is key in risk control to develop financial derivatives and financial institutions capable of withstanding risk. Fortunately, Shanghai has done pretty well in this regard.

Besides the tools for diversifying risk, the investors should also be able to circulate their financial assets at low costs.

Based on expectations for the future, investment decisions would be changed frequently. If the change is costly in a certain financial market, investors would automatically refrain from investing in this market.

A choice to cut down the trading costs in the financial market is to make full use of the market, exploring its functions as much as possible. Some effective means to facilitate circulation in the financial market include free exchange, a free capital market and allowing international players in the market.

Regional economic development around the financial centre also has a direct influence on the trading cost in the market.

A third factor for the appeal of a global financial centre is transparency.

Participants of the financial market have different motives. Investors purchase securities for better returns, businesses issue stocks for financing and security houses supply professional services for profit.

All of them need free information flow and transparency to achieve their specific targets. Otherwise, the financial resources could not be allocated efficiently or fairly.

The fourth indispensable factor in a global financial hub is a reliable legal system strong enough to check the financial speculation.

As financial globalization deepens, the activities in a financial market become increasingly comprehensive and beyond the reach of common individual investors.

Institutional investors have created prosperity in regions where global financial centres are located with their unprecedented active businesses in recent years. Meanwhile, their investment activities also caused crises in many other places.

It is not rare to see that institutional investors sacrifice the interests of other investors or stability in other countries for their own benefit. A typical example of this is the Southeast Asian financial crisis in 1997.

A well-designed legal system and reliable supervision mechanism could prevent the market players from destroying the steady development of the financial centre.

One of the fundamental reasons drawing investors to a global financial centre is that they expect a chance to boost their fortune, directly or indirectly, from the market. So the center’s prosperity would be a strong factor in its appeal.

To sum up, the primary target in establishing a global financial centre should be to facilitate the efficient reallocation of global financial resources through the six basic functions of the financial market.

The six basic functions are discovering prices, diversifying risks, ensuring circulation, releasing information, helping company governance and creating value.

Only when all six of these functions are developed in a balanced way can a global financial centre come into being.

Note: the author is a professor of finance and vice-dean in the School of Economics at Fudan University

(China Daily September 21, 2006)