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Testimony

China’s economy and financial markets: Reforms and risks

Eswar Prasad

Editor’s note: On April 27, Eswar Prasad testified before the U.S. China Economic and Security Review Commission on the status of market-oriented economic reforms in China.

Chairman Shea, Vice Chair Bartholomew, and honorable members of the
Commission, thank you for the opportunity to share with you my views on the status
of market-oriented economic reforms in China, with particular emphasis on financial
market reforms and capital account liberalization, along with a discussion of the
risks the economy faces. In this testimony, I will also discuss China’s efforts to
expand the international use of its currency, the renminbi (RMB), and how this is
tied in to the domestic reform agenda.

These developments have taken place against the backdrop of a challenging
domestic environment. Over the past year, China’s GDP growth has slowed
significantly, producer prices continue to fall, and various other indicators of
economic activity have weakened, including growth in industrial production,
investment, and imports. However, the most recent data on GDP growth as well as
industrial and services sector activity suggest that the economy has stabilized. Still,
some further macroeconomic stimulus might be necessary to hit the government’s
growth target of 6.5 percent.

On a more positive note, there has been some progress over the last 2-3 years on
growth rebalancing, an important objective of the 12th five-year plan. The
consumption to GDP ratio has gone up slightly, the service sector’s share in the
economy has risen to over 50 percent, and the household saving rate has declined.
China’s current account and trade surpluses have declined from their levels in 2007,
although the merchandise trade surplus has climbed back to nearly 6 percent of
GDP in the last half of 2015.

Capital Account Liberalization

China still has an extensive capital control regime in place, but it is selectively and
cautiously dismantling these controls. In most cases, constraints on capital inflows
and outflows have been loosened but not eliminated. Nevertheless, the country’s
capital account is becoming increasingly open in de facto terms.

China’s government has created a number of schemes that allow for controlled and
calibrated opening of the capital account to both inflows and outflows. These
schemes have been designed to generate many of the indirect benefits of financial
openness (such as domestic financial development and international portfolio
diversification) while enabling freer movement of capital. Table 1 contains a
summary of the main schemes that have been instituted in recent years to liberalize
inflows, outflows, and two-way flows.

Rising foreign investments by Chinese households, corporations, and institutional
investors have led to major changes in the pattern of China’s overall exports of
financial capital. The composition of gross outflows has shifted markedly from
reserve accumulation to official and unofficial flows due to both the private and state
sectors. This shift is consistent with the government’s stated objective of shifting
foreign exchange holdings from the central bank’s balance sheet to those of
households, corporations, and state-controlled entities such as the sovereign wealth
fund.

The objective of “foreign exchange holdings by the people” (rather than the central
bank) will have a significant impact on the composition of future capital outflows
from China. While the government is providing channels for international portfolio
diversification, which is a positive development, there is a risk that lack of effective
oversight of domestic securities markets and institutional investors that enable such
diversification could portend risks for household and corporate balance sheets.

Table 1. A Summary of Recent Schemes to Liberalize Cross-Border Capital Flows 

Channels for Inflows

Qualified Foreign Institutional Investor (QFII) Scheme: Launched in 2002. Allows qualified foreign institutions to convert foreign currency into RMB and invest in Chinese equities (both A shares and B shares) and a range of other RMBdenominated financial instruments. As of October 2015, a total quota of $78.9 billion had been granted to 277 foreign institutions, including 8 central banks and 10 sovereign wealth funds. 

Renminbi Qualified Foreign Institutional Investor (RQFII) Scheme: Launched in 2011. Allows qualified institutions to use offshore RMB funds to invest in Chinese equities and other RMB-denominated financial instruments. As of July 2015, a total quota of $68.4 billion had been granted to 135 financial institutions. 

Channels for Outflows 

Qualified Domestic Institutional Investor (QDII) Scheme: Launched in 2006. Allows Chinese domestic financial institutions—commercial banks, securities companies, fund management companies, and insurance companies—to invest in offshore financial products such as securities and bonds. As of November 2015, a total quota of $90 billion had been granted to 132 financial institutions. 

Qualified Domestic Individual Investor (QDII2) Scheme: Proposed in 2013; not yet launched. Will permit individual retail investors with at least RMB 1 million ($160,000) in assets to invest in certain offshore financial products. 

Channels for Two-Way Flows 

Free Trade Zones (FTZs): Shanghai FTZ launched in September 2013. Three new FTZs in Guangdong, Tianjin, and Fujian launched in April 2015. The FTZs use a “negative list” approach to regulate foreign investment—there are few restrictions on foreign investment in industries not on the list. Cross-border capital transactions and establishment of financial institutions within the zones have been liberalized. 

