China is reaching a critical pass, after over two decades of reform and opening-up, in the development of social, economic, political, and legal systems.
The past few years have seen increasing debate over the economic reform. There are basically two camps. The first camp argues that China is not yet a country with mature socialist market economy, and its economic reform is still under the way. Consequently, the government continues to play an important role side by side with the market in resource allocation, while the dual-track system formed in the past is yet to be fully changed. Given the co-existence of the market and the government in resource allocation, a cascade of problems have been incurred, such as ecological degradation, decline of overall economic efficiency, waste of resources, sacrifice of minority groups' interests, and social injustice. To a large extent, these problems arise simply because the past reform has not been full and thorough. However, there is another camp that tends to put the blame on the reform and opening-up itself, citing the prevailing economic and social problems to underlie their suspicion of the validity of the policy.
The recent plenary session of the National People's Congress (NPC) held in March has provided a periodic conclusion to the dispute: China's economy can only develop through the reform and opening-up, and so can China's modernisation. Very likely, the significance of the NPC's plenary session will not be fully understood until years after. In the government work report endorsed by the NPC on March 5th, Premier Wen Jiabao unequivocally pronounced that, to attain the development goal of the new stage, the reform must be deepened and the opening-up must be broadened in an all-round way. He also added that the economic reform must be pushed forward along with the reforms of political, cultural and social management systems, making the opening-up a key driver of the reform and development. Premier Wen's speech has provided a clear-cut direction for China's future policies and development. In discussing the means of further reform and opening-up, he emphasised that the administrative reform must be stepped up, and the government functions must be further transformed, pushing forward the separation between ownership and management, and reduction and regulation of administrative licenses and approvals. This implies that anything that should not be undertaken by the government must be given to the hands of the market, businesses, social organisations, and intermediaries. In other words, the government should have its hands off from anything that can be handled by the market. When it specifically comes to finance, an important sector of China's economy, how shall we understand the essence of the plenary session of the NPC? How can we further deepen the reform and broaden the opening-up? As a scholar, I would like to share with you some of my views.
THE NECESSITY OF BROADENING AND DEEPENING THE FINANCIAL REFORM
China's economy is bound to be affected if the financial sector remains unreformed. One major reason for low efficiency of China's traditional growth pattern and waste of resources is the distortion of factor price which is directly related to the financial system. The price of financial capital has long been artificially kept on a low level, resulting in huge capital waste and low capital productivity.
The ultimate goal of financial reform is to serve real economy. It is of little value to focus on the number or market cap of listed companies, or the stock index; what is significant is the extent to which China's financial system serves its national economy and sustains the development of its real economy. Such a concept needs to be firmly established in academic research, policy formulation and practices. When we are talking about financial reform, we quite often forget what the ultimate goal of this reform is. We take it for granted that the financial reform aims to create a booming and mature financial sector and financial market. However, a healthy and prosperous financial sector is the means, with the development of real economy being the ends. In a market economy, or in any economy, real economy is the major force of value creation, whereas the financial sector is merely a reflection of the value of real economy.
To support and promote the development of real economy, the financial system must be able to accurately price financial assets. Only with accurate price signals, can the market mechanism effectively allocate resources and can the economic entities reasonably leverage and allocate capital. The pricing in this sense has dual implications, including pricing for revenues and pricing for risks of financial assets.
Apart from serving real economy, the financial system has an important role to reduce risks of the financial sector and to maintain the stability of finance and economy.
FOUR SPECIFIC OBJECTIVES OF THE FINANCIAL REFORM
Based on the ultimate goal, we have identified four specific objectives of the financial reform.
First and foremost, the financial reform should aim to build properly-behaved financial institutions that are profit- rather than policy-oriented organisations with the constraint of hard budget. Only with hard budget, can financial institutions develop an ability to identify and manage risks. We have seen too many examples in the banking sector or the securities market: huge losses were incurred by poor risk management. When the budget is soft, there is no hard measurement of the performance of financial institutions, and it is the government who eventually pays the bill for any loss. Under this system, problems are almost inevitable when financial institutions have no incentive to identify and manage risks. Apart from the ability to identify and control risks, properly-behaved financial institutions should also develop an ability to innovate to meet the demand for diversified financial products.
The second objective of the reform is to establish a financial market with considerable scale, depth and high efficiency. Such a market should be able to offer a wide spectrum of products with diversified participants. Only by meeting these requirements, is the market able to accurately price financial assets, send accurate price signals to the society, and guide the society to allocate resources effectively.
The third objective is to build an independent and effective financial regulatory system. Presently, the financial regulatory system in China is not independent, but affiliated to the government. Consequently, it is burdened by numerous social targets, serving as a government tool of policy implementation, rather than an effective means of market regulation. To improve regulatory efficiency, the regulatory system must be independent from the administrative system and subjects of regulation. Without independence, justice will be hampered and regulatory efficiency will be reduced. An independent financial regulatory system should operate by the law and for the law instead of by administrative orders. The practitioners of the regulatory system should be professionals in the market, rather than government officials and public servants.
