Market Socialism: Chinese Financial Reforms

As the Chinese economy is restructuring itself from investment oriented to the consumption-oriented economy, finance or asset trading gains major importance. An individual can have the asset which he in a consumption-oriented economy must be able to sell for quick liquidity.

This article will explain how fledging finance in the Chinese market socialist economy may operate. Since the fall of Brettonwoods Agreement in 1971, US turned itself into financial capitalism by continuously inflating asset prices by channelling credit into the asset market. Thus asset trading presented a profitable investment opportunity to US business. This is how the US turned itself into the hyper consumption-oriented economy. But China does not have this option.

This is because Chinese currency is used just 1.2% as the reserve currency by other countries while for the US it is still 65%. Chinese asset market won’t get continuous credit, unlike the US. Thus China has to rely on finance only for serving the purpose of easy availability of liquidity and not as an alternative non-productive profitable investment destination. It surely implies Chinese finance won’t make Chinese economy as much consumption oriented as US finance turned the US economy into.

But asset trading market being driven by individual whims of private profiteers is difficult to manage. This will become even more difficult as Chinese finance will seek the greater role of foreign investors. Chinese stock market still has just 1.5% foreign participation compared to 31% in the US and just 6% of the Chinese population affected by it compared to 70% in the US. Chinese finance is still largely dependent on state-owned banks and asset trading market is still the minor player.

Implications of Financial Reforms

As China continues to open its capital markets, we see several potential implications:

• Investors will be able to capture the full diversification benefits of including China in their global portfolios. This should become more of a reality as major benchmark providers begin adding A-shares to their market indices.

• The Chinese renminbi (RMB) will continue to internationalise. The Society for Worldwide Interbank Financial Telecommunication (SWIFT) describes the RMB’s internationalisation as going through three phases: “First, use for trade finance, then for investment and in the longer-term, as a reserve currency.” Right now, the RMB is in the second phase.

• Capital flows to China’s markets will increase as the RMB becomes more flexible and convertible, and as restrictions on foreign companies doing business in China are gradually removed. For instance, we could see the easing of restrictions on joint ventures between foreign fund companies and local securities firms and reduced financing requirements for local enterprises with foreign banks.

• Chinese corporations will become increasingly familiar with international best practices for corporate governance and industry self-discipline. Ultimately, investors would benefit from adherence to higher standards.

• It is said that the long road to opening up the bond market will lead to a better pricing of risk, and bond yields i.e. borrowing costs for companies that better reflect actual market conditions.

Development of Financial Sector

China’s financial system remains bank-dominated, with the state directly controlling most of the banking system. Recognizing the importance of a better financial system for an improved allocation of resources within the economy, the Chinese government has instituted a number of reforms in recent years. Bank deposit and lending rates have now been fully liberalized. Commercial banks can now set these rates freely, although the PBC still sets reference rates to guide banks.

An explicit bank deposit insurance program has been in operation since May 2015. This program is intended to expose banks to some degree of market discipline by replacing the implicit full insurance of all deposits by the government. The system also allows for early intervention by the banking regulator and has an improved resolution mechanism for failing banks. Since the system is relatively new, there have been no test cases as yet.

China’s aspirations to make the RMB a global reserve currency rest in large part on the pace of development of its fixed-income markets. Reserve currency economies are expected to issue high-quality and creditworthy government debt or government-backed debt instruments that can serve to hedge against foreign investors’ domestic currency depreciation during a global downturn. China’s fixed income markets, especially for corporate debt, have developed considerably in the last few years. The stock of government bonds stands at about $3.5 trillion.

The nonfinancial corporate debt was practically nonexistent a decade ago, but the outstanding stock has now risen to about $1.5 trillion. Turnover, a measure of trading volume, remains quite low in both markets, however. China has recently lifted restrictions on foreign investors’ participation in its bond markets, which should improve both the depth and liquidity of these markets over time.

Chinese Socialist Financial Sector

In the weeks since its June 12 peak, China’s main exchange, the Shanghai Composite, was down 25 per cent, while Shenzhen, the smaller, tech-dominated exchange, was down 35 per cent.  Since the two exchanges started their slide, investors lost about $3.5 trillion, equal to China’s total market capitalization in 2012. This collapse challenges the government’s credibility and commitment to reform.