Shanghai-Hong Kong Stock Connect: Launched in 2014. Allows mainland Chinese investors to purchase shares of select Hong Kong and Chinese companies listed in Hong Kong, and lets foreigners buy Chinese A shares listed in Shanghai. HK-to-Shanghai annual quota: RMB 300 billion ($47 billion); daily quota RMB 13 billion ($2 billion). Shanghai-to-HK annual quota: RMB 250 billion ($39 billion); daily quota: RMB 10.5 billion ($1.6 billion). 

Mutual Fund Connect: Launched in July 2015. Allows eligible mainland and Hong Kong funds to be distributed in each other’s markets through a streamlined vetting process. Initial aggregate investment quota: RMB 300 billion ($47 billion) each for inward and outward fund flows.

The Exchange Rate Regime

China has continued to move gradually—and at least in principle—towards a more
flexible market-determined exchange rate. On August 11, 2015 the People’s Bank
of China (PBC) changed the reference pricing mechanism for the onshore CNYdollar
exchange rate, whereby the PBC sets the opening price for trading on the
Shanghai China Foreign Exchange Trading System (CFETS) each morning. The
reference price is no longer delinked from the previous day’s closing price although,
with RMB trading now taking place in markets such as London that are in other time
zones, the two prices need not necessarily be the same. The key point is that the
RMB exchange rate relative to the dollar is now more subject to market forces. This
policy change was combined with a 1.9 percent devaluation of the RMB relative to
the dollar.

It appeared that the PBC had combined a move to weaken the RMB with a shift to a
more market-determined exchange rate. China’s currency move could be
interpreted as a relatively modest and defensive one, aimed at signaling that the
PBC would not persist in supporting the RMB’s value relative to the dollar if the
dollar were to keep rising against other major currencies. Indeed, in the year before
this move, the trade-weighted effective exchange rates of the RMB had appreciated
by about 13 percent. However, the shift in currency policy set off a negative reaction
in financial markets that were already nervous because of fears over a sharp
slowdown in growth in China and the sharp drop in the Chinese the stock market
since June 2015.

On December 11, 2015, the PBC indirectly hinted at another change in policy,
posting on its website an article indicating that the CFETS would begin publishing a
set of trade-weighted exchange rate indexes. This approach appears to reflect a
change in the PBC’s strategy regarding both practice and communications. First, by
finally putting into practice a policy that had in principle been in operation since
2005, this move would make it easier for the PBC to delink the RMB from the dollar.
Second, the PBC may be preparing the market for further RMB depreciation relative
to the dollar in the short run—if the dollar were to strengthen further—and focusing
attention on a more suitable benchmark for future movements in the currency.
However, the PBC has not revealed what currencies will be in the basket that the
RMB’s value is managed against and what the weights on those currencies will be.

From August 2015 until January 2016, there was substantial downward pressure on
the RMB. China’s foreign exchange reserves, which peaked at nearly $4 trillion in
June 2014, fell to about $3.2 trillion by January 2016. Since then, the pressure
appears to have eased and the stock of foreign exchange reserves has stabilized.
However, there is still a lack of clarity about the precise nature of China’s exchange
rate policy, with PBC officials stating only that the value of the RMB is determined
by supply and demand, with the PBC also striving to manage the currency’s value
“with reference to” a basket of currencies.

Financial Sector Development and Reforms

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.

These reforms are important steps in the right direction. Future reforms and
development of the banking system will have significant implications for the
development of China’s more nascent financial markets, including the corporate
bond market and also for economic development more broadly.

In particular, 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. 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.

China’s financial markets have improved in some respects during the last decade,
but there are still significant gaps, especially in terms of achieving sufficiently large
and liquid debt markets. More importantly, the structure and quality of debt markets
will also need to be improved to fully prepare for a currency used widely in
international financial transactions and reserve holdings. With relatively low external
and government debt positions, China’s debt markets can in principle expand
rapidly without serious threat to inflation credibility or vulnerability to external risks. Effective regulation of corporate debt markets is an important priority, so these
markets can expand without generating financial instability. As discussed in the next
section, the financial system features prominently among the major risks that the
Chinese economy faces.