The fourth objective is to develop a rational investor group. Without this element, the healthy development of the financial system is built on the sand. The rational investor group refers to those who, as investors, have a sound understanding of their rights and the access to information, and who, as shareholders, are endowed with right to vote and all other rights stipulated by the company charter. However, guaranteed return on investment is excluded from their rights; no investors have the right to require anyone, including the government, to warrant their returns on investment. Protecting investors' interests does not equal to guaranteeing their returns on investment. These are two different concepts. A rational investor enjoys the potential benefits and takes the potential risks simultaneously. Additionally, a rational investor should develop the concept of value investing, rather than follow the trend or pure speculation.
The financial reform has numerous objectives, but the above four are among the most important ones.
HOW TO REALISE THE OBJECTIVES?
How can we realise the objectives of the financial reform? Premier Wen has offered a solution in his words: "Anything that should not be undertaken by the government should be given to the hands of the market, businesses, social organisations, and intermediaries. Guided by this principle, we need to further lower the ratio of state ownership in the financial sector. In SOEs where the government is the major shareholder, the incentive for profit-making is insufficient, with the profit goal giving away to social goals. Also, fiscal and financial organisations are often mixed with each other under the state ownership, constituting the primary source of soft budget constraint in financial institutions. Corporate governance is another serious problem when the state remains the overwhelming majority shareholder. Therefore, the split-share reform is more than necessary, which should be carried out unswervingly. Equally problematic, the remuneration for employees at the state-owned financial institutions is not based on the market but on the package for public servants. Last but not the least, state ownership also gives rise to inequality, as the state-owned financial institutions have a natural advantage over private institutions in information, capital, policy and regulation.
Therefore, the government must withdraw from the financial sector to realise the reform objectives. It has been proved by global experiences that state-owned financial institutions are not likely to secure a sustainable development. Be they commercial banks, securities companies or insurance companies, financial institutions with genuine global competitiveness and sustainability are unexceptionally private-owned. In the case of China, it is imperative for the government to deepen the financial reform and to further reduce the proportion of state ownership. The existing state-owned or state-controlled financial institutions need to be privatised. If privatisation has to take long, they should at least be freed from policy tasks, with profit-maximisation as the top priority. In the meantime, their operation and management should be marketised, recruiting the management and employees from the market with a market compensation scheme.
Another important measure of the reform is to deregulate the financial trading and remove the approval system, endowing businesses with the right to issue stocks and bonds. At present, companies need to have the prior approval of the competent authority before they issue stocks and bonds. The approval system has been replaced by the filing system, which in many cases is the approval system de facto. The quota system for corporate bonds should be removed immediately; in the meantime, the price regulation over loans, stocks and bonds should be lifted gradually. The market should be open to develop a diversified body in the market, and the banking, securities and insurance sectors should be open to domestic private capital. Simultaneously, financial legislation should be accelerated to legalise the private placements, private equities, and underground money houses that have been active in the financial market. With laws in place, the government can better regulate.
In addition to withdrawing from financial institutions, the government should stop using public resources to rescue financial institutions. Instead, it should formulate legal procedures so that the rescuing efforts could resort to legal actions, not to officials' will powers. Which financial institutions should or should not be rescued? How should the rescue be conducted? What procedures should be employed? All these issues should be included in the legislation. Moreover, the government should stop all sorts of administrative measures to rescue the securities market, and resolutely leave both prices and indexes to the market.
BROADEN FINANCIAL OPENING-UP
There is a tendency in China to contradict financial opening-up with financial safety. However, we must recognise that the major factors jeopardising China's financial stability and safety are from inside, rather than from outside. In a basically self-closed market with virtually no foreign capital, our commercial banks have accumulated trillions of non-performing assets; over half of the securities companies are plagued by liquidity problem; the trust sector is still in a predicament in spite of several straightening-out efforts; and the reform of urban and rural credit cooperatives is in exploration and experimentation. All these realities demonstrate unequivocally that we haven't done a satisfying job of a thorough reform. The root cause for financial risks is the lack of incentive and ability for financial institutions to identify and control risks. To ensure the nation's financial safety and stability, the top priority is to develop or to reform a group of financial institutions into properly-behaved organisations, capable of identifying and managing risks and able to compete with foreign counterparts. This is the fundamental strategy to safeguard our financial safety.
The ultimate goal of financial development is to offer a diversified portfolio of low-cost financial products for businesses, institutions and individuals to promote national economic development and to enhance people's living standard. Therefore, whether a financial institution is foreign-owned or Chinese-owned is always secondary. The introduction of strategic foreign investors helps break the existing interest structure, and improve the corporate governance of financial institutions. Additionally, it reinforces the profit-seeking motivation, enhances the ability to identify and manage risks, and promotes innovation in products and services. Such a reform direction should be maintained, instead of being halted or even reversed.
How shall we increase the scale and depth of foreign investment? First of all, the upper limit of shareholding by foreign investors should be lifted gradually. Second, joint venture securities companies should be reopened. Third, foreign invested institutions should be allowed to be engaged in stock and bond rating business in China.
To conclude, the government must pull out from the financial industry as soon as possible. However, as Rome was not built in a day, the four objectives are not to be realised overnight. The reform takes enduring and assiduous efforts. But as a scholar, I feel obligated to contribute to the discussion and help form a consensus in the society. When rational policy and market expectations are built, our financial reform will move on smoothly.
The author is Professor of Economics and Finance at CEIBS. The article is based on the speech by Prof. Xu on April 6th at the forum "China 2006: Policy Initiatives and Implications. The original version is in Chinese and has been reviewed and approved by the author.
