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Investors will need a keener focus on credit and risk analysis in a challenging new terrain
CONTRIBUTORS AIDAN SHEVLIN, LAN WU
The Chinese government is committed to further financial sector reform, believing that market-driven interest rates and profit-minded institutions are central pillars of efficient capital allocation and continued economic growth. But the next phase of reform, full interest rate liberalization, will present fresh challenges. The government, regulators and banks will all look to strike a balance between free markets and government control, aiming to spur economic growth while restraining unhealthy financial risk.
Interest rate liberalization has begun gradually, and we expect that its evolution will continue at a fairly steady pace. However, in a centrally planned market, in which many investors do not fully understand or acknowledge counterparty and credit risks, the process could derail, at least temporarily. In addition, vested interests — including local governments and state-owned enterprises that benefit from cheap borrowing, as well as large commercial banks that enjoy attractive interest rate margins—could present roadblocks to liberalization. Finally, the recent slowdown in economic growth and rise in leverage will create further challenges.
Despite the various obstacles and complications, two powerful forces are at work: the government’s push to create a sustainable domestic growth model and the desire of investors to benefit from the higher yields of liberalized markets. Together they demonstrate China’s aspiration for more market-driven interest rates, better access to capital and greater investment choice.
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Financial sector reform is a key component of China’s multi-decade economic restructuring plan, designed to shift from a centrally planned, government-controlled economy to a unique Chinese hybrid best described as a socialist market system.
Historically, the People’s Bank of China (PBoC) has dominated China’s banking and financial sectors, but gradual liberalization has allowed commercial banks to establish operations, bond markets to actively trade, money markets to determine the price of liquidity and a shadow banking system to evolve. Still, China’s largest commercial banks have continued to dominate financial intermediation, while the PBoC’s prescribed deposit rates and other monetary policy controls have created vast distortions and overcapacity in many industries.
"The next major step in China’s financial reform—interest rate liberalization—is about to occur.”
The next major step in China’s financial reform—interest rate liberalization—is about to occur. This fundamental change in how Chinese financial institutions price interest rates and manage risk will have significant implications for investors.
Central elements of the proposed liberalization include the introduction of a deposit guarantee scheme and a legal framework by the government to remove the implicit guarantee all financial institutions enjoy, allowing failing banks to default. In addition, deposit rates will be liberalized and PBoC capital allocation controls will be removed.
These reforms should ensure more accurate, market-driven interest rates, a broader range of financial products and more competition. But they will also create greater uncertainty, risk and instability. More rigorous risk and credit analysis is critical for institutional investors to confidently invest in this new regime.
In 1978, China took its first steps toward economic reform, beginning a gradual shift from a centrally planned, government-controlled economy to a Chinese hybrid best described as a socialist market system. The government aimed to build a stronger, more powerful economy and improve living standards in a society that was still overwhelmingly rural.
More than 35 years later, China’s progress has been astonishing and the success of its reforms unmistakable. After many years of double-digit growth, a massive migration to cities and an extraordinary decline in poverty, China ranks as the world’s second-largest economy.
"Financial sector reforms have been critical to this transformation.”
Financial sector reforms have been critical to this transformation. From a single bank economy, in which the PBoC acted as both the central bank and a commercial bank, the sector has evolved into one characterized by publicly traded companies driven by market fundamentals.
But China’s large commercial banks continue to dominate financial intermediation, while the PBoC exerts strong control over interest rates and markets. This has created pervasive distortions throughout the financial system, subsidizing borrowers, limiting private enterprise credit and curtailing the impact of other social reforms. In addition, the limitations of China’s current investment- and export-focused economic model have become apparent, with slower GDP growth and spiraling borrowing required to maintain the government’s avowed pace of expansion.
Today, China stands on the brink of a major financial reform—interest rate liberalization. The Chinese government and the PBoC are committed to fundamental changes that will move the Chinese economy from an investment-driven to a more sustainable, domestically driven, consumption-based growth model. Recent comments by the PBoC suggest that it expects full interest rate liberalization within a medium-term horizon of three to five years.
How might interest rate liberalization impact investors? Though much will depend on the government’s final policy, we believe that interest rate liberalization will create significant and widespread uncertainty. t will dispel investor complacency and force a new attention to risk in all bank and financial products.
In the 65-year history of the People’s Republic of China, no bank has ever defaulted, creating a widespread belief that all banks enjoy an implicit government guarantee. This has muted natural investor caution and encouraged injudicious investments in a wide range of high-risk, opaque financial instruments
Removal of this moral hazard will stimulate the need for more accurate and insightful counterparty risk analysis. Even before interest rate liberalization takes full effect, investors will have to shift their perspective, carefully considering risk-reward trade-offs as they have never done before.
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