Economic and Financial Risks

The Chinese economy faces risks in several categories. The first is related to
capital account liberalization and the possibility of a surge of capital outflows, which
could destabilize the financial system as well as the overall economy. The second is
a set of concerns specifically about China’s financial system, including the stability
of the banking system, wild swings in the stock market, and a large shadow banking
system. The third set of risks is related to more fundamental aspects of China’s
policymaking. These include the possibility of policy missteps in the process of the
difficult and risky transition from a largely command-driven economy to a more
market-oriented one. Indeed, many of the reforms and measures taken to promote
the RMB’s international role have created their own risks for the economy.

The Capital Account

Allowing for the free flow of financial capital has been an important element of the
plan for increasing the RMB’s international stature. However, many developing
economies have faced crises when they opened up their capital accounts without
having a market-determined exchange rate and a well-functioning financial system.

An analysis of China’s external balance sheet, i.e., its international investment
position, suggests that the economy faces only modest direct risks from a more
open capital account. Foreign direct investment and portfolio equity together
account for 70 percent of China’s external liabilities. This structure of liabilities is
safer than one dominated by foreign currency debt.

China has traditionally had a low level of foreign currency external debt, which
amounted to about $800 billion or 7 percent of GDP in 2015, a lower ratio than
virtually any other major emerging market (total external debt, including debt
denominated in RMB, was $1.5 trillion). The stock of foreign exchange reserves,
which was $3.2 trillion in February 2016, is sufficient to meet all of these debt
obligations. Moreover, China’s net foreign assets amounted to $1.6 trillion at the
end of 2015, implying that it has enough foreign assets to more than cover all of its
foreign liabilities. In short, China is not subject to the traditional risks associated with
opening up the capital account in advance of increasing exchange rate flexibility.

China’s approach to capital account liberalization has allowed it to retain some
control over capital flows. The schemes the government has put in place allow it to
control the volume of flows in both directions and, to a significant extent, the
composition of flows as well. However, trying to maintain a gradual approach to
freeing up the exchange rate while opening up the capital account can create
tensions that show up in large and volatile movements of capital.


Capital Outflows and Capital Flight

Capital flow surges in one direction or another can be exacerbated if the exchange
rate is not allowed to adjust freely, and speculative pressures on the currency start
building up. The scale of outflows during 2015 indicate how sentiments about
economic and financial market conditions can shift quickly. These outflows put
pressure on the PBC to expend a significant portion of its reserves to keep the
RMB’s external value stable.

Many emerging market economies have faced balance of payments crises following
a rapid rundown of foreign exchange reserves. In China’s case, as noted earlier, the
stock of reserves still remains high by traditional metrics such as coverage of
imports or external debt. But if Chinese households and corporations were to
withdraw bank deposits on a massive scale and transfer the money abroad,
reserves would cover only about 15 percent of total deposits. To take account of
such factors, the IMF calculates a composite metric of reserve adequacy that takes
into consideration potential capital flow volatility. By this measure, China had one
and a half times the adequate level of reserves at the end of 2014. Even with the fall
in reserves since then, the stock remains above this metric.

A more worrisome aspect of capital outflows is related to capital flight through both
illegitimate and legitimate channels. Capital flight is quite different from more
conventional outflows that are driven by a desire for portfolio diversification or
macroeconomic factors such as better interest rates in other countries. One
possibility is that the anti-corruption drive has caused some ill-gotten wealth to leave
the country to avoid expropriation during the crackdown process.

Illicit capital flows are a particular concern for financial stability as they bypass
traditional channels that the government can control. One widely used proxy
measure for such flows is net errors and omissions (NEOs), which is the residual in
the balance of payments accounting and reflects unrecorded capital account or
current account transactions. Negative NEOs typically reflect money leaving the
country through unofficial channels. China’s NEOs have been persistently negative
since 2009. During 2014, such outflows amounted to $140 billion and in 2015 they
were $132 billion.

Money laundering and capital flight also go hand in hand. Casino operations in
Macau have long been seen as a major conduit for money laundering and illicit
capital flows from the Mainland. Regulatory authorities on the Mainland have taken
aggressive steps to combat these operations as capital flight has picked up. An
alternative channel for capital flight is related to informal financial institutions that act
as conduits for cross-border transfers. In 2015, China’s Ministry of Public Security is
reported to have cracked down on an illegal foreign-exchange network that it said
handled up to $64 billion in transactions. In September 2015, authorities discovered
37 underground banking dens accounting for deals totaling more than $38 billion,
according to a statement on the ministry’s website.

Although a full-blown capital flight crisis seems unlikely, particularly given China’s
relatively strong external balance sheet characterized by a low level of external debt
and a large stock of foreign exchange reserves, the government has certainly been
concerned about illegitimate outflows and the fact that they may exacerbate overall
capital outflows and add to financial and macroeconomic stresses the economy is
already facing.

