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No financial business as usual if China's economy is to grow

By Sun Lijian: 0 Comment(s)Print E-mail Shanghai Daily, July 16, 2012

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[By Zhou Tao/Shanghai Daily]

After 30 years of heady growth, the value of China's banking assets is almost equal to its stock market capitalization. The diversity of the banking sector and financial products has improved dramatically especially after China's WTO entry.

A multitude of foreign financial institutions seeking a share of China's globalization dividends have set up operations in Shanghai, raising the city's profile in world financial markets.

China's newfound financial clout notwithstanding, it lags far behind Western countries in terms of financial sophistication. The crisis that originated in the United States is a result of excessive and unbridled financial innovation.

Nonetheless, China was affected, precisely because its finance sector was not innovative enough.

For instance, Chinese banks have been comfortably deriving their profits chiefly from interest rate differences.

And under a system where there is inordinate regulation, banks lack the initiative to boost the added value of their services.

The vacuum of quality financial services has been filled by underground finance, namely, shadow banking. But its development is not well regulated, guided or protected. The consequence is that shadow banks are vulnerable to the smallest of external shocks.

China's capital market places way too little constraint on the healthy growth of listed firms.

To compensate for this, various regimes like pre-IPO regulatory approval, an independent directors system and liability sponsor system were introduced. Despite these efforts, irregularities like rent-seeking are rife.

Moreover, quite a few listed start-ups, be they GEM (Growing Enterprise Market) companies, micro-credit firms, rural banks or private equities, haven't performed as well as had they touted in their IPO prospectuses. Many of them are obsessed, to varying degrees, with the pure capital game, and don't bother building a foothold in the real economy.

Add to all these problems the hollowing out of pension funds and the spotty credibility of insurance companies, and China has a serious deficit in financial soft power. The deficit is reflected in six respects.

First, price distortion of financial assets. China's interest and exchange rates haven't been fully marketized. Besides, the capital market is segmented, typically in the bond market, where integration between bank, national and corporate bonds is non-existent. One result is that a lot of financial services are grossly overrated and overpriced.

Leveraged speculation

If the authorities choose to open up the capital market at this point, amid ongoing easing measures in the West, financial predators will likely resort to low-risk leveraged speculation, and with a fairly small amount of money, make off with the life savings of millions of Chinese residents. Recent history is littered with such tragic precedents.

Second, insufficient liquidity. Although Chinese bourses boast one of the world's largest capitalizations, investors trade stocks at an unsettling frequency, resulting in price fluctuation.

Another consequence is unfair distribution of wealth between secondary and primary stock markets.

The problem will get worse during an economic downturn. When stock indices in other countries go down, Chinese stocks take a steeper plunge; when world stocks rebound, Chinese stocks still founder on a shortage of liquidity.

One reason for this contrast is that Chinese investors are more risk-averse than Western counterparts, as they are less affluent and more jittery.

Third, poor ability to diffuse risks. China's management of default or liquidity risks is severely limited.

Banks usually prepare for a rainy day with nothing but collateral and some idle cash.

Systemic market risks are essentially borne by investors themselves.

These old-fashioned forms of risk management lead either to credit crunch or credit glut. For example, banks make excessive loans to government-backed big firms that can pledge ample collateral for credit. Yet they are unwilling to lend to small firms with little collateral.

As a matter of fact, if Japan's lost 10 years has something to teach us, it is that once systemic crises erupt, there is no way to realize on collateral.

No prior stress tests would help banks much in that case.

The only thing to learn from US regulators in handling the sub-prime mortgage meltdown is their awareness of risk diffusion.

In times of prosperity, they had already securitized assets, something that contributed to risk diversion.

Fourth, partial information disclosure. Insider trading and fraudulent reporting of corporate earnings and losses have been the scourge of Chinese stocks. Authorities should design mechanisms to plug the loopholes of information asymmetry that are often exploited to make profit. And they should go after those suspected of such wrongdoing and punish them harshly if violations are confirmed.

Fifth, immature corporate governance. Everyone has by now learned, from a host of the country's efforts - ranging from accelerated interest rate marketization to global ambitions for the yuan, from continued reform of financial executive pay to introduction of a stock exit strategy - how important competition and incentives are to improve financial services and bolster bottom lines.

Rural finance hasn't made much headway because it is hobbled by lack of collateral as well as the absence of modern financial management.

That's where government incentives can and need to be more vigorously promoted.

Misguided notions

Sixth, misguided notions about wealth generation. If finance cannot contribute to the real economy, investors' wealth creation will work like a zero-sum game: one man's gain is another man's loss.

Besides, wealth will eventually either be concentrated in the hands of a few in an unfair market, or flow to inefficient banks should its owners refuse to engage in speculation.

Either way it goes, the cost of financing the real economy increases.

China's retail stock investors habitually time their moves with short-term policy adjustments. Yet this will do little to alter the capital market's perennial inability to generate wealth.

Therefore, for finance to undergird the real economy, it is necessary to introduce professional financial institutions capable of making high-value investments and boost Chinese financial sophistication. Only when finance functions well in supporting businesses and industry can the whole society really become rich.

The author is executive vice dean of the School of Economics at Fudan University. Shanghai Daily staff writer Ni Tao translated his article from Chinese.