The Chinese government responded to the stock collapse with some steps that are impossible in a typical liberal democratic capitalism.  On June 29, the Ministry of Human Resources and Social Security and the Ministry of Finance published draft regulations allowing pension funds managed by local governments to invest in stocks, funds, private equities, and other stock-related products. The proportion of investment in stocks will be capped at 30 per cent of the pension fund’s net value.

The funds have combined assets worth more than $322 billion (RMB 2 trillion), of which up to $97 billion could flow into the stock market.  On July 1, the CSRC allowed investors to use homes and other real assets as collateral to borrow money to purchase stocks. On July 4, 21 brokerages set up a fund worth about $19 billion (RMB 120 billion) to buy shares. The same day, CSRC suspended all new initial public offerings to reduce volatility. On July 5, the CSRC said the PBOC will uphold market stability by providing funds of about $42 billion (RMB 260 billion) to a state agency, the China Securities Finance, to lend money to brokerage firms for purchases of shares.

The PBOC also announced that the China Securities Finance will receive liquidity to hold the line against systemic risks—in essence using PBOC money to directly buy shares—a radical departure from its traditional role as a lender to brokerages. On July 8, CSRC banned shareholders with stakes above 5 per cent from selling shares for six months. Listed state-owned enterprises (SOEs) were ordered not to sell shares and to buy their own stocks, with 292 committing do to so. The Chinese “national team” of entities related to or influenced by the country’s government was formed in 2015 to help support stocks during that summer’s market turmoil.

In the second quarter, the groups bought an estimated net 116 billion yuan — or nearly $17 billion — worth of local stocks that are known as A shares, Goldman Sachs’ Chief China Equity Strategist Kinger Lau said in a Friday report. The national team is heavily overweight banks, energy and insurance companies, and has relatively fewer holdings in consumer staples and technology industries. National Team holds 28% shares of Chinese Construction Bank, 23% of Jiangsu Yueda Investment, 20% of TBEA, 20% of Shinva Medical Instrument and so on. In this way, the Chinese state financial player is helping the Chinese government to manage the Chinese stock market.

Managing Private Whims 

It seems that on the one hand, the Chinese government will allow asset prices to be determined by market forces and hence will accept the risk of the market being carried away by the whims and emotions of private. Similarly, the Chinese government will also allow international players to participate more in Chinese asset market. Thus the risk of private whims and emotions affecting the market will be amplified further. This will be done to make RMB attractive as the global store of value and global transactions. This will help the Chinese government to settle more long-term settlements in RMB for Belt Road projects. Thus while the Chinese asset market will raise consumption demand by easing liquidity availability, Belt Road projects can create more investment demand by making RMB settlements less costly.

But how will the Chinese government tame in the private whims? China seems to be evolving a specific financial socialism where state financial players like National Team will engage in buying and selling of assets to determine private whims itself. In case of July 2015 Chinese stock market crash, the government directly intervened and asked state agencies and even private players to buy and not sell shares to prop up the market. But in the coming years, state financial investors and traders may actually have more roles in transactions but also in affecting the whims of private players. Even international private players can be incentivised to act along the line of government without any direct intervention. The flow of information can be controlled too to check negative whims of national and international private players.

Conclusion

Western economists and media may try to see Chinese rising finance in terms of Western financial capitalism which is about creating consumption demand by doling out debt through asset market investments. But Chinese finance may act as a tool of the Chinese government to make RMB transactions in international projects cheaper and hence help state enterprise led Belt Road projects more important in creating demand. Definitely Chinese consumption demand will rise due to financial reforms but it will never go to the level of USA and state enterprise and state bank led investment demand generation will not stop as well.

Participation in the Chinese financial system by the private sector may also remain considerably low when compared with West. Moreover, finance may gradually regulate how much investment demand will be created by state-owned enterprises and banks raising the efficiency of such investments. Chinese potential economy is too big for Western financial investors to either ignore or influence. So in the long run, Western investors may end up helping the Chinese government objective rather than spoiling them. Chinese financial reforms will surely set the future of the global economy.

DISCLAIMER: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy and position of Regional Rapport.