The Debt Burden

China’s overall level of debt has raised considerable concerns about a looming
crisis. The level of central government debt was only 17 percent of GDP in 2015.
The IMF computes a measure of augmented public debt, which includes various
types of local government borrowing, including off-budget borrowing by such Local
Government Financing Vehicles (LGFVs) via bank loans, bonds, trust loans, and
other funding sources. By this measure, China’s public debt to GDP ratio is
estimated to be 60 percent in 2015, which would still be below the public debt to
GDP ratios of major advanced economies.

However, the broader picture of debt in China looks more worrisome. According to a
recent McKinsey report, the level of gross debt in 2014 was 282 percent of GDP.
This includes government debt (55 percent of GDP, similar to the IMF’s estimate)
and debt owed by financial institutions (65 percent of GDP), nonfinancial
corporations (125 percent of GDP), and households (38 percent of GDP). More
recent estimates suggest that corporate debt may have risen above 150 percent of
GDP by early 2016.

The level of Chinese corporate debt is a major concern, especially since a
substantial portion of outstanding bank loans has gone to large SOEs. The notion
that such high debt levels heighten the risks of a financial meltdown is, however,
overstated. The balance sheet of the government as a whole is healthier than an
examination of just the gross debt figures would suggest. There are undoubtedly
corporations that have borrowed too much and will suffer considerable financial
stress, which could result in bankruptcy or painful restructuring. The government, on
the other hand, has a large trove of assets—including its foreign exchange
reserves, ownership stakes in the state enterprises, and foreign investments
through the sovereign wealth fund.

A legitimate concern, however, is that many of the problems with debt in China will
ultimately cause a collapse of the banking system, which has financed much of the
debt accumulation.

Banking System

The average ratio of nonperforming assets (NPA)—loans that are unlikely to be paid
back—to total bank loans outstanding is around 2 percent. But this is widely seen,
even by the government itself, as an understatement of the true extent of the
problem. Adding in the category of “special mention” loans, those which are not yet
in default but have a high probability of becoming so, even the official data put the
NPA ratio at about 5 percent. Banks have kept NPAs off their books by
“evergreening” their loans, i.e., giving even weak and unprofitable companies new
loans to pay off their old loans.

Private analyst estimates of the actual ratio of NPAs range from 6–7 percent to as
much as 20 percent, with even higher ratios of around 25 percent for some of the
smaller banks. Still, Chinese banks do not face the potentially catastrophic
problems that many Western banks faced during the financial crisis. Most of their
funding comes from bank deposits, which tend to be stable, rather than from debt.
Moreover, banks have about 17 percent of required reserves at the PBC.

Even if a banking crisis can be avoided, however, it will still be necessary to cover
losses from loans made to companies that become insolvent or go bankrupt. This
could involve a combination of two types of measures—sweeping nonperforming
assets into asset management companies and infusing new capital into the banks.
This will ultimately result in a fiscal cost. This cost would be reduced by partial loan
recoveries, asset sales, and the use of loan loss provisions that banks maintain.
Still, the fiscal cost will be substantial.

A bigger question the Chinese economy faces is whether the financial system,
especially the banks, are being freed up from government directives and allowed to
operate on a commercial basis to a greater extent. While there has been modest
progress on banking reforms, at a minimum addressing the legacy problems
created by state-directed lending and distorted incentives in the banking system will
incur significant costs.

Shadow Banking

The government has also taken a more aggressive approach to rein in shadow
banking, which involves credit intermediation through entities and activities outside
the regular banking system. China’s shadow banking sector has expanded rapidly
as a way around many of the regulations imposed on the formal banking system
including (until recently) controlled interest rates, a high level of reserve
requirements on bank deposits, and rising demand for financial intermediation
services that are not satisfied by traditional institutions or conventional banking
products (both for savings and credit).

Definitions of the shadow banking system vary, but the major categories of credit
that fall under its rubric include (i) entrusted loans, which involve nonfinancial
corporates as borrowers and lenders, with banks acting as intermediaries but
bearing none of the credit risks; (ii) trust loans, which are financial transactions
undertaken by trust companies that are regulated separately from banks and have
some characteristics of banks and fund managers; and (iii) bank acceptances,
instruments issued by banks that commit to pay a fixed amount in a given period
and that are backed by deposits of the party seeking these certificates. There is a
range of other instruments included in definitions of the shadow banking system,
including wealth management products (WMPs) that offer higher returns than
traditional bank deposits and that can even be offered by banks themselves.

The shadow banking system is not large relative to that in many advanced
economies, although its growth rate in China in recent years is certainly among the
highest in the major economies. Based on data from Moody’s, shadow banking
assets amount to 65 percent of GDP in China, compared with 150 percent in the
United States and a world average, weighted by country size, of about 120 percent.

Concerns about the financial stability risks posed by the growth of shadow banking
have prompted the Chinese authorities to impose stricter regulation of shadow
banking activities, both by banks and nonbank financial entities. Off-balance sheet
activities by the commercial banks could affect their risk profiles. While trust
companies and other nonbank financial entities are not backed by the government,
their liabilities pose broader risks as the failure of any such institution could
undermine confidence in the overall financial system.

In its present form and at current levels, it is unlikely that the shadow banking
system by itself poses significant threats to overall financial stability. Nevertheless,
the government has been concerned that risks in this sector could translate into
vulnerabilities in the formal banking system (given the connections between the two
sectors through products such as WMPs).

With rising concerns about the financial stability implications of the shadow banking
sector, various regulatory agencies have stepped up their oversight of this sector.
This has resulted in a decline in shadow banking. In recent months, the flow of
credit associated with shadow banking has been small or even negative.

Stock Market Swings

After a sharp run-up during 2014 and the first half of 2015, Chinese stock market
indexes have fallen sharply. This prompted a series of measures by the government
to limit the stock market turmoil. Some of these measures were heavily
interventionist and, although described as emergency measures, they have hurt the
credibility of the government and created doubts about its attitude toward marketoriented
reforms. The measures included propping up stock prices and also limiting
activity that could push down prices.

The key measures to mitigate downward pressures on stock prices include:

  • Limitations on short selling, with the China Securities Regulatory
    Commission threatening to arrest those engaged in “malicious short selling”
  • A ban on initial public offerings for four months starting in July
  • Suspension of trading in the shares of over a thousand firms
  • A six-month ban on stock sales by stockholders with a 5 percent or higher
    equity stake in a given company

Measures to prop up prices through direct intervention include:

  • New rules allowing pension funds to invest up to 30 percent of their net
    assets in equities (previously, pension funds could not invest in equities)
  • Relaxation of rules on margin financing
  • Giving banks permission to make corporate loans using equity as collateral
  • A PBC pledge to lend RMB 250 billion ($40 billion) to major brokerage firms
    through the China Securities Finance Corporation to help them cope with
    liquidity shortages
  • State-owned funds and institutions encouraged to buy stocks

Other propaganda measures included news articles in official media blaming
“foreign forces” for the stock market turbulence. In addition, nearly 200 people were
arrested for allegedly spreading false information that caused the market crash.
Those arrested included financial practitioners, regulatory officials, and also
financial journalists.

The government’s other actions to stabilize the market have not inspired confidence
either. On January 4, 2016, the CSRC introduced a circuit breaker mechanism in
the Chinese stock market. This led to a negative reaction in markets, with the main
indexes plunging by about 14 percent over the next three days. The circuit breakers
were activated multiple times during that period, worsening the sell-off as many
market participants tried to sell their holdings before the circuit breakers were
activated. The circuit breaker was deactivated three days after its introduction. 

Chinese stock markets have been prone to concerns about weak corporate
governance, limited transparency, weak auditing standards, and shoddy accounting
practices. In the absence of broad institutional and regulatory reforms that are
necessary to support effective price discovery and the overall efficient functioning of
stock markets, these markets could remain unstable. The recent volatility in the
stock market and the manner in which the government has addressed it has
heightened many of these concerns.

Policy Instability

There are two reasons to be concerned about the path that China is taking towards
market-oriented reforms. The first is the unbalanced nature of the reforms. The
second is the government’s ambivalent approach towards economic liberalization
and the operation of free markets.

Reforms on the real side of the economy have not kept pace with financial
liberalization. The 13th five year plan echoes many items from the previous plan,
including further restructuring of state enterprises, liberalization of the services
sector so new firms can more easily enter this sector and operate with fewer
restrictions, streamlining of the tax and public expenditure systems, and easing of
restrictions on labor mobility within and across provinces. China’s economy and the
RMB’s rise have also been impeded by the lack of a robust institutional
framework—including transparency in the policy-making process, sound corporate
governance and accounting standards, and operational independence for the
central bank and regulatory authorities—that ought to supplement financial and
other market-oriented reforms.

The turmoil in equity and currency markets during 2015 and 2016 appears to have
shaken confidence in the economic management skills of the leadership. Such
volatility, and the heavy-handed intervention it has sometime